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 Auditing theory and practice 
 
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AUDITING 
 
 THEORY AND PRACTICE 
 
 BY 
 
 ROBERT H. MONTGOMERY, C.P.A. 
 
 of the firm of Lybrand, Ross Bros. &. Montgomery. Editor Dicksee's 
 
 ''Auditing*' (American Edition), Instructor in Accounting, 
 
 Columbia University. Formerly Lecturer on Auditing, 
 
 University of Pennsylvania and New 
 
 York University. Attorney-at-Law. 
 
 NEW YORK 
 
 THE RONALD PRESS COMPANY 
 
 1912 
 
 "' L;i;Af;Y 
 
his 
 
 Copyright, 191 2, by 
 ROBERT H. MONTGOMERY 
 
 Entered at Stationers' Hall, London 
 
 j4// rights reserved 
 
TO 
 
 E. S. M. 
 
 . ^ v'- WITHOUT WHOSE INSPIRATION 
 
 THIS BOOK WOULD NOT 
 
 HAVE BEEN WRITTEN 
 
PREFACE 
 
 There is a demand for a practical book on auditing which 
 up to this time has not been met. If my twenty-four years of 
 continuous experience in professional accountancy work is a 
 sufficient practical training, I trust I have established a prima 
 facie excuse for the presentation of this book, which contains 
 more of practice than of theory. 
 
 Auditing, in its broadest sense, is the most important branch 
 of accountancy. During the early years of my clerkship in the 
 office of Mr. John Heins, of Philadelphia (then President of the 
 American Association of Public Accountants), and later, while 
 acting as an instructor in the School of Accounts and Finance 
 of the University of Pennsylvania, I strongly felt the need of a 
 dependable textbook on the subject. My attention was all the 
 more directed to the paucity of books on auditing and on other 
 accounting and cognate subjects by contrast with the full and 
 comprehensive literature of the legal profession which I had 
 found of such great assistance in my studies preparatory to 
 admission to the bar. 
 
 Mr. Dicksee's work on auditing was for many years an au- 
 thority in American offices. In 1905 I published an American 
 edition of his book, in which I omitted the statutes and other 
 matter which related solely to British practice, and rewrote, or 
 left unchanged, the parts applicable to American practice. The 
 book met with such success that in 1909 a second edition was 
 required. 
 
 During the last few years, however, I have noted in the pro- 
 fession a radical departure from the principles and procedure 
 enunciated by Mr. Dicksee. More is now expected of the 
 auditor, and, happily, many of the profession have met this 
 broader demand and have shown that the services of the prac- 
 titioner must extend over the whole field of business activity. 
 In view of these recent and important developments, I feel 
 
vi PREFACE 
 
 justified in giving a subordinate place in this work to what were 
 formerly regarded as the chief objects of an audit; and what I 
 consider to be the major objects of a modern audit are discussed 
 exhaustively. 
 
 It may be that I am too radical in some of my interpreta- 
 tions of the ideal procedure. Perhaps to follow strictly the rules 
 laid down in this book would require more time than any auditor 
 is willing to devote to a single engagement. The exigencies of 
 a particular case may make the opportunities for investigation 
 more limited than the auditor would wish them to be. But the 
 student and the young practitioner particularly should, never- 
 theless, be careful not to restrict the scope of their theory and 
 practice until they have considered the last safeguard which 
 can be applied to business transactions and have followed up the 
 slightest hint which may throw light upon any irregularity in a 
 concern under audit. 
 
 I would not have the courage to present this book to the pro- 
 fession if it had not been for the commendatory assurances and 
 helpful suggestions of my partners, William M. Lybrand, C. P. 
 A., and Walter A. Staub, C. P. A., and my friend Joseph E. 
 Sterrett, C. P. A., who read all my manuscript and to whom I 
 am tremendously indebted. I am also indebted to John R. Wild- 
 man, C. P. A., of the New York University, who also read my 
 manuscript and from whom I received many suggestions which 
 I am sure will make the book more helpful to students. 
 
 The very comprehensive chapter on Municipal Auditing was 
 (with very minor exceptions) prepared by U. L. Leonhauser, 
 C. P. A., Secretary of the Metz Fund for Promoting Efficient 
 Municipal Accounting and Reporting. 
 
 Other suggestions of value have cofne to me from my friends 
 in the profession, among whom I must mention Herbert M. 
 Temple, C. P. A., Waldron H. Rand, C. P. A., George T. Klink, 
 C. P. A., E. G. Shorrock, C. P. A., Seymour Walton, C. P. A., 
 Edward L. Sufifern, C. P. A., an5 John B. Geijsbeek, C. P. A. 
 
 Necessarily much of my work was done at irregular inter- 
 vals, which meant that my notes required careful revision and 
 arrangement. This work was done for me by Gerald van 
 Casteel, Esq., of the New York Bar, and I take this opportunity 
 to express my appreciation of his able and conscientious work. 
 
PREFACE vii 
 
 As my friends did not undertake to rewrite all of my manu- 
 script, I am conscious of many imperfections in the present 
 volume, and I shall gratefully receive any constructive criticism 
 with which I may be favored by those who feel enough respon- 
 sibility in connection with accountancy literature to contribute 
 to another edition of this book, which I suppose will appear in 
 the course of time. " 
 
 Robert H. Montgomery. 
 55 Liberty St., New York, 
 2d Sept., 1912. 
 
TABLE OF CONTENTS 
 
 CHAPTER I. PURPOSE OF. THIS BOOK 
 
 PAGE 
 
 Auditing an analytical; practical accounting a constructive science i 
 
 Conventional balance sheets not always intelligible 2 
 
 Financial statements should be informational as well as statistical 2 
 
 Example of financial statement 3 
 
 Practical business experience an essential supplement to theoretical study 
 
 of auditing 7 
 
 Auditing as "the profession of business advice" 7 
 
 CHAPTER II. THE PURPOSES AND ADVANTAGES 
 OF AN AUDIT 
 Auditors must educate business men to appreciate the advantages of an 
 
 audit 8 
 
 Audits formerly confined to detection or prevention of fraud and error — 
 
 now of broader scope 9 
 
 Minor objects of an audit lo 
 
 Detection of fraud 1 1 
 
 Misappropriation of money or goods 1 1 
 
 Manipulation of accounts for ulterior purposes I2 
 
 Detection of errors — usually accounting work only 13 
 
 Errors of principle I3 
 
 Clerical errors '4 
 
 Errors of omission — tests usually sufficient 15 
 
 Errors of commission 16 
 
 Oflfsetting errors 16 
 
 Auditor's purpose: to discover and disclose the truth about accoimts 17 
 
 Advantages of an audit '^ 
 
 Condition of affairs accurately shown by a disinterested expert 18 
 
 Bai^ loans facilitated by certified accounts 18 
 
 Partnership difficulties obviated by continuous audit 20 
 
 Fire losses more favorably adjusted upon an authenticated balance 
 
 sheet 20 
 
 Audits facilitate the bonding of employees 21 
 
 Audits give protection to stockholders and the public 21 
 
 Sale of business easier when accounts are certified 22 
 
 Recovery from auditor for negligence 23 
 
 ix 
 
X TABLE OF CONTENTS 
 
 CHAPTER III. THE AUDITOR'S QUALIFICATIONS 
 
 PAGE 
 
 Bookkeeping 24 
 
 Accounting: must consider values as well as figures 24 
 
 Value of theory high, but must be supplemented by practical experience. . 25^ 
 General experience of business customs and methods and of economic and 
 
 legislative problems essential to an auditor 26 
 
 Special faculties essential to an auditor 27 
 
 Education 29 
 
 Special and prehminary knowledge; professional education; knowledge 
 
 of law 30 
 
 Moral qualities 30 
 
 Audit clerks' attitude toward principal and clients 31 
 
 Qualifications required by the public 32 
 
 Incompetent "auditors" 32 
 
 Misfit cost-keeping systems 33 
 
 CHAPTER IV. THE DUTIES OP AN AUDITOR 
 
 Non-professional and amateur auditors: danger of employing 34 
 
 Corporate provision that certified accountants must be employed 35 
 
 Official auditors employed by national and state governments 36 
 
 StaS auditors, or comptrollers should not assume executive work 37 
 
 Professional auditors defined 38 
 
 Auditor not an insurer 38 
 
 Employees' bonds, reasons for, and manner of insisting upon 39 
 
 Audit of a Firm or Individual 
 
 Auditing for a partnership 40 
 
 Partnership agreements, auditors' ability to draw up 41 
 
 (1) Nature of business. 
 
 (2) Capital. 
 
 (3) Changes in capital. 
 
 (4) Interest on capital. 
 
 (5) Withdrawals. 
 
 (6) Undrawn profits. 
 
 (7) Interest on loans or withdrawals. 
 
 (8) Distribution of profits or losses. 
 
 (9) Approval of accounts. 
 
 (10) Salaries of partners. 
 
 (11) Dissolution. 
 
 (12) Special causes for dissolution. 
 
 (13) Settlement after dissolution. 
 
 (14) System of accounts. 
 
 (15) Disputes over accounts. 
 
 (16) Firm insurance. 
 
 (17) How to avoid litigation. 
 
TABLE OF CONTENTS xi 
 
 Audit of Corporations p^^j, 
 
 OfiBcers and directors: business advice by the auditor to 44 
 
 Informal proceedings by officers as to salaries, dividends and loans 45 
 
 Directors' interests in contracts and liabilities for debts and unearned 
 
 dividends a-. 
 
 Tactful criticism by auditor of corporate affairs 48 
 
 Advantages of corporation audit 48 
 
 Auditor's responsibility 49 
 
 (i) to stockholders. 
 
 (2) to directors. 
 
 (3) to officers. 
 
 Auditor as an Expert Witness 
 
 Preparation always essential 50 
 
 Witness can testify to his own work only 51 
 
 Information should not be volunteered, nor unfavorable facts unnecessarily 
 
 disclosed gi 
 
 Conclusions and opinions 52 
 
 Practical limitations as to impartiality of expert witness 52 
 
 The Auditor of an Institution or Similar Organization 
 
 Reasons for and against accepting such engagements 54 
 
 All institutions soliciting funds should be audited 54 
 
 The Subscriptions Investigating Committee of the Chicago Association 
 
 of Commerce 54 
 
 Special Audits 
 
 Classes of «. 54 
 
 Caution as to assuring auditor's fee in special audits 55 
 
 CHAPTER V. ETHICAL DUTIES— LEGISLATION 
 
 Precepts of professional conduct 56 
 
 Rules of professional conduct 57 
 
 Legislation 
 
 Proposed act for compulsory certification of financial statements in 
 
 Pennsylvania 58 
 
 Proposed "New York Business Companies Act" 59 
 
 Officers 60 
 
 Meetings 60 
 
 Balance sheet 61 
 
 Duties of auditors 62 
 
 Private balance sheet 63 
 
 English Companies (Consolidation) Act 1908 64 
 
 CHAPTER VI. HOW TO BEGIN AN AUDIT 
 
 (i) As to the client: fixing the legal responsibility 66 
 
 (2) Do not start until you are sure you will finish 66 
 
xii TABLE OF CONTENTS 
 
 How TO Begin an Audit (Continued) page 
 
 (3) Secure the friendly cooperation of the client's staff 67 
 
 (4) Fees: compensation must depend on service rendered; per diem rates; 
 
 scale of fees in New York City; instance of proper acceptance 
 
 of a contingent fee °9 
 
 (5) As to where the work is done 73 
 
 (6) Working papers; stationery; classifying errors; permanent filing 77 
 
 (7) Familiarity with system in use 77 
 
 (8) Schedules of books, records, and names of clerks 78 
 
 (9) Procedure where previous audits have been made 79 
 
 (10) Final considerations: detailed or balance-sheet audit? 79 
 
 Detailed audit: relation of proper internal check and staflE audit 
 
 upon 80 
 
 Balance-sheet audit 82 
 
 System of internal check 83 
 
 (i) The cashier 83 
 
 (2) Vouchers 84 
 
 (3) Sales 84 
 
 (4) Ledgers 84 
 
 (5) Other considerations: inventories, collections, incoming mail, pay 
 
 rolls, vacations 84 
 
 Suggestions to client's staff before commencing work 85 
 
 (i) Final balance. 
 
 (2) ControlUng accounts. 
 
 (3) Schedules of negotiable paper, etc. 
 
 (4) Creditors' statements. 
 
 (5) Vouchers. 
 
 (6) Inventory. 
 
 (7) Accounts receivable. 
 
 CHAPTER VII. BALANCE-SHEET AUDIT— ASSETS 
 
 General — Current Assets 
 
 General principles and limitations of balance sheet audit 87 
 
 Current Assets 
 
 Liens and hypothecations 89 
 
 Proportion of current accounts to other habilities and capital 89 
 
 Cash 
 
 Cash in bank; pass books; excessive balances 91 
 
 Cash on hand; "cash items"; petty frauds; several accounts 92 
 
 Accounts Receivable 
 
 Trade debtors; consignments; normal volume of outstandings 94 
 
 Suggestions as to overdue accounts 96 
 
 Discounts . . . . ' 96 
 
 Rents, etc., receivable 97 
 
TABLE OF CONTENTS xiii 
 
 Accounts Receivable (Continued) pj^GE 
 
 Miscellaneous; advances on contracts; illustrations; deferred charges to 
 
 operating 97 
 
 Deposits which are not "accounts receivable" 99 
 
 Verification of outstandings by correspondence 100 
 
 CHAPTER VIII. BALANCE-SHEET AUDIT— ASSETS (Continued) 
 
 Current Assets 
 
 Notes receivable; business customs as to; discounted notes; dishonored notes. loi 
 
 Stock subscriptions 103 
 
 Installment contracts 103 
 
 Inventories 
 
 Raw materials and stock to be resold in the same form 104 
 
 Basis of value shoidd be: "cost or market, whichever is the lower" 104 
 
 Discussion of the English rule that "an auditor is not a valuer" 105 
 
 Rules for Verifying Inventories 
 
 Thirteen general rules for verifjring inventories 107 
 
 In re Kingston Cotton MiU Company case 108 
 
 Gross profits 109 
 
 Goods in process no 
 
 Finished goods; anticipating profits; overhead expenses in 
 
 The turnover 112 
 
 Supplies, stores, etc . .' 113 
 
 Investment securities 113 
 
 Securities as stock-in-trade; market values; coupons; precautions necessary 
 
 in examining securities 113 
 
 Temporary investments, expediency of making; test of availability of 
 
 holdings 115 
 
 Postage and other stamps 116 
 
 Deferred charges to operation : 116 
 
 CHAPTER IX. BALANCE-SHEET AUDIT— ASSETS (Continued) 
 Fixed Assets 
 
 Period to be covered 117 
 
 Overvaluations to offset stock issues 117 
 
 Component elements of the values 118 
 
 Value as a going concern and "scrap" valuation 119 
 
 Land and buildings, free and clear title to 1 19 
 
 (1) Land should appear at cost; improved and unimproved property; 
 
 illustrative cases 121 
 
 Increased value is not always an increase in assets 122 
 
 (2) Bmldings; leaseholds; depreciation of building and appreciation 
 
 of land 122 
 
 Machinery and equipment; depreciation; record of machinery; excessive 
 
 depreciation reserves; reserve for obsolescence; discarded machinery. . 124 
 
xiv TABLE OF CONTENTS 
 
 Fixed Assets (Continued) page 
 
 Small tools '^5 
 
 Furniture and fixtures ^^° 
 
 Packages; deposits on packages 127 
 
 Horses 127 
 
 Wagons, automobiles, etc 127 
 
 Patterns, drawings, lasts; sentimental valuations; changes in style 127 
 
 Electrotypes, woodcuts, etc 128 
 
 Patents; factors in depreciating value of 129 
 
 Fictitious "Patent" accovints 129 
 
 Copyrights 130 
 
 CHAPTER X. BALANCE-SHEET AUDIT— ASSETS (Continued) 
 Fixed Assets (Continued) 
 
 Good will; writing off and manipulation of 131 
 
 Computation of good will; charts of multipliers and factors in computa- 
 tion of good will 132 
 
 Sinking funds 135 
 
 Funds and other permanent investments 136 
 
 Treasury stock, valuation of 138 
 
 Unissued capital stock ; 139 
 
 Wasting Assets 
 
 Values to be written down 139 
 
 Mines 140 
 
 Timber land 140 
 
 Contingent assets; possible credits 140 
 
 Capital stock calls and assessments 140 
 
 Liabilities of directors : 141 
 
 Secret Reserves 
 
 (1) Plant additions charged to maintenance 142 
 
 (2) Excessive reserves for depreciation, etc 142 
 
 (3) Inventories should reflect fair values 143 
 
 (4) Writing down assets; bank permises 144 
 
 Stockholders' interest in knowing of secret reserves 146 
 
 CHAPTER XI. BALANCE-SHEET AUDIT— LIABILITIES 
 
 The balance sheet as a basis for credit 148 
 
 Accounts payable: balance sheet omissions 140 
 
 Trade creditors: checking orders and receiving records; discounts 151 
 
 Consignments I c. 
 
 Notes payable: individual loans j » «.' 
 
 Mortgages j cc 
 
 Bonds I eg 
 
 Judgments i c- 
 
 Interest payable j -g 
 
 Taxes: federal corporation tax law j -g 
 
TABLE OF CONTENTS xv 
 
 Balance-Sheet Audit — LiABitiTiES (Continued) p^gj. 
 
 Water rates igg 
 
 Wages 159 
 
 Rent 160 
 
 Freight i6o 
 
 Traveling expenses and commissions 160 
 
 Legal expenses 160 
 
 Audit fees 160 
 
 Damages 161 
 
 Deposits 162 
 
 Unclaimed dividends 163 
 
 CHAPTER XII. BALANCE-SHEET AUDIT— LIABILITIES (Continued) 
 
 Contingent Liabilities and Capital 
 
 General remarks 165 
 
 Notes discounted 165 
 
 Indorsements: accommodation indorsements 166 
 
 Outside enterprises 168 
 
 Guarantees 169 
 
 Unfilled contracts 170 
 
 The minute book 171 
 
 Reserves 
 
 General considerations 172 
 
 When should a reserve account appear among the liabilities? 173 
 
 Capital and Surplus 
 
 Criticism of conventional balance sheet 176 
 
 Capital stock: overvaluations of property 176 
 
 Premiums on capital stock 177 
 
 Sinking fund accounts 177 
 
 Reserve for working capital 178 
 
 Preferred stock accumulated dividends 179 
 
 Surplus 179 
 
 CHAPTER XIII. PROFIT AND LOSS ACCOUNT 
 
 General considerations 181 
 
 Legal definition of profits 182 
 
 Economic definition of profits 183 
 
 Accountant's definition of profits 184 
 
 Earnings 
 
 Gross earnings 185 
 
 Returns 185 
 
 Ordinary transactions only to be included 186 
 
 Allowances and rebates 186 
 
 Bad debts: expense of credit department 186 
 
xvi TABLE OF CONTENTS 
 
 Earnings (Continued) page 
 
 Treasury ruling on bad debts '°° 
 
 Work in progress: legitimate anticipation of earnings 187 
 
 Departmental profits - 189 
 
 Profit of subsidiary companies: U. S. Steel Corporation's practice 190 
 
 Sales for future delivery: International Harvester Company's practice. . . . 192 
 
 Participations and tmderwritings 193 
 
 Profit on sale of assets 1 193 
 
 Appreciation in value of assets I93 
 
 CHAPTER XIV. PROFIT AND LOSS ACCOUNT (Continued) 
 
 Expenses and Losses 
 
 Reserves and "net profits" 195 
 
 Depreciation — should it be included in current? 197 
 
 Obsolescence: increased efiiciency of new machinery 199 
 
 Accrued expenses, etc 200 
 
 Cash discounts 201 
 
 Trade discounts 201 
 
 Disposition of profit after being determined 202 
 
 English law as to disposition of profits 202 
 
 Profit and Income 
 
 General considerations 203 
 
 Dividends must not be paid from capital: 
 
 New York Stock Corporation Law provision 204 
 
 English law 204 
 
 Decedents' estates: importance of distinction between capital and income in. 205 
 
 Wasting assets 205 
 
 Interest 205 
 
 Dividends 206 
 
 Stock and extraordinary cash dividends 206 
 
 CHAPTER XV. CERTIFICATES AND REPORTS 
 
 Importance of report and precautions as to rendering . 207 
 
 Something more than figures are wanted in a report 208 
 
 Terminology of report must be intelligible to all 208 
 
 Scope of report: results more important than methods 209 
 
 Certificate of audit; avoid ambiguous quaUfications 210 
 
 Forms of certificates 211 
 
 Report of audit subsequent to balance sheet date 211 
 
 Precautions as to suppression of qualifications from report 212 
 
 Form of balance sheet: American and English practices 212 
 
 The ideal balance sheet; specimen forms 214 
 
 Relation of the groups in a balance sheet more important than the arrange- 
 ment of the groups 2ifi 
 
 Statement required by banks 216 
 
TABLE OF CONTENTS xvii 
 
 Certificates and Reports (Continued) p^gg 
 Standard forms of borrowers' statement: 
 
 New York Bankers' Association 217 
 
 American Bankers' Association 220 
 
 Mercantile agencies' 222 
 
 CHAPTER XVI. CERTIFICATES AND REPORTS (Continued) 
 
 Statements requested by credit managers 224 
 
 Credit statement recommended by National Association of Credit Men ... 225 
 
 Liens and hypothecations 227 
 
 Profit and Loss Statement 
 
 General considerations 228 
 
 Condensed form of profit and loss statement 229 
 
 Arrange accounts to show comparison with previous periods and unit costs. 230 
 
 Use of charts 230 
 
 Sales charts 231 
 
 Gross and net profit charts : 232 
 
 Combined purchase and sale charts 233 
 
 Pay roll chart 235 
 
 Product and shipment'chart 236 
 
 Value of comparative statistics: prevention of defalcation 237 
 
 What not to report 238 
 
 Restrictions on client's use of reports 239 
 
 Misleading advertisements 239 
 
 Compulsory reports: EngUsh practice as to 240 
 
 CHAPTER XVII. THE DETAILED AUDIT 
 
 General Principles 
 
 Completed audit defined 241 
 
 Continuous audit defined 241 
 
 Audit note books, their value discussed 242 
 
 Cooley's "American Audit Record," specimen pages 244 
 
 The Audit of Income and Expenses 
 
 General principles 247 
 
 Prior periods ' 247 
 
 Verification of footings and postings 248 
 
 (1) Purchase records 250 
 
 (2) Sales records 251 
 
 Controlling accoimt 251 
 
 Checks received must be deposited 252 
 
 Periodical verification of bank balances 252 
 
 (3) Cash receipts ' 253 
 
 (4) Cash payments 255 
 
 Summary ^56 
 
 Other records, advantages of having 256 
 
xviii TABLE OF CONTENTS 
 
 CHAPTER XVIII. THE DETAILED AUDIT (Continued) 
 
 Verification of Income page 
 
 General considerations 258 
 
 Sales: importance of examining "memo" books 259 
 
 Examination of balance sheets for omissions 260 
 
 Cash discounts: manipulation of 261 
 
 Collections not accounted for: common irregularities 262 
 
 Confirmation of outstandings: forms 262 
 
 Income from investments ■ 265 
 
 Interest receivable; outside ventures and loans; bank interest 266 
 
 Discount for prepayment , 267 
 
 Trade discounts, test of 267 
 
 Rents receivable 268 
 
 Realizations from items previously charged to profit and loss 269 
 
 Consignments and goods out on "memorandum'' 269 
 
 Goods received for sale 270 
 
 Anticipating profits on sales not delivered 271 
 
 Sales of building lots 273 
 
 CHAPTER XIX. THE DETAILED AUDIT (Continued) 
 
 Purchases and Expenses 
 
 Vouchers 274 
 
 Paid cheques as receipts 274 
 
 Instances of forgery 275 
 
 Purchase invoices 276 
 
 Wasting time on checking vouchers 277 
 
 Missing vouchers 278 
 
 Vouchers for petty cash payments, pay roll, etc 279 
 
 Petty cash 279 
 
 The imprest system 280 
 
 Organization and other similar expenses which affect more than one year's 
 
 operation 281 
 
 Selling campaigns and seasonal business 282 
 
 Extraordinary expenditures 283 
 
 Legal expenses and "graft" 284 
 
 Repairs and renewals 284 
 
 Allbwances and returns 285 
 
 Empties 286 
 
 Salaries 287 
 
 Salesmen's commissions 287 
 
 Traveling expenses, entertaining, etc 288 
 
 Wages 288 
 
 Duties 290 
 
 Interest and collection charges 290 
 
 Insurance premiums 291 
 
TABLE OF CONTENTS xix 
 
 Purchases and Expenses (Continued) p^Qj. 
 
 Freight and express 292 
 
 Postage 292 
 
 Journal vouchers 293 
 
 Purchase returns , 294 
 
 Cancellation of vouchers 29s 
 
 CHAPTER XX. THE DETAILED AUDIT (Continued) 
 
 The Trial Balance 
 
 General considerations 296 
 
 Outstanding accounts 297 
 
 Bad or doubtful accounts 297 
 
 Asset and Liability Items 
 
 Notes receivable 299 
 
 Notes receivable protested 299 
 
 Inventories 299 
 
 Premiums and discounts on bonds to be amortized 300 
 
 Premiums on capital stock 300 
 
 Branch accounts 301 
 
 Capital expenditure 302 
 
 Cash discounts on capital payments 303 
 
 Real estate 303 
 
 Buildings , 304 
 
 Machinery, etc 305 
 
 Notes payable 305 
 
 Partners' withdrawals 305 
 
 Dividends 305 
 
 Stock dividends 306 
 
 Capital stock 307 
 
 Bonds 307 
 
 Taxes 307 
 
 Office Methods 
 
 General considerations: the "efficiency engineer" and the stationery "audit" 
 
 houses 308 
 
 OfBce appliances, styles of books and records 309 
 
 Piling systems; essential features of 310 
 
 Copying 311 
 
 Mailing department 311 
 
 Stock on hand 3ii 
 
 Controlling subsidiary ledgers 3^4 
 
 Columnar ledgers 3I5 
 
 Efficiency of organization 3i5 
 
 EfSciency theory applied to office work 316 
 
XX TABLE OF CONTENTS 
 
 CHAPTER XXI. DEPRECIATION 
 
 PAGE 
 
 Definitions, fluctuation, and depreciation 3I7 
 
 N. Y. Court of Appeals and Treasury Department, definitions of depre- 
 ciation 318 
 
 Causes for depreciation 319 
 
 Repairs and maintenance 320 
 
 Methods of applying depreciation in the books: 
 
 (i) Fixed percentage basis 320 
 
 (2) Sinking fund method 321 
 
 N. Y. Third Avenue Railway Co. case 322 
 
 (3) Production method 326 
 
 Depreciation by exhaustion 326 
 
 Sinking fund reauirements to retire bonds, etc., must not be confused with 
 
 depreciation allowances 327 
 
 Depreciation is an operating expense 328 
 
 Depreciation a local issue 329 
 
 Investment of depreciation reserves 329 
 
 Importance of provision for obsolescence 330 
 
 Depreciation of different classes of property 331 
 
 Land depreciation 331 
 
 Buildings; table of allowances for depreciation of 332 
 
 Leaseholds 333 
 
 Machinery and equipment 334 
 
 Rates of depreciation of equipment; tables of 335 
 
 Small tools 336 
 
 Furniture and fixtures 336 
 
 Landlord's fixtures 336 
 
 Horses 336 
 
 Wagons, automobiles, etc 337 
 
 Sliips 337 
 
 Patents 337 
 
 Copyrights 337 
 
 Good will 338 
 
 Wasting Assets 
 
 Mines 338 
 
 Timber lands 338 
 
 Public Utility Companies 
 
 Table of rates of depreciation of 339 
 
 CHAPTER XXII. THE CORPORATION TAX LAW 
 AND DEPRECIATION 
 
 Provision of the law and Treasury Department ruling on 340 
 
 Nipissing Mines Company case 341 
 
 Treasury decision 1742 344 
 
TABLE OF CONTENTS xxi 
 
 CHAPTER XXIII. SPECIAL POINTS IN DIFFERENT 
 CLASSES OF AUDITS 
 
 Financial p^^^ 
 
 Introductory , . 8 
 
 National and State Banks 
 
 Official examination of ,40 
 
 Clearing house examiners of 350 
 
 Responsibilities of bank directors 351 
 
 Cash and securities 3^2 
 
 Correspondents' accounts 353 
 
 Confirmation of demand notes, etc 353 
 
 Certificates of deposit and certified checks 354 
 
 Capital stock 354 
 
 Depositors' accounts 354 
 
 Verification of income 355 
 
 Expenses 355 
 
 Secret reserves 356 
 
 Internal checks 356 
 
 Scope of report 356 
 
 Instances of fraud 357 
 
 N. Y. National City Bank's circular on Bank Examination by Directors. 358 
 
 Savings Banks 
 
 General procedure 360 
 
 Trust Companies 
 
 Powers 361 
 
 Procedure 362 
 
 Investment Companies 
 
 General considerations 362 
 
 Fluctuation reserve 364 
 
 Ascertaining the real value of investments 365 
 
 Stockbrokers 
 
 General considerations 365 
 
 Cash book; clearing house blotter 366 
 
 Ex-clearing house blotter; general ledger; customers' ledger; stock record; 
 
 margin record 367 
 
 Record of money loans; record of stock loans; other books; use of abbre- 
 viations; program of audit 368 
 
 "Blind accounts" 370 
 
 Instances of fraud 371 
 
 Building and Loan Associations 
 
 General considerations 372 
 
 Verification of income 373 
 
xxii TABLE OF CONTEXTS 
 
 Bdilding and Loan Associations (Contiaued) pagb 
 
 Expenses 374 
 
 Inspection of securities; distribution of profits 374 
 
 Forms of balance sheets, etc 37^ 
 
 CHAPTER XXIV. SPECIAL POINTS IN DIFFERENT 
 CLASSES OF AUDITS (Continued) 
 
 Insurance Companies 
 
 General considerations 378 
 
 Fire Insurance Companies 
 
 General considerations 379 
 
 Instance of fraud 380 
 
 Liabilities 381 
 
 Life Insurance Companies 
 
 General considerations 382 
 
 Model forms 384 
 
 Casualty, Health, Surety, Title Guarantee, and Other Companies 
 
 Insurance companies and the corporation tax 389 
 
 Manufacturing 
 
 Pay roll; freights; depreciation of plant 390 
 
 Miscellaneous income; rents; cost and stock accounts 391 
 
 Model forms 392 
 
 Publishers of Books 
 
 Royalties 394 
 
 Salability of stock; consigned goods; stock on hand 395 
 
 Drawings; book-plates 396 
 
 Overvaluation of plates and copyrights; installment business; postage. . . . 397 
 
 Publishers of Magazines and Newspapers 
 
 Advertising and circulation 398 
 
 Subscription income 398 
 
 Verifying the circulation 399 
 
 Manipulation of circulation records 399 
 
 Subscription earnings account 400 
 
 Reserve for returns; printing and mailing; job printing 401 
 
 Breweries 
 
 Opportunities for theft of supplies; collections; investments in saloons. . . . 402 
 
 Mining — Coal Mines 
 
 Sales and inventories; car records; royalties .q.. 
 
 Provision for reduction and depreciation .q. 
 
 Mortgages on coal and ore lands ,qc 
 
TABLE OF CONTENTS xxiii 
 
 Gold Mines p^cb 
 
 General considerations 406 
 
 Trading — ^Wholesale Merchants 
 
 Possibilities of fraud 407 
 
 Foreign business 407 
 
 Retail Merchants 
 
 Internal sales audit ^ 408 
 
 Transactions with employees 409 
 
 Broken package goods 409 
 
 Charging stock at sale prices 409 
 
 Credit memoranda 410 
 
 Department Stores 
 
 Internal audit; C. O. D. and "wiU call" purchases 410 
 
 Merchandise purchases 411 
 
 Discounts on piurchases; salaries and wages; expenses 411 
 
 Departmental accounts; seasonal balances; gross profit on sales 412 
 
 Verifying assets and liabilities; inventory 413 
 
 Automobile Dealers 
 Deposits; cars on hand; accounts receivable; manufacturers' accoxmts; 
 
 inventories 414 
 
 Repair work; time reports; free repairs 415 
 
 Branch Accounts 
 Methods of treating; permanent cash fund; duplicate records; goods billed 
 
 to branches 416 
 
 Schedules of branch debtors; foreign branches 417 
 
 CHAPTER XXV. SPECIAL POINTS IN DIFFERENT CLASSES 
 OF AUDITS (Continued) 
 
 Public Service Corporations 
 
 Powers of public service commissions 418 
 
 Interstate Commerce Commission 419 
 
 Depreciation as affecting rate regulation 420 
 
 Discussion on method of determining profits 420 
 
 Distinction between construction and maintenance 422 
 
 Additional equipment; proper capital charges 423 
 
 Standard schedule of revenue and expense 424 
 
 Appraisals of Public Utilities 
 
 Suggested procedure 425 
 
 Steam Railroads 
 
 Standardization of accounting 427 
 
 Apportionment between construction and maintenance 428 
 
xxiv TABLE OF CONTENTS 
 
 Steam Railroads (Continued) page 
 
 Traffic earnings 4^8 
 
 Internal audit; reports of station agents; instances of fraud 4^9 
 
 Depreciation charges 43° 
 
 Shipping Companies 
 
 Charter-parties; depreciation; insurance fund 43 ' 
 
 Electric Railways 
 
 Classification of accounts 433 
 
 Revenue 433 
 
 Ticket sales; advertising; miscellaneous receipts; outstanding tickets 434 
 
 Apportionment between capital and income; construction and equipment. . 435 
 
 Depreciation of plant; reconstruction expenditures 436 
 
 Liability for damages; accident reserves 438 
 
 Taxicab Companies 
 
 Master's sheet; driver's card 439 
 
 Mileage records; depreciation 440 
 
 Forms of financial statements 441 
 
 Electric Light and Power Companies 
 
 Accounting systems; forms of consumers' register 445 
 
 Meter-reader's book; sales of appliances 446 
 
 Gas Companies 
 
 Sale of residuals 447 
 
 Sale of appliances; expenditures; depreciation 448 
 
 Water Companies 
 
 Flat rate and meter charges; consumers' ledger; municipal ownership 449 
 
 Uniform accounts 450 
 
 Telephone Companies 
 
 Disposition of gross revenue by Bell System 450 
 
 Assets; income; plant; taxes; directories; depreciation 451 
 
 Commercial department; subscribers' ledger; depreciation 452 
 
 Depreciation reserve 453 
 
 CHAPTER XXVI. SPECIAL POINTS IN DIFFERENT CLASSES 
 OF AUDITS (Continued) 
 
 Municipal 
 
 Preparation of budget; fixing of tax rate 455 
 
 Authorization of expenditures; business departments of a city 456 
 
 Sources of revenue ; control of receipts and expenditures ac-j 
 
 Controlled financial stationery ^ eg 
 
 Periodical examinations .en 
 
 Audit of revenue. 
 
 460 
 
 Taxes 460 
 
TABLE OF CONTENTS xxv 
 
 Municipal (Continued) p^^gg 
 
 Assessments ' 45q 
 
 Rents and franchises 461 
 
 Audit of outstanding accounts 461 
 
 Audit of expenditures ^gj 
 
 Sinking funds 462 
 
 Financial statements 463 
 
 General Account Balance Sheet 
 Accounts receivable — ^unpaid taxes; miscellaneous revenues receivable; 
 due from other funds; stores; temporary loans in anticipation of 
 taxes 464 
 
 Capital Account Balance Sheet 
 Cash; assessments receivable; local improvements in progress; other ac- 
 counts; depreciation ; 465 
 
 Assessment or special improvement bonds; bonded debt 466 
 
 Trust Fund Balance Sheet 
 
 Cash, securities, and investments 466 
 
 Invoices payable, vouchers and pay rolls payable, warrants payable; re- 
 serve for public and private trusts 467 
 
 Current Operation and Surplus Account 
 U. S. Census Bureau classification 467 
 
 Fund Balance Sheet — General Account 
 Authorizations to incur liabilities; estimated revenues; appropriations not 
 
 liabilities 468 
 
 Available balance and unapplied balance; reserve for retirement of loans; 
 
 Metz Fund Hand Book 469 
 
 Fund Balance Sheet — Capital Account 470 
 
 Summary Consolidated Balance Sheet 470 
 
 Municipal Accounts, Forms 471 
 
 CHAPTER XXVII. SPECIAL POINTS IN DIFFERENT CLASSES 
 OF AUDITS (Continued) 
 
 Executors and Trustees 
 
 The wiU or deed of trust; inventory; income from securities 475 
 
 Rentals; vouchers; commissions; investments; apportionment between 
 
 principal and income 47^ 
 
 Premiums paid on securities 477 
 
 Partition of an estate; minors 478 
 
 Educational Institutions 
 Income; examination of securities; annual report; accounting records 
 
 generally 479 
 
xxvi TABLE OF CONTENTS 
 
 Charitable Organizations pagb 
 
 General considerations; patients' accounts; State appropriations and 
 
 audits; income and expense accounts 480 
 
 Disbursements; trust funds; uniform accounts 481 
 
 Forms of uniform accounts required of charitable organizations by the 
 
 comptroller of New York City 482 
 
 Churches 
 Special features of church accounts 484 
 
 Clubs 
 
 Income; dues; room charges; restaurant and bar orders; miscellaneous 
 
 receipts; depreciation of furnishings; apportionment of expenses 486 
 
 Architects 
 Payments; commissions and fees; imfinished work 486 
 
 Doctors 
 Patients' ledger; recording visits; credits; payments; depreciation on 
 
 automobiles, etc 488 
 
 Lawyers 
 Special features of accounts; separation of personal and trust funds; 
 
 clients' accounts 489 
 
 Contractors 
 Separate accounts for each contract; pay roll and materials; certificates 
 
 of work in progress; determining profit on xmcompleted contracts. ... 491 
 Subcontractors 492 
 
 Real Estate 
 Verifying rentals; expenses 492 
 
 Commissions; allowances for accrued taxes; insurance premiums; bonuses; 
 
 tract development; illustration of fraud 493 
 
 Land and Development Companies 
 
 Scope of operations; expenses and additions to property 494 
 
 Lot ledger; construction ledger; cost and operating ledgers; details of 
 
 points to be covered in audit 495 
 
 Hotels 
 Earnings and expenses; receipts; depreciation of furnishings 497 
 
 Restaurants 
 Service and collections; checker 407 
 
 Advertising Agencies 
 Details to be considered ^-7 
 
TABLE OF CONTENTS xxvii 
 
 Theaters p^cb 
 
 Cash system; verifying receipts; methods of keeping accounts 498 
 
 Settlement sheet; weekly statement; procedure in audit of theater ac- 
 counts; attendance book 499 
 
 Theatrical Companies 
 Preliminary expenses; properties; costumes; electrical apparatus; scenery; 
 
 vouchers; depreciation 500 
 
 CHAPTER XXVIII. INVESTIGATIONS 
 
 General considerations 502 
 
 Classes of investigations 503 
 
 Scope of the Work 
 
 Instructions from clients; working papers to be preserved 503 
 
 Details which may be omitted 504 
 
 Where assets are appraised; definite report wanted; handling books and 
 
 records 505 
 
 False entries sometimes forgeries; books as evidence 506 
 
 Loose-leaf records; erasures; original records necessary 507 
 
 (i) Upon the Sale or Purchase of a Business 
 
 Chief points of difference 508 
 
 (a) Something more than figures wanted 508 
 
 Compilation of business statistics 510 
 
 (b) Period covered 511 
 
 (c) Analysis of earnings and expenses; gross earnings 512 
 
 Net earnings and fluctuations 513 
 
 Comparative statement of a trading business . . . . : 514 
 
 Verification of sales; common manipulations 515 
 
 The turnover 516 
 
 Profits on fluctuations; decrease in expenses 517 
 
 Advertising and other deferred charges; leases 518 
 
 Inventories 519 
 
 Other factors which affect earnings 520 
 
 (d) Future requirements and economies; an auditor should not prophesy. . 520 
 
 Insufficient capital 522 
 
 Economies exaggerated 523 
 
 Former owners' attitude ..." 524 
 
 Competition 525 
 
 (e) System of accounts; criticism should be postponed 525 
 
 Condition of accounts an index to proprietors; preparation for new 
 
 system 5^6 
 
 CHAPTER XXIX. INVESTIGATIONS (Continued) 
 On Sale or Purchase of a Business (Continued) 
 
 (f) Elimination of unusual items; earnings; income from assets not taken 
 
 over interest on deposits; sale of assets 528 
 
xxviii TABLE OF CONTENTS 
 
 On Sale or Purchase of a Business (Continued) pagh 
 
 Appreciation of assets; insurance profit; damages for change of grade, 
 
 etc., expenses; excessive reserves 5^9 
 
 Defalcations; fire and other losses not insured; actions at law 53° 
 
 (g) Adjustments and qualifications; partners' salaries; contracts 53' 
 
 Taxes; royalties 532 
 
 Orders of public service commissions 533 
 
 (h) Errors in books . ; 533 
 
 (i) Investigation on behalf of a retiring partner when the business is being 
 
 sold to a continuing partner 534 
 
 Valuation as "going concern"; accounts receivable 535 
 
 Cost of stock; apportionment of profits or losses on contracts 536 
 
 Income accoimt 537 
 
 (j) Investigation for those in charge of reorganizations 537 
 
 (2) Investigation for Creditors, Etc. 
 
 (a) Examination for bankers: 
 
 Extension of business 539 
 
 Collateral v. integrity 540 
 
 Future business; bank loans to be repaid 541 
 
 (b) Investigation for purely credit purposes: 
 
 Functions of credit manager; character, capital, and capacity. . . . 542 
 Business failures in the U. S.; economy of compulsory audits; 
 
 unscientific methods 543 
 
 Lack of capital; credit risks 544 
 
 Insurance; errors of principle 545 
 
 Fraud; character 546 
 
 (c) Investigation in patent legislation: 
 
 General considerations; general accounting principles do not 
 
 govern 547 
 
 (3) Fraud 
 
 The "trusted employee'' 548 
 
 Possibihties to be studied; extent of fraud 549 
 
 Attitude toward a defaulter; admissions 550 
 
 The MiUwall Dock Case; the Bank of Liverpool Case 551 
 
 CHAPTER XXX. HOLDING COMPANIES 
 
 Consolidated balance sheets and profit and loss statements; balance sheet. 553 
 
 Form of balance sheet csa 
 
 Accounts receivable ccg 
 
 Profit and loss account ecy 
 
 Unprofitable subsidiaries c c8 
 
 Preparation of profit and loss account ccg 
 
 Partial ownership of subsidiaries; comparative statements cgj 
 
TABLE OF CONTENTS xxix 
 
 CHAPTER XXXI. INTEREST 
 
 PAGH 
 
 Various methods of calculating interest; principal 563 
 
 Rate of interest; time 565 
 
 Custom in banks and trust companies 566 
 
 Custom among business houses; custom among stockbrokers 567 
 
 N. Y. Clearing House; U. S. Treasury Department 568 
 
 The unit period 568 
 
 CHAPTER XXXII. THE LIABILITIES OF AUDITORS 
 
 Legal responsibility 571 
 
 Exact status of an "Auditor" in England 573 
 
 Liefl of an auditor; rights of an auditor retained by the year and dismissed 
 during the year; criminal liability of auditor for corruptly and know- 
 ingly certifying falsely 574 
 
 As TO THE Civil Liability of an Auditor Who Is Negligent in the 
 
 Preparation of His Report and Like Matters 
 
 (i) In general 574 
 
 (2) Cases where the auditor was held not Hable 577 
 
 (3) Cases where the auditor has been held liable 580 
 
 (4) Periodical audits 587 
 
 (5) No expedient can overcome the obligation of the auditor to make full 
 disclosure to the stockholders 588 
 
 (6) As to the hability of an auditor for libel 588 
 
 Summary 5^8 
 
 Official Legal Opinion on Duties and Liabilities of Auditors 590 
 
 CHAPTER XXXIII. THE LIABILITIES OF DIRECTORS 
 
 Board-minutes inspection; compensation of directors 593 
 
 Directors may inspect books; legal Uabihties of directors 594 
 
 The American Malting Co. case 595 
 
 CHAPTER XXXIV. FEDERAL TAX ON CORPORATIONS 
 
 General considerations 601 
 
 Full text of the law 602 
 
 Accountants' discussion of the law with the Attorney General 608 
 
 Interpretation of the law by Treasury Department 614 
 
 Regulations by Commissioner of Internal Revenue 618 
 
 Treasiury decisions on corporation tax law 624 
 
 Inconvenience of making returns for calendar year 631 
 
 Partnership and individual excise tax 632 
 
 CHAPTER XXXV. CERTIFIED PUBLIC ACCOUNTANT LAWS AND 
 
 EXAMINATIONS 
 
 States having laws -for regulating professional accountants 639 
 
 General scope of the examinations 640 
 
 Specimen examination papers 641 
 
Y 
 
CHAPTER I 
 PURPOSE OF THIS BOOK 
 
 The purpose of this book is to set forth the principles under- 
 lying the theory and practice of auditing and to outline the 
 working program which must be followed in whole or in part 
 in every audit. 
 
 An ideal audit cannot be made without a full perspective 
 of the science of accounts, for many who have a good working 
 knowledge of the details of practical accounting find it difficult 
 to visualize, as it were, the records of business transactions. 
 
 The auditor who best accomplishes his task is the one who 
 is able to put himself in the place of those for whom the accounts 
 are intended, and he will not find this easy unless he has been 
 trained to make the most of the figures which appear in a balance 
 sheet or profit and loss statement. To present correct accounts 
 is not enough, because correct accounts may not be clear to 
 those for whom they are intended. A scientific system of ac- 
 counts is a method whereby a graphic and intelligent record of 
 facts may be assembled and by logical processes reduced to 
 readable form. 
 
 Auditing is the analytical, as practical accounting is the 
 constructive, branch of accountancy. 
 
 But the modern auditor is more than an analyst. The log- 
 ical development of his profession and the increased apprecia- 
 tion of the value of his work have added to his former duties 
 certain constructive functions which must be fulfilled in connec- 
 tion with a large proportion of his engagements. 
 
 The average business man has been trained from boyhood 
 to read facts and figures from continuous printed pages. The 
 trial balance of a ledger means nothing to him, except that part 
 of it which contains the accounts receivable and payable, and 
 these must not be called "Debit Balances" or "Credit Balances" 
 if we would avoid the chance of being misunderstood. 
 
 Many intelligent people fail to grasp the usual and conven- 
 tional hypothesis underlying the theory of double entry book- 
 
2 AUDITING 
 
 keeping, and therefore facts or figures presented to them in a 
 technical or formal shape may not accomplish the intended 
 result. 
 
 Probably the majority of business men have been shown 
 trial balances from their books which mean nothing to them, 
 and this applies to the usual monthly balance as well as to the 
 one made after closing the books. A balance sheet in conven- 
 tional form is perfectly clear to the eye trained to read and 
 understand figures and is perhaps as concise and satisfactory 
 an exhibit as could be desired for the person who understands 
 figures, but thousands of business men frankly acknowledge that 
 they do not grasp the full import of a financial statement in the 
 accepted form. 
 
 But if the man who is entitled to know all the facts con- 
 tained in these balance sheets cannot or will not understand this 
 method of presentation, is it not our duty to try another form 
 and keep on trying until the results of his business become as 
 interesting reading to him as the daily trade reports? If the 
 client had his own way he would ask for a report on his busi- 
 ness prepared so that he could read it. 
 
 This is the point of view to which every accountant must 
 direct his attention until he can so connect figures and trans- 
 actions that an audit will no longer mean a mere verification of 
 the figures in the books, but will include a lively appreciation 
 of every ramification of the business. In other words, the 
 auditor must visualize the transactions themselves to see that 
 their conversion into dollars and cents is reflected in the books 
 of account. 
 
 The proprietor knows intuitively all of the possible func- 
 tions of his business; the auditor may not know them intui- 
 tively, but he must ascertain how and why the proprietor looks 
 at the business as he does, otherwise there will be no meeting 
 of minds between the auditor and his client. Without a com- 
 plete understanding of each other's point of view, ideal profes- 
 sional relations can never be maintained. 
 
 The following memorandum is submitted as suggestive 
 only, but it is more than likely that it would be read through 
 to the end by every man or woman who might have an interest 
 in the enterprise in question. 
 
PURPOSE OF THIS BOOK 3 
 
 Statement of Financial Condition of A and B at the 
 Close op Business, December 31, 1911 
 
 The total assets of the firm on this date amounted to 
 $213,333, consisting of the following items: Cash in bank, 
 $9,465. This is somewhat less than is usually carried, but a 
 number of bills were paid on December 31st, which reduced the 
 bank balance accordingly. Bills Receivable, $8,450. These are 
 notes not yet due, and are all believed to be good. They can, if 
 necessary, be discounted at the bank and furnish additional 
 funds. Accounts Receivable, $29,416. These were gone over 
 carefully on December 31st, and an amount equal to all accounts 
 long overdue was charged to Profit and Loss and carried to 
 Reserve for Bad Debts account. They are also carried in a 
 separate ledger and are being carefully looked after, and a fair 
 amount will no doubt be realized therefrom. The sales for the 
 month of December were nearly $20,000, and, as practically all 
 sales are at thirty days' time, it is evident that collections are in 
 fine shape. 
 
 Stock was taken on December 31st and amounted to $39,460. 
 The market was somewhat lower on that date than when most 
 of the goods were purchased, so, in order to be conservative, the 
 inventory was priced at market. All obsolete and damaged 
 stock was inventoried, but was not valued. It is proposed to 
 dispose of all this dead stufif as soon as possible, as it is in the 
 way, and is the source of constant expense and annoyance. The 
 inventory sheets have been securely bound and placed in the 
 safe. 
 
 The insurance on stock aggregates $45,000, which is about 
 ten per cent in excess of the inventory. The rate, however, is 
 only about forty cents since the installation of the sprinkler 
 plant, and, as the amount fluctuates from day to day, it is con- 
 sidered advisable to cover a small margin above the estimated 
 stock. The insurance question comes up automatically once a 
 week so that we cannot be caught unawares, as was the case 
 recently with the X Y Z Company. 
 
 In November, we paid the insurance for an entire year in 
 advance, so that on December 31st the proportion prepaid 
 amounted to $762, which is carried as an asset, because it should 
 be charged against the operations of 1912. We also paid the 
 
4 AUDITING 
 
 discount on the notes at bank in advance to the extent of $412, 
 and this is carried as an asset in the same way as the insurance. 
 
 On a conservative basis, the furniture and fixtures on hand 
 on December 31st were worth over $6,000, but as liberal depre- 
 ciation has been written off each year, this item now stands at 
 $3,418. We are carrying insurance for $6,500, however, and 
 in case of a fire there would be no trouble about adjusting the 
 loss and proving our claim, as a carefully prepared schedule 
 of each article, with date of purchase and cost price, is kept 
 in the safe. 
 
 Our land and buildings are now carried at a net valuation 
 of $84,710, made up as follows: Cost of land in 1897, $50,000; 
 cost of buildings, $49,862. We have carried to our reserve 
 account annual depreciation at the rate of four per cent per 
 annum, reducing the accounts to $34,710. This rate is probably 
 tbo high, as two and one half per cent per annum is stated to 
 be the proper rate of depreciation on buildings like ours, but, 
 as the depreciation is charged into the expenses every year, it 
 keeps us on the safe side when figuring our costs, and, if it 
 should ever be considered advisable to tear down some of our 
 older buildings, the rate of depreciation charged will be justified. 
 The machinery account now stands on our books at a net valua- 
 tion of $37,240. The original cost of the machinery now 
 installed in the plant was over $60,000, but depreciation at rates 
 varying from ten to twenty per cent per annum has been 
 charged on the same theory as with buildings. Much of our 
 machinery is of a type which is subject to improvements and 
 new inventions, and, as has been the case in the past, some 
 so-called modern machines may become obsolete over night. If 
 our machinery account were carried on our books at cost or 
 nearly so, as is done by some of our competitors, we would no 
 doubt be afraid to abandon it for fear of the resulting shrinkage 
 in our assets, but the liberal depreciation charged and the con- 
 sequent margin in this account permit us to keep absolutely 
 up to date with our entire equipment. Unquestionably a fair 
 share of our continued success as manufacturers is due to this 
 policy. 
 
 Our auditors tell us that they have never examined the 
 affairs of a single bankrupt concern where the machinery 
 
PURPOSE OF THIS BOOK 5 
 
 account was not inflated by reason of insufficient depreciation 
 being written off, and they point out that the moral is obvious. 
 
 The depreciation on buildings and machinery is not de- 
 ducted directly from the respective accounts, but is carried 
 separately as a reserve. The reason for this is that in case of 
 fire we can submit the cost of all the buildings and machinery 
 to the adjusters and show them the accounts in the books. We 
 have a subsidiary building and machinery ledger, which shows 
 each building and each machine separately with cost of installa- 
 tion, etc. The aggregates of the detailed items in this ledger 
 agree exactly with the totals in the general ledger. 
 
 If a fire occurred it would be a matter of negotiation as to 
 the deductions for wear and tear, and, as the adjusters would be 
 obliged to make their calculations on a basis of the life of the 
 buildings and machines or their replacement cost, we ought to 
 realize a much larger amount than that shown in the balance 
 sheet. This conservative valuation not only means that we 
 are not fooling ourselves, but our banks realize that we are not 
 fooling them and compliment us on our method every time 
 it is explained to them. 
 
 The President of the National Bank told us a short time ago 
 that he believes we can borrow a larger amount on our state- 
 ment as it is made up than some concerns whose plants may 
 have cost far more, but whose methods are not as conservative. 
 The distrust occasioned by lack of conservatism leads a banker 
 to discount all the assets ruthlessly, while with us they feel 
 perfectly safe in relying on our figures and "go the limit" when 
 we ask for credit. 
 
 The assets referred to above aggregate at their reduced valu- 
 ation $213,333. The total liabilities on December 31st amount 
 to $74,493, leaving net capital invested in the business $138,840, 
 of which there stands to the credit of Mr. A. $74,910. and to 
 the credit of Mr. B. $63,930. 
 
 The liabilities in detail are as follows : 
 
 Bills payable, $18,500, consisting of three notes for $5,000 
 each, and one for $3,500. The former were discounted at the 
 National Bank and are due January 25th, February 25th, and 
 March 2Sth. The $3,500 note was discounted at the Citizens 
 Bank and is due February 25th. As our purchases are increas- 
 
6 AUDITING 
 
 ing, due to the approach of the busy season, these notes will 
 have to be renewed and additional funds secured. Our line at 
 the National Bank is now $40,000, and at the Citizens Bank 
 $25,000. This is more than sufficient to carry us through the 
 season and will enable us to discount all our bills. The unpaid 
 accounts payable for purchases on December 31st amounted 
 to $24,218. No bills are overdue, and all invoices carrying cash 
 discounts have been paid. 
 
 The collections which are sure, are not sufficient to meet all 
 of our bills on our regular pay day (the 20th), so $10,000 should 
 be borrowed, say on the i8th. The accrued wages up to the 
 night of the 31st amounted to $1,340. 
 
 The taxes accrued to the same date amounted to $435. This 
 represents a tax rate of two per cent, which is a decided advance 
 over last year. We are unable to discern any additional benefits 
 arising out of the increase, and it might be in order to suggest 
 to the municipal authorities that it is up to them to establish 
 efficiency and cost records and justify the enormous sums they 
 are expending annually in an apparently aimless manner. 
 
 The only remaining liability is the mortgage for $30,000 on 
 the real estate. As the interest rate is five per cent and as it is 
 not due for three years, no action with respect to this debt is 
 suggested. 
 
 The foregoing narrative is necessarily colorless and lacks 
 the local flavor which might easily be woven about the balance 
 sheet of a going business, so that as read solely by those con- 
 nected with the particular undertaking, one item after another 
 would awaken interest and stimulate action with respect to 
 those figures which might appear to be unfavorable. 
 
 It is not hard to imagine a state of affairs different from 
 that described, and it is quite within reason to prophesy that 
 a cleverly written description of balance sheets in the manner 
 described would excite decisive action on the part of an execu- 
 tive with respect to unfavorable items where previous efforts 
 along routine lines had failed. In any event, it is well worth 
 trying, particularly in connection with a profit and loss or trad- 
 ing statement where comparisons are important and instructive. 
 An occasional witticism or business "story" would not be out 
 
PURPOSE OF THIS BOOK 7 
 
 of place, assuming always that a proper diagnosis has been 
 made of the executive to whom the report is addressed. 
 
 There are many ramifications of business affairs which can- 
 not be understood without more or less actual experience and 
 technical training, and which therefore cannot be satisfactorily 
 elucidated within the limits of one book ; but it is the firm belief 
 of the author that a common-sense knowledge of bookkeeping 
 and a general acquaintance with business aifairs are the most 
 necessary foundation of the student of auditing. 
 
 It is not expected that a clerk with a httle knowledge of 
 accounts or a business man with no practical experience in other 
 lines than his own can by a mere reading of these pages acquire 
 at once the skill necessary for the professional accountant. 
 Nevertheless, this book is intended for the instruction of those 
 having but little experience as well as for the guidance of the 
 qualified public accountant. Accountancy is a science, and it 
 should be possible to present its underlying principles so that 
 they may be comprehensible to the average mind. Theory 
 alone, however, will never qualify anyone to practice as a public 
 accountant any more than a medical student is qualified to prac- 
 tice medicine, no matter how thorough a knowledge of the 
 science of medicine he may have acquired through lectures and 
 books, unless he has had an opportunity to verify his book knowl- 
 edge and demonstrate his skill in the hospital and the clinic. 
 
 If anyone who proposes to take up the study of auditing, 
 has not had a fairly thorough training in bookkeeping, and in 
 addition has not had sufficient practical experience in business 
 aflfairs to enable him to keep his poise when he is required to 
 think and act quickly, he had better postpone his course until he 
 has acquired enough experience to lay the necessary foundation. 
 
 It is absurd for any student to take it for granted that a good 
 memory applied to a book on auditing will make him a good 
 auditor. 
 
 The work of the auditor engaged in public practice is im- 
 portant enough to raise this work to the dignity of a profession. 
 It has been called the proiession of business advice. Some one 
 has defined a profession as a calling which demands of its mem- 
 bers a high order of intellectual attainment, which can be 
 acquired only by long and arduous preliminary training. 
 
CHAPTER II 
 
 THE PURPOSES AND ADVANTAGES OF AN AUDIT 
 
 The average business man is not familiar with the purposes 
 and advantages of an audit. A small minority have retained 
 professional auditors and have gained their impressions of what 
 an audit should be from the experiences growing out of such 
 employment. 
 
 Where the auditor possessed a broad vision and had the 
 advantage of long and varied experience, the result was a revela- 
 tion to the business man. He found the value received so 
 greatly exceeded the cost of the service that the relation became 
 a continuing one. The client advised other business men to do 
 likewise, and so the practice of the skillful auditor expanded. 
 
 But why is it that so many business men have never availed 
 themselves of the opportunity to secure a service which has 
 proved to be so valuable to their competitors, and why is it that 
 many practitioners have not succeeded in enlarging their prac- 
 tice during the last few years, while a considerable number of 
 auditors have built up large organizations and now have 
 intrusted to them a very large volume of work ? It must be that 
 the business man who does not employ professional auditors is 
 ignorant of the advantages of an audit, and that the would-be 
 auditor who fails to secure enough engagements lacks the full 
 conception of the objects of an audit, and therefore fails to 
 create the proper impression upon the clients whom he does 
 obtain. It follows that he will not be called upon for subsequent 
 service, and naturally he is not recommended to the friends of 
 his client. 
 
 The author has had nearly twenty-four years' experience in 
 professional auditing in the United States. During this time 
 there has been a vast development in commerce and finance and 
 the science of auditing has made equal strides. But this latter 
 fact is not known to all business men nor to all of those who 
 have decided to enter the accountancy profession. 
 
 There will be further and rapid developments, but one can 
 
 8 
 
THE PURPOSES AND ADVANTAGES 9 
 
 hardly hope to keep pace with progress, much less be a factor 
 therein, unless acquainted with its history. 
 
 The author has had the pleasure and privilege of knowing 
 most of the successful practitioners in this country. He is famil- 
 iar with their methods and he has watched the growth of their 
 organizations. 
 
 The successful auditor is the best medium through which 
 the business public will gain knowledge of the advantages of 
 an audit. To be successful the auditor himself must have a 
 thorough and definite grasp of the purposes of an audit. 
 
 The following observations and suggestions are based upon 
 a careful study of actual conditions and may be relied upon by 
 the student as representative of the accumulated experience of 
 the auditors who head the profession at the present time. 
 
 THE PURPOSES OF AN AUDIT 
 
 In what might be called the formative days of auditing 
 students were taught that the chief objects of an audit were : 
 
 (i) The detection or prevention of fraud; 
 
 (2) The detection or prevention of errors ; 
 but in recent years there has been a decided change in the 
 demand and in the service. That is to say, the financiers and 
 business men who originally retained professional auditors to 
 look for fraud or errors have enlarged their demands and now 
 require a vastly broader and more important class of work, 
 which those auditors who have advanced in skill and knowledge 
 have been able to understand and perform. We must therefore 
 relegate the former "chief objects" to a subordinate position 
 without in any way depreciating their importance. 
 
 The relative position of the present-day purposes are : 
 
 (i) To ascertain the actual financial condition and earnings 
 of an enterprise for 
 
 (o) Its proprietors (partners or stockholders) ; 
 
 (&) Its executives (managers, officers, or directors); 
 
 (c) Bankers or investors who are considering the purchase 
 of securities ; 
 
 (d) Bankers who are considering the discounting or pur- 
 chasing of its promissory notes. 
 
 (2) The detection of fraud or errors as hereinafter explained. 
 
lo AUDITING 
 
 The results secured by auditors are required for the follow- 
 ing, among other purposes : 
 
 (o) In order that stock and bond holders or other owners 
 may have submitted to them at regular intervals a compre- 
 hensive, even though a condensed, statement of the financial posi- 
 tion and the net results of the operations of the business in which 
 they have a proprietary interest, and that the fairness and accu- 
 racy in all essential particulars of the statement submitted may 
 be attested by means of a certificate or report of a disinterested 
 and competent authority. 
 
 {b) Upon a proposed sale or incorporation or other change in 
 form or management, such as an attempt to bring in additional 
 capital or the death of a partner or large stockholder. Matters 
 of the highest importance arise in connection with the interests 
 of partners in the event of death or other change in the partner- 
 ship relations. 
 
 (c) To submit similar statements in more detail to banks and 
 note brokers as a basis of credit. 
 
 (d) To submit certified statements to the mercantile agencies 
 and to other organizations which call for periodical reports. 
 
 (e) To ascertain the true causes of fluctuations in profits or 
 expenses. 
 
 (f) To state the facts in disputes or litigation, and to investi- 
 gate the causes of bankruptcy for creditors or stockholders. 
 
 This is a partial list only of the manifold purposes for which 
 audits or investigations are being demanded. 
 
 The nineteenth century auditor who looked chiefly for fraud 
 or errors no doubt served a useful purpose, but his methods now 
 illustrate the history rather than the modern practice of 
 auditing. 
 
 Due consideration will now be given to the subject of fraud 
 and errors. In subsequent chapters the present-day demands 
 for "higher" auditing will be met with a full discussion of the 
 more important work of the professional auditor. 
 
 THE MINOR OBJECTS OF AUDIT 
 
 The elementary or minor objects of an audit are: 
 (i) The detection of fraud. 
 
THE PURPOSES AND ADVANTAGES ii 
 
 (2) The detection of errors, and conversely the prevention 
 of fraud and the prevention of errors, particularly of errors of 
 principle. 
 
 The latter, of course, include the moral effect of an audit, 
 which extends also to that very desirable result of keeping the 
 work of the office staff sharply up to date. This might be 
 classed as a constructive object. 
 
 (i) The Detection of Fraud: There can be no doubt but 
 that the business public look upon the discovery of fraud as an 
 important object to be attained by an audit, and experience has 
 demonstrated that sufficient fraud has been so disclosed to 
 warrant a continuance of the service of auditors who are 
 retained to discover fraud if it exists. 
 
 Gradually, however, the business man is being educated to 
 understand that the discovery of fraud is one, and only one, 
 of the objects of an audit, and by no means the most valuable 
 to him. 
 
 The detection of fraud is first in the logical presentation of 
 the objects of an audit, as less experience is required to unearth 
 it, and more definite suggestions can be made to the student 
 in regard to it than is the case with the more important branches 
 of the auditor's duties. 
 
 While an auditor who brings to bear all of his skill and 
 resources, and who leaves no stone unturned in his search for 
 fraud, but fails to discover a well-concealed defalcation, is le- 
 gally exempt from liability therefor, yet he is, and properly 
 should be, considered professionally responsible for such fail- 
 ure, and his practice suffers accordingly. Therefore particular 
 attention must be paid to all possible avenues which are open 
 for the dishonest clerk or official who has an opportunity to 
 manipulate the records of business transactions. 
 
 Opportunities for wrong-doing vary, as a rule, with the 
 size of the undertaking. In a small business the details are 
 apt to be supervised by one or all of the proprietors, while in a 
 large business much of the detail is necessarily left to subordi- 
 nates. The auditor must be governed by the circumstances sur- 
 rounding each engagement and then determine the amount of 
 detail to be covered. 
 
 (a) Misappropriation of Money or Goods: Usually fraud 
 
12 AUDITING 
 
 consists of defalcations involving the misappropriation of cash, 
 either by the failure to account for cash receipts or by the entry 
 of payments which are fictitious in part or whole. 
 
 In the following pages there will be outlined a procedure 
 based on long experience which will disclose such practices in 
 all ordinary cases. 
 
 With respect to the misappropriation of assets other than 
 cash, a far more difficult task is at hand, but experience in such 
 cases has also permitted the outlining of general rules which will 
 materially assist the auditor. 
 
 (b) Manipulation of Accounts for Other Purposes: The 
 abstraction of cash or goods is not the only reason for the 
 manipulation of accounts. The auditor who has covered these 
 two classes of frauds fully must, in addition, consider the possi- 
 bility of other irregularities. 
 
 In many undertakings the sources of cash receipts and the 
 disposition of cash expenditures are so carefully guarded that a 
 misappropriation of cash is almost impossible. 
 
 It is hard to convince the business man whose accounts are 
 so guarded, that an audit is of value, but relying again on ex- 
 perience, it has been demonstrated time and again that pecuni- 
 ary profit in such cases may be obtained by the manipulation 
 of records. Usually the fraud has been perpetrated by an 
 ofificial (frequently one who has the entire confidence of every- 
 one) who has an interest in, or who receives a bonus based on, 
 the net profits of a business or of a department thereof. In 
 other cases the purpose is to deceive bankers, creditors, or 
 stockholders. 
 
 The auditor must have all these purposes constantly in 
 mind when determining his course of action. If he does not 
 consider all the elements involved before commencing a given 
 engagement, he may find at the end of a detailed audit that a 
 balance sheet audit would have enabled him to secure satisfac- 
 tory results in much less time. 
 
 In discussing hereafter the respective advantages of these 
 two classes of audits, the author will endeavor to assist the prac- 
 titioner in the selection of a proper line of procedure. 
 
 (2) The Detection of Errors: This object of an audit does 
 not receive the attention which it deserves, and the auditor him- 
 
THE PURPOSES AND ADVANTAGES 13 
 
 self is probably to blame for the present condition of afifairs in 
 this respect. 
 
 During the time professional auditing was in a formative 
 state in this country, auditors were frequently engaged to ad- 
 just accounts which had been badly kept by inefficient clerks. 
 It was found that the books were not in balance, and that in 
 order to adjust them a vast number of errors had to be located 
 and corrected. In many cases this work consumed months of 
 time and a correspondingly large fee followed. This was called 
 "auditing," but in reality it was accounting work of the most 
 elementary kind. A careful bookkeeper unacquainted with 
 most of the principles of accountancy could have performed the 
 service equally well and far more cheaply. 
 
 This practice cast more or less discredit on professional 
 auditors, so that the tendency during recent years has been to 
 belittle the importance of locating errors in books of accounts 
 and to magnify the advantages of concentrating on the search 
 for fraud and the verification of the balance sheet. 
 
 The author feels that this branch of auditing should be ac- 
 corded its proper place in stating the objects of an audit, and 
 the attention of the student is particularly called to the points 
 of importance in the detection of errors. 
 
 For convenience the following classification is made, involv- 
 ing errors caused by ignorance, fraud, or mistake: 
 
 (a) Errors of Principle. 
 
 (b) Clerical Errors. 
 
 (c) Errors of Omission. 
 
 (d) Errors of Commission. 
 
 (e) Offsetting Errors. 
 
 (a) Errors of Principle: This is the most important class 
 of errors and is one which the auditor must never overlook. 
 
 Errors of principle usually afifect both the profit and loss 
 account and the balance sheet. The most common error is 
 to debit an asset instead of an expense account. For instance, 
 an item of repairs will be charged to buildings account, or a 
 payment covering expenses or services will be charged to the 
 personal account of the payee and thus be included among the 
 accounts receivable, instead of being charged to an expense 
 account. 
 
14 AUDITING 
 
 Other errors of principle do not affect the net profit or loss, 
 but may seriously affect the conclusions which are drawn from 
 the various revenue or expense accounts. For instance, an ex- 
 ecutive may have determined that the advertising appropriation 
 shall be limited to five per cent of the sales. A large item of 
 advertising expense may be charged to some other expense 
 account in error, with the result that the executive, depending 
 upon the ledger to give him the total expenditure, will author- 
 ize additional advertising and thus incur an unintentional and 
 perhaps unnecessary expense. 
 
 Errors of principle are most easily detected by making an 
 intelligent analysis of the accounts in connection with the prepa- 
 ration of the profit and loss account and the balance sheet. 
 
 (b) Clerical Errors: These are the most frequent errors 
 which exist, and unfortunately few books of accounts are free 
 from them. They consist of errors in the footings and forward- 
 ings of the books of original entry and ledgers ; errors in post- 
 ings other than those mentioned under (a), consisting of post- 
 ings to wrong accounts in the same class, as to one customer 
 or creditor instead of another, or the posting of an incorrect 
 amount, posting to the wrong side of the ledger, or errors in 
 drawing off the trial balance. 
 
 These errors are usually due to carelessness, but the auditor 
 is not justified in assuming that accounts in which such errors 
 exist are free from fraud. He must differentiate between cleri- 
 cal errors and intentional manipulation of the records. A care- 
 ful examination must therefore be made of enough of these 
 errors for the auditor to satisfy himself that they are bona fide. 
 For instance, an excessive footing of a pay-roll or expense ac- 
 count might be carelessness or fraud; the posting of a greater 
 amount to the credit of a customer's account than is shown in 
 the cash book might be an honest error in posting or it might 
 indicate an attempt to conceal a defalcation. 
 
 A fair test of these errors, however, is sufficient. It is no 
 part of an auditor's duty (as such) to locate all clerical errors, 
 and the auditor who devotes a considerable part of his time 
 to this work lays himself open to just criticism. 
 
 Auditors lose sight of the fact that the closing of books 
 and the resulting balance sheets are based on estimates only. 
 
THE PURPOSES AND ADVANTAGES 15 
 
 Some auditors spend many hours in adjusting balance sheet 
 items in order to correct a few trifling errors, when there are 
 valuations of hundreds of thousands of dollars in plant, mer- 
 chandise, stocks, etc., all of which are necessarily estimates and 
 which fluctuate from day to day — as must the value of all ma- 
 terials and goods. So long, therefore, as small errors in cal- 
 culations, extensions, etc., do not, relatively speaking, actually 
 affect the balance sheet, time should not be wasted on such 
 adjustments. 
 
 (c) Errors of Omission: An auditor is justified in spend- 
 ing more time in looking for errors of omission than in con- 
 nection with any other class of errors. 
 
 Where the internal check is not perfect, the utmost care 
 must be taken to verify all possible sources of revenue to ascer- 
 tain whether or not all such items are entered in the books. 
 Errors of omission usually do not affect the trial balance and 
 are, therefore, not detected automatically. They are distin- 
 guished from the class of errors where items are not posted 
 at all, as with these (except where both sides of a journal entry 
 are not posted) the trial balance is affected and the usual check- 
 ing back of the postings would locate the differences. 
 
 Instances of errors of omission are as follows: Goods may 
 be delivered but not billed ; rent may not be charged or collected. 
 On the other hand, purchases may be made and the goods 
 received, but the invoices for same may not be entered in the 
 books. In order to cover this class of errors, the auditor should 
 locate all books of original entry, whether so-called memoran- 
 dum books or other informal records, then a fair selection of 
 items should be traced into the regular books of account. If the 
 test does not disclose any material differences, it may be as- 
 sumed that the records are accurate. If the test should disclose 
 one or more errors of sufficient size to affect the results favor- 
 ably or unfavorably, a more extensive test should be made. It 
 might be well, however, before extending the verification to 
 request authority for so doing from the client. 
 
 In an examination of the accounts of a publisher the auditor 
 compared the advertisements appearing in one issue of a popu- 
 lar magazine with the book in which charges to advertisers 
 were entered. It was found that an insertion of a full page 
 
i6 AUDITING 
 
 had not been charged for. The item was billed and collected. 
 Thereupon the other eleven issues were carefully checked, but 
 no other omission was found. 
 
 If the auditor names a fixed fee for an audit, it is always well 
 to state tfiat tests only will be made. If an error is discovered 
 in the test, the auditor has fiifilled his agreement and need not 
 go further unless an additional fee is arranged for. If he will 
 broach the subject as soon as the test is completed there will 
 probably be no difficulty in securing an extra allowance, but 
 if no reference is made to his purpose to charge extra for addi- 
 tional work, he will usually have difficulty in collecting anything 
 at all additional, no matter how many or how few errors are 
 brought to light. 
 
 (d) Errors of Commission: These occur chiefly in connec- 
 tion with the books and records of original entry and consist 
 of items which are incorrectly recorded, either in whole or in 
 part. 
 
 For instance, an entry in the sales book may be incorrect as 
 to quantities, or in the extension of the items. These errors do 
 not affect the trial balance and frequently remain undetected. 
 
 The same tests as are recommended under (c) above 
 should be followed, except that it is not usually necessary to 
 cover as many items. Calculations of purchase and sales items 
 are frequently verified by two persons in the offices where they 
 originate, and almost invariably are checked in the offices to 
 which they are sent. 
 
 The test, therefore, may be extremely limited, provided it 
 is apparent that care is taken by the clerks in charge of such 
 work. 
 
 (e) Offsetting Errors: These occur fairly often, and while 
 they could be classed under the other headings mentioned, they 
 are dangerous enough to deserve special mention. 
 
 An offsetting error is one which is counterbalanced by an- 
 other error or errors. It is an annoying type. As one error may 
 occur in an asset or liability account and the other in an expense 
 or income account, an auditor is not justified in passing any 
 accounts until satisfied that such errors do not exist. Of course, 
 this does not mean the verification of every posting, but it does 
 call for the tests or analyses described more fully hereafter. 
 
THE PURPOSES AND ADVANTAGES 17 
 
 Few executives realize the great number of clerical errors 
 which are made every day. Perhaps these are most numerous 
 in banks, brokers', and other offices where the accounts are bal- 
 anced daily. An immense amount of work is accomplished in a 
 short space of time. Clerks work at high pressure, and knowing 
 that there will be a check on their work before they leave at 
 night, they do not verify their entries as they go along, as is the 
 case with many clerks who depend on the monthly trial balance 
 to detect their errors. Consequently a great number of errors 
 are made, and are located and corrected as soon as it is found 
 that the day's work must be checked back. Many of these 
 errors are of $10, $100, or $1,000. Therefore it is not strange if 
 two errors of the same amount should be made in the same day 
 in different departments, so that the accounts for that day actu- 
 ally balance in spite of the two errors. 
 
 Recently the author was called in by the senior partner of 
 a large stock exchange house who was greatly troubled over the 
 fact that two errors of $100 each had been made on a certain day 
 and had remained undetected for three weeks. He felt that 
 something was wrong with the system of accounts or with his 
 clerks ; he could not decide which. He was advised that the dis- 
 covery and reporting of the mistake by the only clerk who could 
 have benefited by it indicated that fraud was not intended, but 
 that if a similar case arose soon again, a fuller investigation 
 should be made. 
 
 The rule, therefore, is that an offsetting error may occur at 
 any time, but that the law of averages would operate against 
 much duplication. 
 
 The Auditor's Purpose: An auditor's duty is to discover and 
 disclose the truth about accounts, but this is too general a desig- 
 nation of his duties to use when confronted with a specific case. 
 Furthermore, the business world must, for many years to come, 
 be educated up to a proper appreciation of an accountant's func- 
 tions, so the present-day auditor must be a teacher as well as an 
 adviser. He must be prepared to explain the purpose of his 
 work and set forth clearly the objects to be attained as the result 
 of his labors. 
 
 The professional auditor, therefore, must give the impres- 
 sion of having a scope and purpose far in advance of the old- 
 
i8 AUDITING 
 
 time auditor, whose work was chiefly confined to ascertaining 
 whether the accounting party had properly recorded all receipts 
 and payments on behalf of his principal. In fact, the old- 
 fashioned audit was a cash audit. A modern audit, however, 
 although it includes the examination of cash transactions, has as. 
 its ultimate purpose the verification of the balance sheet. 
 
 An auditor should be prepared to state that he must make 
 such an examination of the books and records of the undertaking 
 as will enable him to satisfy himself whether or not the balance 
 sheet is properly drawn up so as to exhibit a true and correct 
 record of its financial affairs. 
 
 An auditor who has not himself a clear idea of the value or 
 advantages of an audit can hardly expect to impress his client 
 as to his purpose. 
 
 ADVANTAGES OF AN AUDIT 
 
 The chief advantages are, of course, identical with the main 
 purposes of an audit. The minor objects, viz., that fraud will be 
 disclosed if it exists ; that technical errors, if any, will be discov- 
 ered and corrected ; that errors of principle, if they exist, will be 
 detected, and the means of preventing their repetition in the 
 future pointed out, have been discussed. 
 
 The major advantages which have been mentioned may now 
 be enlarged upon. 
 
 (i) Condition of Affairs Accurately Shown: An accurate 
 statement of affairs, together with a profit and loss account, 
 showing how this position was reached, is prepared by a disin- 
 terested expert. In a vast number of cases this statement by 
 the auditor is the first accurate information which the client has 
 ever had as to his own condition. 
 
 Left alone, a business man seems to love to fool himself; 
 so he goes along, year after year, overstating his assets, over- 
 looking depreciation, and forgetting his liabilities. A correct 
 balance sheet made up by a professional auditor brings him 
 sharply to time. It will never be known how many enterprises 
 have been saved from ultimate failure through the presenta- 
 tion of unwelcome facts by an auditor who cannot and will 
 not be influenced by former inaccurate statements of condition. 
 
 (2) Bank Loans: Certified accounts are particularly valu- 
 
THE PURPOSES AND ADVANTAGES 19 
 
 able as a basis for bank loans. All leading bank managers recog- 
 nize the assistance rendered to them in the course of their busi- 
 ness by public accountants, and even if a business man is in the 
 happy position of not requiring occasional aid from his banker, 
 yet his financial rating is considerably higher if he is thoroughly 
 up-to-date in the care of his books and accounts. 
 
 The extension of credit by a bank depends on the judgment 
 of its officers as to the ability of the borrower to repay the loan 
 when due. The auditor, by reason of his independence, is able 
 to assist the banker in forming his judgment. The prospective 
 borrower cannot view the condition of his own business without 
 bias. The borrower expects to postpone the time of payment 
 and therefore anticipates a future condition more satisfactory, 
 doubtless, than is the case at the time of the application. The 
 auditor must, in a measure, pass on the probability and the 
 possibility of the future in the light of past results. 
 
 This does not excuse an auditor who estimates a definite 
 profit in the future, out of which a bank loan will be paid, but it 
 does support the recent statements of prominent bankers that 
 the services of professional accountants are becoming of increas- 
 ing value to them, largely because they are able to report orally 
 the result of their "sizing up" of the borrower or the prospective 
 borrower. 
 
 If an auditor refrains from expressing any oral opinion on 
 the probabilities of the future of a business the accounts of 
 which he has just subjected to the most thorough analysis and 
 scrutiny, it is possibly because he relies upon the ancient fiction 
 that an accountant deals with facts only, and that future results 
 are not facts ; or perhaps he is afraid to express his own convic- 
 tions. 
 
 If he finds that he is usually right in his forecast of future 
 business, it would seem only fair that his conclusions should be 
 communicated to his client at the time they are formed. 
 
 It is an unquestioned advantage for any borrower to be able 
 to comply with the requirements of the banker or note broker 
 to whom he applies for a line of credit. The attention of a pros- 
 pective client, may, therefore, be properly drawn to the official 
 action of the supreme body of American bankers. 
 
 At the Convention of the American Bankers' Association, 
 
20 AUDITING 
 
 held at Denver, Colo., in 1908, the Committee on Credit Informa- 
 tion reported, urging "that every member exert his influence to 
 have all paper purchased from note brokers presented with 
 accompanying statements audited by Certified Public Account- 
 ants . . . ," and to that end asked that the Association, by the 
 adoption of the Committee's report, "recommend that its mem- 
 bers, in purchasing commercial paper from note brokers, give 
 preference to such names as furnish accompanying statements 
 audited by Certified Public Accountants." 
 
 Prominent bankers, from time to time, have urged their asso- 
 ciates in conventions and elsewhere to require all prospective 
 borrowers to furnish certified statements. 
 
 Unfortunately, competition in banking circles is still too 
 keen to permit this rule to be adopted. Some recent large losses 
 by banks, arising out of gross overvaluations of assets and 
 understatements of liabilities on the part of borrowers, may 
 incline them to require certified statements by impartial account- 
 ants. 
 
 (3) Partnerships: Partnership books should always be ad- 
 justed by a professional accountant if for no other reason than 
 that he will act impartially and comply fully with the articles of 
 copartnership. These accounts are peculiarly liable to disturb- 
 ances by causes from which corporations on the whole are 
 exempt. Disputes occur as to salaries, division of profits, part- 
 ner's overdrawings, inattention to business, and many other 
 things which would to a large extent be obviated if the books 
 were regularly audited by a competent outsider. A partner dies 
 and there is trouble with his administrator as to the division and 
 withdrawal of the decedent's capital, in many cases resulting in 
 expensive lawsuits and the permanent crippling of the business. 
 A partnership goes into bankruptcy, perhaps through miscon- 
 duct of a trusted partner, tiad a continuous audit been in force 
 the fraud might have been nipped in the bud. Again, for the 
 protection of a limited or special partner and a silent or dormant 
 partner a periodical independent audit is essential. 
 
 (4) Fire Loss : In the case of loss of merchandise by fire, a 
 properly authenticated balance sheet prepared by a public ac- 
 countant is a material aid in the adjustment of claims. This is 
 not a theory; it has been demonstrated in practice. All business 
 
THE PURPOSES AND ADVANTAGES 21 
 
 men anticipate the possibility of a fire, but few of them consider 
 just how they will collect their insurance. 
 
 During the progress of an audit the auditor will ascertain 
 the methods of bookkeeping in force, and whether, in case of 
 fire, the records would be properly protected. He will ascertain 
 if a perpetual inventory be maintained, or whether it would be 
 necessary to calculate the amount of the loss upon the usual 
 basis, that is, to take the last recorded inventory, add purchases 
 to date of fire and deduct cost of goods sold, the result being 
 the stock on hand at time of fire. 
 
 The cost of goods sold is ascertained by deducting from the 
 sales the average gross profit realized in prior periods. Fire in- 
 surance adjusters are shrewd and experienced and the business 
 man whose records are in poor order is usually forced to settle 
 upon a basis satisfactory to the adjuster. If the business man's 
 accounts are in good shape and he can show that the last inven- 
 tory had been certified to, he can decline to compromise and 
 insist on the full amount of his claim being allowed. 
 
 (5) Bonding: A cashier whose books are audited regularly 
 has little trouble in securing a good company to act as surety 
 for him; in fact, several of the best companies insist, as part 
 of the contract, that this be done periodically. 
 
 (6) Protection of Stockholders and the Public : The interests 
 of the real proprietors of a business (the stockholders in the 
 case of a corporation) should be protected in every feasible and 
 reasonable manner. One way in which such an end might be 
 served would be to conform to the EngUsh method. There stock- 
 holders elect at the annual meeting a professional accountant 
 as the auditor of the company for the ensuing year, and his 
 report is made to the stockholders and not to the officers and 
 directors. 
 
 A corporation which has nothing to hide cheerfully sends 
 its balance sheet out to its stockholders, and if the latter exhibit 
 enough interest in the matter to request that the certificate of 
 a professional auditor be attached, such request will probably 
 be comphed with. Therefore, in every possible and dignified 
 way the auditor should impress upon stockholders the many 
 advantages to themselves of such procedure. 
 
 The value of the publicity of audited accounts cannot be 
 
22 AUDITING 
 
 overestimated. In a general way all corporations are believed 
 to be making unreasonable profits, particularly all corpora- 
 tions which in any way attempt to serve the public. 
 
 For instance, in New York City, the taxicab companies have 
 been attacked in the newspapers and one ordinance after another 
 has been passed regulating fares, all, of course, reducing them. 
 During the last four or five years at least two millions of dollars 
 have been lost by three or four of these companies. During this 
 time they have not made periodical statements to their stock- 
 holders nor to the public, setting forth these losses and the 
 reason therefor. For some mysterious reason publicity has been 
 shunned. 
 
 It is about as certain as anything can be that if certified 
 statements of operations had been secured and sent to. the news- 
 papers annually, commencing, say, four years ago, a far differ- 
 ent state of public opinion would have resulted. 
 
 Corporations which are secretive about their accounts or 
 which issue statements not certified to, have only themselves to 
 blame if they are made the victims of hostile legislation. 
 
 (7) Sale of a Business: The author has had several experi- 
 ences in which it was demonstrated that if periodical statements 
 of the results of operations duly certified to by responsible 
 auditors had been available, large enterprises would have 
 changed hands in a few days, but such statements not being 
 promptly available, the sales were not made. 
 
 In one case the president of a corporation in which he owned 
 a controlling interest was ofifered two and a half million dollars 
 for control, subject to examination by accountants. He ac- 
 cepted. When an attempt was made to ascertain the earnings 
 for a period of years it was found that no accurate records had 
 ever been kept. Large profits had been realized, but the only 
 reason this was known was because the money was in the bank. 
 Physical inventories had never been taken and book inventories 
 had not been kept. At the time of the proposed purchase the 
 plant was operating on an extensive scale, but as no cost records 
 were kept, it was impossible to determine the rate of profit on 
 the current output. The deal was called off. 
 
 The president complained bitterly. He had paid enormous 
 dividends, which he knew had been earned, but no one could 
 
THE PURPOSES AND ADVANTAGES 23 
 
 determine just when they were realized, and the condition of 
 the accounts cast suspicion on the whole enterprise. 
 
 Practically all business men look forward to retiring sooner 
 or later. It is a kindness to them to indicate how much easier 
 and more certain it will be for them to accomplish their purpose 
 if they can produce correct certified accounts than to depend 
 upon unaudited accounts, which may fail to meet the require- 
 ments of a prospective purchaser. 
 
 (8) Recovery for Negligence: The final advantage of an 
 audit (and one upon which perhaps serious differences of opin- 
 ion may exist as to the advisability of public discussion) is, that 
 a client who may suffer loss through the dishonesty of an em- 
 ployee may recover an equivalent amount from the auditor, 
 provided that the latter is shown to have performed his work 
 in a grossly negligent manner, and provided, of course, that the 
 defalcation occurred during the period covered by the audit and 
 continued thereafter. For further discussion of this interesting, 
 if not pleasant, topic. Chapter XXXII, "Liabilities of Auditors," 
 should be consulted. 
 
CHAPTER III 
 
 THE AUDITOR'S QUALIFICATIONS 
 
 Bookkeeping: The first important qualification of the 
 professional auditor is a thorough knowledge of practical ac- 
 counting, which necessarily embraces a complete mastery of 
 bookkeeping. Bookkeeping is so readily learned by any one of 
 ordinary intelligence that it is the most elementary step in the 
 auditor's career. 
 
 Accounting: Accounting, however, is a science, and repre- 
 sents the highest development of bookkeeping. Accounting is 
 not an exact science like mathematics; it is an applied or prac- 
 tical science. 
 
 Modern accounting must consider values as well as figures. 
 The question of values enters so largely into every statement 
 which exhibits the financial condition of a business enterprise 
 that in the last analysis a balance sheet is an expression of opin- 
 ion. The accountant as such is not a valuer or appraiser, but 
 neither is he a copyist to transcribe figures from books, and with- 
 out verification, hold them forth as dependable. 
 
 The majority of books of account do not represent the true 
 financial position of their respective concerns, nor do they cor- 
 rectly show the current operations as they occur from day to 
 day. Therefore the auditor must have such technical knowledge 
 as will enable him to recognize and criticize accounts from a 
 constructive point of view. 
 
 It is not enough that accounts are honest; in order to be 
 correct they must include intelligent groupings of all cost and 
 revenue factors, and they must indicate the true relations be- 
 tween the various groups. 
 
 Correct accounts are not necessarily complicated accounts. 
 All depends upon the ability and experience of the designer, and 
 as with all professional work, the greater the skill the greater the 
 simplicity. 
 
 Accounts are merely the written expression of every-day 
 commercial transactions. The written records, in order to be 
 
 24 
 
THE AUDITOR'S QUALIFICATIONS 25 
 
 of real value, must be constructed along scientific lines, and in 
 order to accomplish this, there must be a lively appreciation on 
 the part of the accountant of the vital connection between the 
 transactions themselves and the written records thereof. 
 
 Value of Theory: The degree of Certified Public Account- 
 ant, no matter from what State it is secured, cannot be deemed 
 to be, in itself, a sufficient license to practice as a professional 
 auditor. The qualifications already enlarged upon would be 
 minimized to a hopeless degree if it were to be assumed that this 
 degree can take the place of experience and training far broader 
 than the examination papers will ever require. 
 
 It is a well-known fact that hundreds of bright bookkeepers 
 have passed the C. P. A. examinations who never have had the 
 opportunity of inspecting more than one or two sets of books 
 and whose business experience has been limited to. one or two 
 special lines. 
 
 Nevertheless, the academic instruction and study of text- 
 books which forms a part of the C. P. A. courses will do much 
 to help the student. Much of the accumulated experience of 
 the profession has been preserved in books, and out of this expe- 
 rience has grown an approved general course of procedure that 
 is of great value. 
 
 The majority of audits can be largely mapped out before the 
 work is commenced, and in many instances before the books are 
 inspected for the first time. Conditions may compel a change in 
 procedure, but in few cases will there be any change in prin- 
 ciples. 
 
 Therefore, in auditing, as in no other branch of accountancy, 
 theory has a well-defined place, and the professional auditor who 
 is unacquainted with all the developments of the science as 
 improved and published by the other members of his profession 
 will find himself as far behind the times as the physician would 
 be who stopped purchasing medical books and reading medical 
 periodicals. It is impossible for any one auditor to cover every 
 ramification of accounting within the limits of his own practice. 
 
 He can secure the benefit of what others are doing provided 
 only that the others will reduce their experiences to writing. 
 The study of these writings serves as a basis for working the- 
 ories which can be generally applied. 
 
26 AUDITING 
 
 The auditor who scorns theory usually performs superfluous 
 work and may be distinguished by his lack of clients. The 
 following quotation from a recent address illustrates the impor- 
 tance placed upon theoretical training for a business career : 
 
 Is it necessary to teach young business men theoretically, and if so, how 
 is it to be done? The answer is found in the fact that in the last half cen- 
 tury tremendous changes have taken place in the business world, and, while 
 these are largely technical, they are connected with such an array of social, 
 legal, political, and economic disturbances that the modern business man 
 Rnds himself confronted with a host of problems of which his grandfather 
 had barely an inkling, and which cannot be solved by rule of thumb. He 
 needs understanding of political economy, of technology, of geography, of 
 commercial law, and of various other things as an initial equipment. 
 
 The aim is not to make a man a complete economist, a complete lawyer, 
 a real chemist or an engineer, but to have him understand the elements of 
 all these lines of activity. He must acquire a thorough knowledge of business 
 management and of the goods that are handled, his mind must be awakened 
 to a keen and intelligent interest in his occupation, he must be taught to 
 think swiftly, accurately, and to a definite conclusion, and to grasp compre- 
 hensively all related matters; he must learn to read human nature and gain 
 personal habits of order, exactness, and conscientiousness. The way is pre- 
 pared for his uniting, in the actual business life which follows, theory and 
 practice in comprehensive relation, the preliminary professional instruction 
 making his thinking and his daily work harmonious and fruitful. 
 
 General Experience: The auditor conducting a general prac- 
 tice must be equipped to render service to every variety of busi- 
 ness life. Without warning his first engagement may cover any 
 one of many varieties of classes of accounts: municipal, public 
 service, trading, manufacturing, banking, brokerage, insurance, 
 professional, executors, institutional, and many niore. 
 
 The professional auditor must have the benefit of what may 
 be termed the equivalent of a clinic. No one careful of his health 
 will consult a doctor who has not had the practical training 
 which comes only from direct study of living patients. 
 
 Therefore the auditor must have a broad familiarity with 
 general business customs and methods. It may be urged that 
 it is difficult to acquire anything but the merest smattering of 
 one business only, even by ye^rs of diligence, but this is incor- 
 rect. A working knowledge of the various classes of undertak- 
 ings mentioned above can be attained by some years of applica- 
 tion, but it may as well be admitted that the professional auditor 
 
THE AUDITOR'S QUALIFICATIONS 27 
 
 can expect to be' recognized as fully qualified only after he has 
 had these years of experience in diversified lines. 
 
 As a matter of fact, there is only one satisfactory training 
 ground, and that is the office of a public accountant. In no other 
 way is it possible to secure the actual insight into a large number 
 of business enterprises within a reasonable length of time. 
 
 But, it is not enough to see the practical side of business 
 life; there is a vast quantity of general training which can be 
 and should be acquired by study, reading, and observation. 
 
 The professional auditor is in a sense a specialized account- 
 ant. The corporation lawyer, the efficiency engineer, the busi- 
 ness systematizer, the scientific manager, the cost-system 
 installer, are specialists, as are surgeons and oculists. But pro- 
 fessional men do not become skilled specialists until they have 
 acquired the ground work of their professions, and this applies 
 to the profession of accountancy as well as to law and medicine. 
 
 The auditor should have a fair knowledge of economic the- 
 ories, labor questions, bonus and profit sharing plans of wages, 
 banking principles and foreign exchange. He should study 
 political economy, and follow the trend of public regulation of 
 monopolies and trusts. 
 
 Federal control is a vital issue and the auditor's duty to 
 himself and the future of his profession requires him to take 
 an interest in all actual or prospective legislation aflFecting busi- 
 ness interests. 
 
 In the past, too, many of the federal and state laws relating 
 to corporate and other business undertakings have been framed 
 and passed by those who have been lamentably lacking in 
 knowledge and experience, with the result that the laws are not 
 observed, or if an attempt is made to enforce them, unjustified 
 annoyance and expense follows. If it is known that he is well- 
 informed on legislation, the auditor will find that he will be 
 consulted. 
 
 Special Faculties: In addition to the broadest kind of general 
 training, the auditor who would be happy in his chosen profes- 
 sion requires certain faculties or talents which are inborn rather 
 than acquired. 
 
 The most important of these are an imaginative and analyt- 
 ical mind. Of course his mental equipment must be of the 
 
28 AUDITING 
 
 highest type, but if he does not possess these two qualities the 
 work of an auditor will be more or less burdensome and it will 
 be practically impossible for him to get the most out of any 
 accounts except those kept in the simplest form ; even with these 
 the man without a well-developed and vivid imagination is apt 
 to take too much for granted and lose the opportunity to 
 uncover fraud or carelessness. 
 
 The analytical faculty is perhaps the more important of the 
 two. In many cases serious defalcations have been discovered^ 
 and gross irregularities and extravagances have been disclosed 
 by careful analyses of accounts, where a perfunctory audit con- 
 sisting of routine checking of postings, footings, and vouchers 
 would not have given rise to suspicion. The auditor who does 
 not come naturally by the analytical faculty must cultivate it 
 assiduously or success is impossible. 
 
 The analytical faculty will lead naturally to a proper group- 
 ing or synthesis of the results of the auditor's labors. As has 
 been well said (Mr. Allen Ripley Foote, President of the Inter- 
 national Tax Association, at the meeting of the American Asso- 
 ciation of Public Accountants at Denver, in October, 1909) : 
 
 A correct tabulation is not in itself a correct record. A record, to be 
 correct, must be kept in a way to show, by proper grouping, the true relation 
 between every factor involved in costs of living, costs of distribution,' costs of 
 doing business, and, in the final statement, showing the profit or loss for a 
 fiscal year or for a period of years. Conclusions, or business and political 
 policies based upon records that are not correct, must inevitably be unsound. 
 
 There is a wide difference between honest accounting and scientific ac- 
 counting. One may have a record that will honestly account for every dollar 
 received and expended without having a record that will give any intelligent 
 information regarding the true relation between all economic factors in- 
 volved in statements of costs or of profits and losses. 
 
 The records of all accounts should be intelligently grouped to show the 
 economic effect of every factor essential to a true statement of costs or of 
 profits and losses. 
 
 In a recent examination of the accounts of a brewery, an 
 auditor had nearly completed the verification of the accounts 
 without disclosing any hint of dishonesty ; he. then analyzed all 
 costs and compared them with the results. In him the analytical 
 faculty was developed to an uncommon degree, for he applied 
 the knowledge of chemistry which he had acquired to the costs 
 
THE AUDITOR'S QUALIFICATIONS 29 
 
 and decided that the results were not correct. A further and 
 more detailed verification of the purchases disclosed the fact 
 that the head maltster had diverted large quantities of materials 
 to a plant owned by himself. 
 
 This, perhaps, is an extreme case, and it may not be reason- 
 able to include chemistry among the auditor's qualifications, but 
 it illustrates the value of a wide and liberal education. If the 
 fraud had not been discovered, the auditor might have escaped 
 censure, but his would not have been an enviable position, and 
 the result justified the time involved in his study of chemistry. 
 
 Education: It is not intended to discuss the extent of the 
 auditor's elementary studies, but it is obvious that the most 
 complete course is the most desirable one. In other words, his 
 preliminary education cannot be too extensive. Literature, 
 languages, and history all have their value to the professional 
 auditor, as do all subjects included in the education of a person 
 of culture. 
 
 It is admitted by all that special knowledge and special 
 mental training are required for success in business and pro- 
 fessional life, and it is a tremendous advantage if this knowl- 
 edge and training can be acquired without too much expenditure 
 of time and eiifort. In business the tendency is toward too long 
 an apprenticeship. A clerk may perform a certain function ten 
 thousand times in spite of the fact that he has reached perfec- 
 tion after one hundred operations. The law or medical student, 
 on the other hand, usually receives too little preliminary educa- 
 tion. 
 
 It is to be hoped that the accountancy student will find the 
 happy medium and acquire a maximum of useful knowledge 
 with a minimum of effort. 
 
 This preliminary knowledge involves the study of the raw 
 materials of industry, with the sources of their supply and the 
 methods of their production ; of the principles which underlie the 
 financing of a business, the granting of credit, the sale of goods, 
 the education of the consumer by means of advertising; the rela- 
 tion of the business man to transportation facilities; the prin- 
 ciples of commercial law, of real estate values, and of insurance ; 
 of the institutions and agencies of commerce and finance. 
 
 A professional education demands of the student not merely 
 
30 AUDITING 
 
 attendance at lectures and mastery of textbooks, but the work- 
 ing out of problems and cases and the investigation of questions 
 involving the principles of the science which he is studying. 
 
 The accountancy student should at least read as much along 
 the lines of his future work as is required of a law student along 
 legal lines, and the latter covers tens of thousands of pages of 
 textbooks, reports of cases, digests, etc., before and after his 
 examination. 
 
 If at all possible, the accountancy student should acquire 
 some knowledge of the law; the ideal training of a public ac- 
 countant includes the study of all departments of the law, but if 
 time does not permit, the student should endeavor to master the 
 principles of at least the following branches: partnerships, con- 
 tracts, corporations, evidence, surrogate or estate, real and per- 
 sonal property. 
 
 Moral Qualities: No matter how skillful and experienced an 
 auditor may be, these qualities alone are insufficient to command 
 the confidence of the public. The professional auditor must 
 have a reputation for absolute integrity or his clientele will be 
 limited and his chances for success very limited. He must have 
 the ability to discover the truth and the courage to proclaim it 
 without fear or favor in spite of the many temptations to be 
 silent or equivocal. Frequently the telling of a blunt truth will 
 be distasteful to the client and may threaten the loss of further 
 engagements from the same source, but these instances, fortu- 
 nately, are becoming rare, and the auditor who never deviates 
 from the truth will never regret it, either from an ethical or 
 financial standpoint. 
 
 As has been said by A. Lowes Dickinson, C. P. A. : 
 
 The moral qualities called for are so high that it should place the pro- 
 fession at the head of all which come into contact with business affairs. The 
 lawyer's duty is first of all to his client, and that duty frequently compels 
 him to avail himself of technicalities and other means of enabling that client • 
 to evade the law and its penalties; but the public accountant has only one 
 duty to his client and to the public, and that is to disclose to him or for him, 
 "the truth, the whole truth, and nothing but the truth," so far as his abilities 
 and special training to that end enable him to ascertain it. No legal quibble 
 will save him from moral condemnation if he fails in this duty; no juggling 
 with words and phrases will absolve him from responsibility, moral and often 
 legal, for results which he has reason to know are not what they seem to be, 
 
THE AUDITOR'S QUALIFICATIONS 31 
 
 or which, having regard to his special training in business affairs and the 
 accounts relating thereto, he ought to have known did not represent the 
 facts. Errors there may be, and must be, and for errors made after full and 
 proper precaution taken and due care exercised no responsibility will lie. 
 But there is no profession in which the results of careless errors or misstate- 
 ments will more certainly bring retribution- 
 Audit Clerks: It is assumed that every assistant in an ac- 
 countant's office is a student and aspires to become a principal. 
 
 The discussion of the qualifications of the professional 
 auditor will, therefore, apply to them as well as to all other 
 students, but certain special qualifications may be mentionedl 
 which -are desirable and necessary, provided the audit clerk, or 
 assistant accountant, expects to advance in his chosen line. He 
 must be trustworthy to an extraordinary degree, for he must 
 observe all of the trust relations which exist between his 
 employer and the client, and also perform the full measure of 
 duty which every employee owes to his employer. 
 
 The most successful business men of to-day were at one 
 time the most industrious and loyal employees. The man who 
 does not serve well will not direct well. Nearly all of the pro- 
 fessional accountants who are in the front rank to-day at one 
 time occupied subordinate positions and did their work so well 
 that promotion was inevitable. 
 
 The work of the junior is largely routine and is frequently 
 uninteresting. The intelligent and honest clerk will follow direc- 
 tions implicitly, or else he will report to his senior that he wishes 
 to know the purpose of what he is doing before he proceeds. 
 The former is the wisest course, but if an audit clerk has had 
 some experience, there can be no objection to his endeavoring 
 to discover the relation of his work to the audit as a whole. 
 
 The clerk's attitude toward the client and the client's staff 
 should be that of friendly interest : friendly because the relations 
 are close and confidential and an attitude of utter indifference is 
 not understood nor appreciated by the client. Obviously the 
 clerk should not become so friendly with the client's staff that 
 suspicion may arise as to his ability of willingness to criticize 
 those of the staff who may require it. 
 
 If the clerk cherishes the hope that in time he will set up 
 for himself, he should never allow himself to speculate on the 
 
32 AUDITING 
 
 chances of securing for clients in the future those upon whose 
 accounts he is working. Simple loyalty and honesty to his 
 employer should drive such thoughts out of his head; but for 
 those who may not appreciate these qualities and who therefore 
 do not observe them, it should be said that no successful prac- 
 tice has ever been built on such a foundation. Clients so gained 
 expect to pay less and are more exacting ; they usually have de- 
 manded certificates and reports which were not warranted by 
 the facts, and they expect to find the younger auditor more com- 
 plaisant. 
 
 In discussing the auditor's qualifications, great stress was 
 laid on the value of imagination. This quality must, however, 
 be kept under control on the part of an assistant. 
 
 Imagination is closely allied to curiosity, and the client can- 
 not always distinguish between the two. The clerk should 
 impart the results of his imaginings to his senior, so that what 
 may be a "false alarm" will be withdrawn before being discussed 
 with a client or his staff. 
 
 Qualifications Required by the Public : The profession is not 
 yet well enough known to the general public to enable a pros- 
 pective client to discriminate in every case between the qualified 
 and the unqualified auditor. Happily this condition is improv- 
 ing daily, and it will not be very long before the properly trained 
 practitioner will be preferred to the one who has neither the 
 capacity nor the skill to undertake accounting work of any 
 importance. The public point of view at the present time was 
 well expressed by Frank W. Main, C. P. A., in the Saturday 
 Evening Post of June i, 1912. He said inter alia: 
 
 That there is much confusion in the popular mind as to the real work of 
 the accountant and as to the very important service which he is rendering 
 in the business world, is not at all surprising. 
 
 In the first place, jobless bookkeepers without number, auditors of in- 
 dividual companies, seeing other fields of advancement closed — and cost 
 clerks, certain that their grasp of the one particular business with which they 
 are familiar has given them a grasp of all businesses and a knowledge of all 
 manufacturing problems — have started out in the professional field as full- 
 fledged auditors, accountants, systematizers, and business experts, when, if 
 experienced at all, their experience is confined to but one limited businesfi. 
 In some cases, at least, these "auditors" have about the same right to be 
 known as professional accountants as a hospital orderly would have to pain) 
 himself off as a skilled physician, 
 
THE AUDITOR'S QUALIFICATIONS 33 
 
 Misfit Cost-Keeping Systems: The initial work which usually falls to 
 the lot of the self-styled accountant on his first incursion into the 
 professional field is usually in a line of business somewhat of the same nature 
 as the one he has recently left. With the nerve which was necessary to start 
 out in business for himself, and with his practical experience in that particular 
 line, he is often able to render valuable service to his clients. As time goes 
 on, however, and his business is extended into other lines, his difficulties in- 
 crease; for unconsciously the effort is made to conform all business to the 
 methods and the systems of the one concern with which he was most familiar. 
 As a result, ludicrous situations usually arise, and the usual experience is 
 that after heroic efforts of a few years he is glad to accept some permanent 
 position at an assured salary with an established concern. 
 
 In his. trail, however, are usually left scores of business men with the 
 well-grounded belief that their own bookkeepers know all that any profes- 
 sional accountant does, and with the conviction that the paying to the ac- 
 countant of the fees which he demands is only foolishness, as they are certain 
 that the same services can be as well rendered by their own employees. 
 
 The second cause of confusion as to the real service which is being 
 rendered by the professional accountant is the impression created by some 
 auditing companies, with their more or less prominent boards of directors, 
 that auditing, accounting, and systematizing constitute purely and solely a 
 business; and that contracts for such work should be very largely placed in 
 the same way that a contract for painting or brickwork would be, namely, 
 to the lowest bidder. 
 
 Our profession now includes a large number of practitioners 
 who are more interested in doing good work than in collecting 
 large fees, or in building up what is known as a "large volume 
 of business." They have the reward which accrues to those who 
 follow the highest ideals, in addition to the pecuniary compen- 
 sation which also accrues to the professional man who stead- 
 fastly adheres to the ethics of his profession and maintains high 
 standards irrespective of present results. 
 
CHAPTER IV 
 THE DUTIES OF AN AUDITOR 
 
 It has been pointed out that the disclosure of the truth "so 
 far as his abiUties and special training to that end enable him 
 to ascertain it" is the first duty of the professional auditor. 
 
 An auditor's duties, however, are so diversified that some 
 space may be properly devoted to a discussion of the more 
 important responsibilities which are thrust upon him. 
 
 Non-professional Auditors: Until within a very few years a 
 great deal of so-called auditing was done which was worse than 
 useless, as it carried with it a sense of security which was wholly 
 unwarranted, but which was substantial enough to deceive the 
 very ones who might have been placed upon their guard if no 
 such procedure had been followed. Many of the most serious 
 defalcations which have come to light have occurred in banks, 
 societies, and corporations, where the accounts were periodically 
 submitted to audit committees or amateur auditors whose lack 
 of skill and experience made it impossible for them to unearth 
 clever fraud and manipulation. 
 
 Unfortunately, the loss in these instances usually falls upon 
 the very class of persons who can least afiford to lose. A number 
 of institutions, societies, and clubs which exist for the purpose 
 of conserving the savings of poor people fail to procure efficient 
 auditors, but — supposedly to save expense — usually appoint one 
 or more unqualified persons to conduct the audits. 
 
 Space does not permit any extended remarks upon the 
 results of the work of these amateur auditors. A full review of 
 the disastrous failures during recent years would alone exhibit 
 the misery which has been caused thereby, and the neglect, 
 ignorance, and carelessness of unqualified practitioners have 
 been a large factor in these results, for in many cases the dis- 
 aster could have been entirely prevented by the exposure of the 
 guilty parties at the time the first so-called audit took place. 
 
 The number of nonprofessional auditors in England is said 
 to be decreasing annually, but such does not appear to be the 
 
 34 
 
THE DUTIES OF AN AUDITOR 35 
 
 case in the United States. The aggregate membership in the 
 British societies of professional accountants exceeds seven 
 thousand, while that of The American Association of Public 
 Accountants, in which all but a small percentage of the profes- 
 sional accountants in the United States are enrolled, is only 
 slightly in excess of one thousand. 
 
 It is the universal practice of surety companies to renew 
 bonds of employees only after certificates have been presented 
 setting forth the fact that the accounts of the applicants for bond 
 renewals have been audited and found correct. A great many 
 corporations and societies of a more or less public nature, such 
 as banks, trust companies, beneficial and loan societies, etc., 
 have their accounts audited annually. Comparing the relatively 
 small number of qualified accountants with the vast amount of 
 auditing work done annually, it is readily seen that a great por- 
 tion of the work is now being done by amateurs. The examina- 
 tions made by stockholders' or members' committees and other 
 amateur auditors are in nearly every instance incomplete, and 
 defaulters whose accounts are being investigated by them are 
 usually quick to realize the lack of thoroughness of the audit, 
 with the natural result that large sums are abstracted with little 
 chance of discovery. It has frequently been found, in instances 
 where peculations have been unearthed by qualified auditors, 
 that the accounts of the defaulter were audited by committees 
 and other amateur auditors, and this latter kind of examination 
 is responsible for many of the defalcations reported annually. 
 
 Many of these amateurs realize that they cannot make thor- 
 ough examinations and would willingly turn the work over to 
 qualified auditors; in fact, it is often the case that professional 
 auditors are employed by, or are substituted for auditing com- 
 mittees and amateurs at the latter's request, and it is hoped that 
 it is only a question of time before all of this important work is 
 done by properly qualified auditors. 
 
 The by-laws of many corporations and associations contain 
 a clause requiring that audits of their accounts and statements 
 of their financial condition be made and certified to by Certified 
 Public Accountants. Many of the largest corporations in the 
 United States have adopted this course, and it is believed that 
 the officers and a majority of the stockholders of corporations and 
 
36 AUDITING 
 
 members of societies generally are becoming impressed suffi- 
 ciently with the necessity thereof to justify the expectation that 
 before long the practice of having this work done by Certified 
 Public Accountants will become general. 
 
 Official Auditors: "Official auditors" is the term used here 
 to designate all who are engaged to audit the accounts of public 
 officials, and such as are designated by State courts to examine 
 and determine the correctness of the accounts of decedents' 
 estates, etc. Lawyers are generally appointed for this last- 
 mentioned work, and the records of the individual transactions 
 are carefully examined by them usually to ascertain that they 
 are not ultra vires. 
 
 Occasionally it has come to light that peculations had been 
 carried on and that the accounts, incorrect in many important 
 respects, remained uncorrected for some time. If the examina- 
 tions of these accounts by these appointees were to be limited 
 to the scrutiny of the individual transactions from a legal stand- 
 point, and the actual auditing of the accounts were to be done 
 by professional auditors, who are qualified by their training to 
 discover accounting errors and defalcations, the accounts of 
 estates would be more efifectively audited. 
 
 The National and State Governments employ official auditors 
 who are required to do much work which should be done by the 
 professional auditor, and the lack of training of the appointees 
 sometimes results in incomplete and inefficient work. Unques- 
 tionably it is only a matter of time before reforms will be 
 demanded and much of this work and responsibility will devolve 
 upon the Certified Public Accountant, or else the present incum- 
 bents will improve upon the quality of work performed by their 
 predecessors and fit themselves for meritorious work. 
 
 Official auditors usually do not have at their disposal suffi- 
 cient time to enable them to make complete audits and are gen- 
 erally limited as to the scope of their work, and it is also partly 
 due to these facts that their examinations are not thorough, and 
 therefore of questionable value. 
 
 The following are the most prominent official auditors 
 employed by the National and State Governments : 
 
 Examiners for National and State Banks, Bankers, and Trust 
 Companies ; Auditors employed by the State Insurance and Char- 
 
THE DUTIES OF AN AUDITOR 37 
 
 ities Departments; Examiners in the Bureau of Corporations of 
 the Department of Commerce and Labor of the National Gov- 
 ernment ; Inspectors of the Bureau of Internal Revenue assigned 
 to examine the accounts of corporations which report their net 
 income as required by the Federal Corporation Tax Law. The 
 supervision of corporations by the National and State Govern- 
 ments has increased considerably the number of official auditors, 
 and with the extension of this supervision their number will be 
 still further increased. The salaries paid to many of these offi- 
 cials are too low to attract men of proper training and ability, 
 and, obviously, their work cannot be expected to be of the high 
 efficiency of that required of qualified auditors. 
 
 The following news item which appeared in the New York 
 Times of June 27, 1912, may be of interest in this connection : 
 
 Attacks Federal Bank Supervision 
 BiNGHAMTON, N. Y., June 26. — The United States Grand Jury, in 
 session here to-day, presented to the court a resolution advising that the 
 revelations in the New Berlin Bank disclosed the fact that the present methods 
 of National Bank examinations were faulty; that perfunctory examinations 
 should be condemned; that the number of bank examiners is insufficient, and 
 the method of compensation is certain to affect the character of the ex- 
 amination. Banker Arnold will be arraigned on indictments alleging bank 
 wrecking to-morrow afternoon. 
 
 Staff Auditors: Another body of auditors, who cannot be 
 included among any of the foregoing classes, consists of those 
 who devote their entire time to one or a very few undertakings. 
 This appHes chiefly where the organization is large and the 
 work diversified to such an extent that an officer can be profit- 
 ably employed whose duties are supervisory only and who does 
 not, or rather who is not supposed to perform any clerical duties 
 or handle money, securities, etc. 
 
 In many of our largest corporations this officer is called the 
 comptroller, and this is the correct title, but so many of these 
 officers are and will be called auditors that it becomes necessary 
 to classify them as such. 
 
 Experience has shown that these auditors gradually have 
 thrust upon them executive duties which are in more or less 
 conflict with the supervisory work which they usually are 
 retained to perform. 
 
38 AUDITING 
 
 A staff auditor cannot vety well occupy two positions at the 
 same time ; he cannot originate or carry out a transaction which 
 is administrative and later attempt independently to check the 
 same operation. 
 
 There have been so many instances of defalcation and fraud 
 by officers or clerks with the title of auditor that it makes the 
 term a misnomer in the mind of the general public. No auditor 
 should have such an opportunity, and if his duties are changed 
 to such an extent that he has the same opportunity to defraud 
 as a treasurer or cashier, then he should no longer be called an 
 auditor. If he does retain the title, it is deceitful, whether will- 
 fully or unintentionally. 
 
 Professional Auditors : The professional auditor is one whose 
 services are at the disposal of the public. He is charged with 
 the responsibility of undertaking practically all of the work 
 which may be tendered to him. He may, therefore, be said to 
 owe a duty to the public to have a well-equipped office and a 
 staff of specially trained assistants, otherwise he cannot con- 
 scientiously undertake work of any magnitude. 
 
 There are, however, a great many persons whose experience 
 and ability qualify them as auditors of the highest rank, but 
 virhose services are not at the call of the general public, and who, 
 therefore, cannot claim to be professional auditors. 
 
 Not an Insurer : In the exercise of his profession the auditor 
 does not become an insurer, in spite of the desire on the part of 
 many clients so to consider him. It is obviously his duty to 
 provide such safeguards as are possible, based on his experience 
 and familiarity with modern practice. He is assumed to have 
 a full theoretical as well as a practical knowledge of the prin- 
 ciples of auditing and to apply them skillfully to every case on 
 which he is engaged. But this, fortunately, is the full measure 
 of his responsibility. 
 
 The position is a reasonable one when examined from an 
 equitable standpoint, particularly when compared with the 
 premiums paid to liability insurance companies for protection 
 against loss by fraud. The audit fee is not intended to and 
 does not include insurance against loss by dishonesty. 
 
 Of course,. circumstances may be such as to raise a presump- 
 tion of negligence or lack of skill on the part of the auditor, but 
 
THE DUTIES OF AN AUDITOR 39 
 
 this does not alter the general rule. A full discussion of this sub- 
 ject will be found in Chapter XXXII, "Liabilities of Auditors." 
 
 Employees' Bonds: Irrespective of the question as to 
 whether or not an auditor is an insurer, he should always include 
 in his audit program the query: "Are all employees who handle 
 funds under surety bonds?" If not, they should be. Some 
 employers are lax in this respect, others will not incur the 
 expense, and a fairly large class dislike to mention the matter to 
 employees who have occupied positions of trust for a number of 
 years. 
 
 The auditor should present the importance of such protec- 
 tion and point out that the expense is comparatively small, but 
 that the risk is not an imaginary one. Of course the auditor 
 has performed his full duty after his recommendation has been 
 considered, and if nothing is done he cannot be blamed for sub- 
 sequent loss. 
 
 It may be, however, that the matter should have consider- 
 ation at each audit as conditions and employees change. It 
 might not be difficult to persuade an employer to adopt a rule 
 that every new employee should furnish a bond at the time of 
 employment. This would mean that in time the entire staff 
 would be bonded. In every case the employer should pay the 
 premium. 
 
 Many employers find it valuable to insist on practically their 
 entire force, including salesmen, furnishing a surety bond. The 
 reason given is that all of them handle funds at one time or 
 another. It makes it easier to demand bonds from cashiers when 
 the rule is general, and a lower rate can be secured where sev- 
 eral persons are covered by one bond. The chief, value, how- 
 ever, in requiring bonds from salesmen is that the employer is 
 assured that a most exhaustive inquiry is made into each appli- 
 cant's character and reputation, extending back over a consider- 
 able period of years. This search is far more extensive than 
 an employer can, or cares to, make himself, and as such a bond 
 for, say, five hundred dollars does not cost more than two or 
 three dollars, it is well worth a trial. Salesmen are usually 
 intrusted with a traveling expense advance, and similar funds 
 are placed at the disposal of other employees. 
 
 Several firms of accountants have enforced this rule for some 
 
40 AUDITING 
 
 years with a considerable measure of satisfaction. It is surpris- 
 ing sometimes to ascertain that an applicant whose credentials 
 seem to be above criticism cannot qualify for a minimum amount 
 bond. 
 
 This is considered a prima facie reason for nonemployment, 
 or dismissal if taken on temporarily, and a good reason must be 
 furnished to ofifset the effect of the refusal of the surety com- 
 pany. 
 
 It is obvious that a man who cannot furnish a five-hundred- 
 dollar surety company bond is not a desirable audit clerk. 
 
 Employers sometimes think that placing an employee under 
 bond in some way obviates the necessity for an audit. As a 
 matter of fact, this precaution is all the more advisable in that 
 a means is provided for recouping the amount misappropriated, 
 if a defalcation does occur. The surety companies themselves 
 advocate periodical audits. The National Surety Company of 
 New York, one of the leading bonding companies in America, 
 says: 
 
 Frequent, regular, and thorough audits of cash and books of account by 
 certified public accountants are unquestionably of the greatest benefit to the 
 business man and institution, and should be universally adopted. 
 
 We cannot put what we state above too emphatically, and it is deserving 
 of the serious consideration of every business man. 
 
 The surety companies frequently quote their minimum 
 rates where they find that the books are regularly audited by 
 professional auditors in whom they have confidence, and this 
 may represent a considerable saving to the assured. 
 
 AUDIT OF A FIRM OR AN INDIVIDUAL 
 
 The duty of an auditor to an individual or a firm is, of course, 
 to disclose to his client, or clients, the facts as he finds them. 
 
 In audits of firms, the rights and liabilities of each partner 
 must be considered. Usually one partner names or retains the 
 auditor, and in many cases assumes an embarrassing proprietary 
 interest over him. Nevertheless, the auditor must maintain the 
 strictest neutrality, for partnerships too often end in litigation, 
 and the auditor who has shown any signs of favoritism may find 
 himself in an unpleasant position. 
 
THE DUTIES OF AN AUDITOR 41 
 
 The partnership agreement should always be read carefully 
 and any provisions as to the accounts noted and verified. Where 
 there is no partnership agreement or where it is deficient in 
 terms, the following guide may be profitably consulted, and 
 where any material divergence exists between what a partner 
 does and what he should do, the attention of each partner should 
 be called to the infraction noted. 
 
 Partnership Agreements: Business men are beginning to 
 appreciate the fact that professional accountants are able to 
 advise them properly with respect to the accounts necessary to 
 prevent disputes over partnership agreements. As accounts are 
 the written record of the business, it follows that almost all 
 dififerences of opinion between partners relate to the accounts. 
 A lawyer does not foresee these dififerences and most of them do 
 not understand accounts, therefore the accountant, whose expe- 
 rience fits him to point out in advance the various matters out of 
 which misunderstandings arise, is the logical adviser and insurer 
 against many of these points of difference. 
 
 The duties of the professional auditor are not always an- 
 alytical; prevention is better than cure, so that when an oppor- 
 tunity presents itself whereby litigation and other unfortunate 
 experiences may be avoided, it is his clear duty to point out the 
 best course to pursue. 
 
 The following rules cover the more important points in part- 
 nership agreements, so far as the accounts are concerned. 
 
 (1) Nature of Business: The scope of the business and the 
 relation of each partner to the business should be clearly stated, 
 also whether a partner is permitted to engage in outside trans- 
 actions arid whether or not each partner is required to devote all 
 of his time to the business. 
 
 (2) Capital : Specify amount to be contributed by each partner, 
 and how it is to be paid. If partners agree to contribute equally, 
 the agreement should state whether cash or its equivalent is to 
 be provided and the penalty, if ^ny, for the failure of one partner 
 to contribute as much as another. 
 
 (3) Changes in Capital: If undrawn profits automatically 
 increase and losses decrease the capital accounts of the part- 
 ners, the agreement should cover the point fully, as the interest 
 of the partners in<sapital and -profits may not be the same. 
 
42 AUDITING 
 
 (4) Interest on Capital: Unless provided for in the agree- 
 ment, capital contributions do not bear interest. If interest is to 
 be allowed, the rate should be fixed. 
 
 (5) Withdrawals: As this is frequently a matter of dispute, 
 explicit provision should be made to cover the manner and extent 
 of withdrawals and the penalty for overdrafts. 
 
 (6) Undrawn Profits: If profits are allowed to accumulate, 
 the agreement should state whether such amounts are to be 
 treated as loans or additional capital. This provision is impor- 
 tant, as clause (8) may provide that profits are to be apportioned 
 on the basis of capital. 
 
 (7) Interest on Loans or Withdrawals: If it is desired that 
 interest should be allowed on loans, or charged on withdrawals, 
 so state and specify the rate. 
 
 (8) Distribution of Profits or Losses: State the method of 
 apportioning profits or losses and specify each partner's percent- 
 age, also any contingency which may affect the share of any one. 
 
 (9) Approval of Accounts : There should be some agreement 
 as to the approval of the individual partner's accounts in respect 
 to withdrawals as well as to the profit and loss and capital 
 accounts. The best way is to require each partner to sign his 
 respective ledger account. 
 
 (10) Salaries of Partners: If any partner is to receive a stated 
 salary, specify the amount, when to be credited, whether or not 
 interest is to be allowed thereon if undrawn, and whether the 
 amount is to be charged as an expense of the business before 
 ascertaining the profit or loss. 
 
 (11) Dissolution: State procedure if partner dies or with- 
 draws; whether books shall be balanced at once or allowed to 
 run on to end of month or other period ; whether, in case of dis- 
 solution, partners are to share losses in same proportion as each 
 one's capital bore to entire capital. 
 
 (12) Special Causes for Dissolution: If partnership can be 
 dissolved for other reason than death, such as disability or 
 intemperance, state complete details. 
 
 (13) Settlement after Dissolution: It is important not only to 
 arrange the method of determining each partner's share upon 
 dissolution, but it is equally important to fix the details of pay- 
 ment. The most equitable way is to provide for full payment 
 
THE DUTIES OF AN AUDITOR 43 
 
 within a fixed period, or to pay a certain proportion annually or 
 semiannually. State rate of interest on balance. 
 
 (14) System of Accounts: To obviate subsequent diflferences 
 of opinion as to the system of accounts, the agreement should 
 specify that double entry accounts be kept, that they be bal- 
 anced regularly, and that they be audited annually or oftener by 
 a professional accountant. It is desirable that the method of 
 selecting the auditor be stated. 
 
 (is) Disputes about Accounts: An arbitration clause should 
 be inserted to the efifect that if any dispute arises involving the 
 accounts, it is to be submitted for settlement to a Certified 
 Public Accountant to be mutually agreed upon. As disputes 
 occur with respect to other matters as well as to the accounts, 
 in such cases the reference should be made to a Certified Public 
 Accountant and a lawyer, with power lodged in them to select a 
 third party in case of disagreement. 
 
 (16) Firm Insurance: If life insurance for the benefit of the 
 firm is to be carried on the life of one or more partners, state how 
 the premiums are to be paid, and the disposition of the proceeds 
 if collected. Also state the disposition if the partnership is dis- 
 solved while the policy is in force. 
 
 The following argument advanced by an insurance solicitor 
 has enough merit in it to commend it to the attention of every 
 professional adviser: 
 
 The alert intelligence of the American business man has discovered in 
 life insurance a most valuable assistance in establishing his credit, and of 
 late years the amount of insurance taken out for purely business reasons 
 has increased enormously. 
 
 Many partnerships have been crippled by the death of a partner at a 
 crucial period in their existence. In every properly coordinated partnership 
 each partner is a specialist in the department over which he has immediate 
 charge. His death not only means a loss in efficiency which competition 
 may render dangerous, but it may also mean the withdrawal of working 
 capital at a time when the replacing of it would be difficult, if not impossible. 
 There are, moreover, instances where it would be especially desirable to buy 
 out the interest of the estate of the deceased and thus prevent the embarrass- 
 ment of having this interest represented by a person ignorant of the business 
 or antagonistic to the other partners. In fact, the more highly developed 
 and successful the copartnership, the greater the possibility of loss through 
 the death of a partner. The indemnity which life insurance offers against 
 such a loss is well nigh perfect, inasmuch as upon the contingency of death 
 
44 AUDITING 
 
 the policy is tantamount to a sight draft upon the company in favor of the 
 surviving partners. 
 
 Partnership policies may be taken jointly upon the lives of a number of 
 partners, providing upon the death of any member of the firm for the pay- 
 ment of the face of the policy to the surviving members. Should the partner- 
 ship be dissolved, however, the policy could, if desired, be converted into 
 separate insurances for equitable amounts upon the lives of the individuals 
 who had composed the firm. Or individual policies may be taken in the first 
 instance upon the lives of each partner. Upon the death of a partner the 
 insurance upon his life would be paid to the surviving partners, the other 
 policies remaining unaffected. Upon a dissolution of the partnership, a 
 partner could purchase his own policy, having it released to such beneficiary' 
 as he might elect, and continue it as his own insurance. This privilege is 
 especially valuable when the health of the insured has become sufficiently im- 
 paired to make it impossible for him to obtain new insurance. 
 
 (17) How to Avoid Litigation: In litigation between partners 
 it has been held that where partnership books exhibit statements 
 of account and entries of periodical settlement and partial divi- 
 sions of assets, but there has been no final accounting, this will 
 not constitute a settlement or account stated so as to preclude a 
 revision of the accounts. 
 
 The auditor should therefore be careful in accepting state- 
 ments of clerks or one partner that the accounts were settled up 
 to a certain date. If at any time a final settlement had been 
 made the words "final settlement to this point" would seem to 
 be necessary to preclude the reopening of the accounts in the 
 event that any subsequent dispute should arise. 
 
 "The binding force of an account stated will not be given to 
 the mere furnishing of an account or other transaction which 
 was not with a view to asserting a claim, establishing a balance 
 due, or finally adjusting the matters of account between the 
 parties." (Cyc. i ; 367.) 
 
 AUDIT OF CORPORATIONS 
 
 In the United States the auditor is usually appointed by the 
 directors, although in most small corporations the directors and 
 officers are identical and the appointment comes from one who 
 acts in the capacity of an officer. 
 
 Officers and Directors: It is always a question as to how 
 far a professional auditor should go in giving advice. Some 
 
THE DUTIES OF AN AUDITOR 45 
 
 accountants of long experience and large practice unqualifiedly 
 recommend that an auditor's duty is to state facts, and facts only, 
 and that inferences therefrom as applied to past or future are not 
 to be drawn by professional auditors. 
 
 The author feels, however, that this is another point in prac- 
 tice where an auditor can frequently be of substantial assistance 
 to his client by going somewhat beyond the facts and figures, 
 and stating modestly and without prejudice the eiifect certain 
 methods have had, or may have in the future. 
 
 This advice may be objected to occasionally and a client or 
 two may be lost, but experience has demonstrated to the author 
 that a great majority of business men feel so helpless about 
 their accounts that they welcome any intelHgent and construc- 
 tive comments, criticisms, and advice which their auditor deems 
 it wise to impart. 
 
 If the auditor does not have the full confidence of his client, 
 the connection is not likely to be a permanent one ; if confidence 
 is reposed in him, it is considered entirely proper for business 
 advice to be contained in a report. 
 
 Officers: Many officers of close corporations, holding all or 
 nearly all of the capital stock, are apt to consider the business 
 theirs, and run it as a partnership. Any bad consequences of 
 this custom seem improbable, particularly so long as the corpora- 
 tion is making a profit, but as no one can foretell the future, and 
 as so many prosperous corporations meet with reverses and sub- 
 sequently go into bankruptcy, there is an obvious duty upon an 
 auditor to advise the officers of close corporations that, for the 
 sake of their own good names, all transactions of a corporate 
 nature should be conducted with more formality than if no such 
 restriction existed. 
 
 This applies particularly to the matter of compensation and 
 dividends. In a vast number of corporations these items are 
 handled without any formality whatever; it is considered too 
 much trouble to have a meeting of the board of directors, so a 
 verbal agreement is made; and once started, the practice con- 
 tinues. It should, therefore, be pointed out, in a tactful and 
 friendly way, that strict observance of the law with respect to 
 all matters in which the relation of the officers to the corporation 
 is concerned is advisable from every standpoint. 
 
46 AUDITING 
 
 As an example of this advice it should be noted that an 
 officer cannot fix, nor participate in the fixing, of his own salary 
 or other compensation. 
 
 In close corporations officers do not hesitate to loan money 
 to carry on the business where the capital paid is insufficient. 
 Frequently their personal accounts represent credit balances 
 throughout a long period. Interest is usually credited thereon 
 at six per cent unless a lower rate is arranged for. In the event 
 of litigation with directors or stockholders who control or (as 
 is often the case) who own one half the capital stock, and where 
 control is divided, the status of these loans may be questioned. 
 
 In one case, not yet decided, two directors loaned large sums 
 to a manufacturing corporation to enable it to produce a large 
 quantity of machinery. The corporation consolidated with a 
 competitor and received securities for its property. These se- 
 curities were the sole asset of the old company and were valu- 
 able but not marketable. The directors who had loaned the 
 money brought suit, alleging that the sums advanced were de- 
 mand loans and were due and payable, and demanded that the 
 securities be sold for what they would bring and their loans paid 
 in whole or part out of the proceeds. 
 
 The other directors resisted the suit and claimed that it was 
 understood that the loans were in the nature of additional cap- 
 ital, and while they were a first lien on the assets, yet a sale 
 of unmarketable securities would be equivalent to a liquidation 
 of the business, which was not contemplated and which would 
 wipe out any equity the capital stock might have. 
 
 It may be a year or two before this case is decided. If an 
 auditor had foreseen this result and had suggested that promis- 
 sory notes be issued from time to time with definite due dates, 
 the trouble would have been averted. This advice would have 
 been bad for the lawyers but extremely valuable to the client. 
 
 The laws of the different States vary to such an extent in 
 respect to, the rights and duties of officers and directors that no 
 attempt is made here to do more than suggest a starting point. 
 
 Directors : The foregoing remarks apply with particular force 
 to directors who are also officers. Where a director receives no 
 compensation, except perhaps a small attendance fee, the warn- 
 ing as to participation in meetings is not so pertinent, but it fre- 
 
THE DUTIES OF AN AUDITOR 47 
 
 quently happens that directors are interested in contracts and 
 other transactions which are authorized or arranged at meetings 
 in which they participate. 
 
 If the auditor discovers this state of affairs and is. convinced 
 of the bona fides of the transactions, he need not criticize, but he 
 can point out the divergence from the law, state the proper pro- 
 cedure, and suggest that at the next meeting of stockholders all 
 such questionable acts of the directors be ratified. 
 
 Under ordinary circumstances a director is held responsible 
 for good faith only, but if the minutes are not full and clear and 
 at some distant day a dissatisfied stockholder or creditor looks 
 sharply for unlawful and unauthorized transactions, the director 
 may find himself involved in annoying, if not expensive, litiga- 
 tion. 
 
 The auditor should, as far as possible, report to the board of 
 directors individually, and it is not improper for him so to word 
 his report as to invite personal conferences with any or all of 
 them. 
 
 A director has an absolute right to inspect all of the books 
 and papers of a company. This includes the auditor's report, 
 and if an auditor has reason to believe that any director does not 
 receive his report, he should investigate and at least ascertain 
 whether the director is knowingly ignorant or whether he is 
 kept in ignorance of the existence of the auditor's report because 
 the officers or his colleagues have something to conceal. Many 
 directors do not know that under certain conditions they are 
 personally liable for all debts in excess of a certain amount. The 
 auditor should post himself on this and other points so as to be 
 able to make helpful suggestions. 
 
 Elsewhere in this book (p. 204) the liability of directors 
 for payment of unearned dividends is fully discussed. It is un- 
 questionably the duty of a professional auditor to warn the 
 directors against any such action, and if it appears that his sug- 
 gestion is unheeded, the auditor should seek legal advice in order 
 to be sure that his own position is unassailable. 
 
 Successful business men might look with more favor upon 
 directorships if they were sure that affairs of the corporation 
 would have the periodical supervision of auditors who seek to 
 broaden, rather than to narrow, their responsibilities. 
 
48 AUDITING 
 
 Auditors are sometimes placed in an embarrassing position 
 through their appointment by the very officer whose accounts 
 they are supposed to audit and criticize. This is peculiarly a 
 situation which requires tact. In view, however, of the clear 
 duty of an auditor to be helpful, it need not be assumed that the 
 work cannot be done as well as in the case of a more independent 
 appointment. 
 
 If the auditor finds grounds for severe criticism, he must do 
 his duty, but anything short of this can be adjusted quietly and 
 amicably. It must be said to the credit of officers who are active 
 in the selection of their own auditors that most of them are 
 sincere in their eflforts, and the frequent criticisms of their own 
 acts which follow are as surprising to them as to anyone else. 
 
 Many corporations are run very carelessly, but an auditor 
 should hesitate about reporting unimportant matters to a board 
 of directors when a personal letter to the executive officers speci- 
 fying what has been done which should not have been done, and 
 what has not been done which should have been done, will be 
 gratefully received and promptly acted upon. 
 
 On the other hand, where auditors have commented rather 
 severely on the acts and omissions of the officers, the only result 
 has been a dislike of all professional auditors and a failure to 
 give consideration to the report. 
 
 Unless an officer is under suspicion he is apt to be much 
 closer to and have the confidence of the board of directors to a 
 greater extent than the auditor. Consequently, if the latter 
 reports anything short of fraud, unless with the full cooperation 
 of the officer, he loses prestige, and probably has lost the chance 
 of being of value, and what is more serious, has hurt the whole 
 profession. 
 
 Instances have been known where auditors have deemed it 
 their duty to be so aggressive as to precipitate a crisis in the 
 affairs of a corporation. The result of such interference might 
 easily react on the owners of the corporation (the stockholders) , 
 whose interests the auditors should protect in every way. Let 
 cooperation and helpfulness be the keynote of corporation audits 
 whether the appointment come from an officer, the directors, or 
 the stockholders. 
 
 Some slight advance has been made towards popularizing a 
 
THE DUTIES OF AN AUDITOR 49 
 
 provision in corporation by-laws requiring the accounts to be 
 audited by professional accountants, but such a provision has, 
 so far, not been adopted by even one per cent of the corporations 
 of the United States. The purchasers of the great majority of 
 the bond and preferred stock issues of industrial corporations, 
 however, are insisting on such a provision, and their action is 
 having a marked influence on public opinion. 
 
 Auditors must educate the boards of directors, and as public 
 opinion is demanding more and more actual supervision on the 
 part of directors, a very large increase in corporation audits may 
 be expected. 
 
 Stockholders, Directors, and Officers: The auditor must 
 reaHze his responsibility in writing a certificate which will be 
 circulated so widely that personal explanations or reservations 
 cannot be made. 
 
 This is probably the greatest responsibility which the pro- 
 fessional auditor faces. 
 
 The auditor of a corporation should at all times bear in mind 
 that he has three parties to serve : 
 
 (i) Proprietors (stockholders)., but stockholders have no 
 separate or individual rights. 
 
 (2) Directors, who are the legal representatives of the stock- 
 holders and who must receive all due consideration as such. 
 
 (3) Officers, who are elected or appointed by the directors, 
 and who are in possession of the property and charged with its 
 proper administration ; in efifect, acting as trustees. 
 
 The present tendency is toward the fullest corporate pub- 
 licity, and it is probable that few boards of directors will delib- 
 erately withhold material information from their stockholders. 
 Nevertheless, the courts do not require full disclosure where the 
 directors have a good reason for avoiding too much publicity of 
 corporate affairs, The time is coming, no doubt, when this rule 
 will be narrowed and any stockholder will be entitled to know 
 far more about his company than he can now demand. 
 
 It is a happy omen that directors are becoming more sensi- 
 tive to criticism than they used to be. A few years ago, if an 
 auditor submitted a report that did not agree with the views of 
 the board of directors, it was not uncommon to see it laid aside, 
 and if any report at all went to the stockholders, it would be one 
 
50 AUDITING 
 
 made up to suit the directors themselves. The auditor was not 
 displaced — he was ignored. Now an auditor is almost sure to 
 get a full hearing before his report is disapproved, and a cour- 
 ageous auditor, who knows he is right, almost invariably wins 
 his point. 
 
 Some auditors are still weak enough to be overpersuaded by 
 an officer or director who wants to make a good showing, but 
 they are digging their own pit. In the long run a subservient 
 auditor will be despised by the clients he retains and shunned 
 by all who are careful of their reputations. 
 
 AS AN EXPERT WITNESS 
 
 Few professional auditors escape their day in court as expert 
 witnesses. The necessity usually arises out of investigations 
 where fraud or disputes are known to exist, but experience 
 teaches that fraud may be discovered in any audit, and in cases 
 where it is least expected. Therefore, the auditor must look upon 
 himself at all times as a potential witness. Neglect to give proper 
 weight to this possibility has caused considerable embarrass- 
 ment on more than one occasion where an auditor has placed 
 someone in charge of an audit who is not qualified to make a 
 creditable witness. Sometimes assistants, thoroughly equipped 
 in other respects, are constitutionally unfitted to appear as expert 
 witnesses. 
 
 Part of the program of an audit, consequently, is a provision 
 for the substitution of an experienced senior or principal as soon 
 as the work has gone far enough to warrant the assumption that 
 an appearance as a witness is probable. 
 
 The author has testified as an expert witness scores of times, 
 and submits the following suggestions based entirely on prac- 
 tical experience : 
 
 (i) Preparation Is always Essential: The average lawyer 
 does not prepare his cases properly, because the majority are 
 settled without suit, or when called are so frequently continued 
 from time to time that he finds it fairly safe to take a chance of 
 waiting until the trial or reference is on before going into the 
 details of the accounts upon which he purposes to examine the 
 accountant. 
 
THE DUTIES OF AN AUDITOR 51 
 
 This makes it all the more necessary for the accountant to 
 be ready. Unfortunately, the lawyer's excuses are received with 
 less annoyance than the accountant's, and the latter must be 
 ready to go into any or all phases of the matter on a moment's 
 notice, or the lawyer, and through him the client, becomes impa- 
 tient. 
 
 The section on working papers (p. 73) should be read at 
 this point. Failure to make full and proper memoranda during 
 the examination is as annoying subsequently as the failure to 
 find data required, either because it is not properly arranged or 
 filed, or because the query raised was not foreseen. 
 
 (2) A Witness Can Testify to His Own Work Only: While 
 an expert witness is permitted to present synppses and sum- 
 maries prepared from records offered in evidence, and is thus 
 not compelled to produce his results item by item, yet he must 
 testify that the results to which he testifies are his own prepara- 
 tion and not the work of others. The state of mind of the presid- 
 ing judge usually decides this point where there is any dispute. 
 
 The author has found it valuable to have ready for inspec- 
 tion certain of the working papers written in his own handwrit- 
 ing. The attorney for the other side almost invariably raises 
 this point when he thinks there is any likelihood of any of the 
 work having been performed by others, and where the witness 
 has a large practice, and is thought to be dependent largely on 
 the work of assistants, or where the report indicates that one 
 man could not possibly have compiled all of the data within a 
 limited period of time. It is of the utmost importance, therefore, 
 that the witness should be ready to state that the results to 
 which he is testifying are his own work; that he brought the 
 figures together; that if he did not perform all of the detail 
 work, it was done under his supervision, and that he presents it 
 as his work. 
 
 (3) Information Should Not Be Volunteered: As an account- 
 ant is supposed to testify to facts only, he will make the best 
 impression when he answers questions explicitly and stops when 
 he thinks the question has been answered. 
 
 If the attorney is not fully conversant with the details of 
 the case, the accountant should, before the hearing or trial com- 
 mencesi prepare for the attorney written questions designed to 
 
52 AUDITING 
 
 bring out all of the matter favorable to his client's side of the 
 case. 
 
 The auditor should never be asked to suppress facts within 
 his knowledge, and cannot honestly do so, no matter how much 
 pressure is brought to bear, but no code of ethics recommends, 
 or as a matter of fact permits, a professional man to volunteer 
 to outsiders, or to the opposing side in litigation, facts which 
 would injure his client. 
 
 The accountant having, as a part of his duty, provided the 
 means whereby favorable facts will be disclosed, must in every 
 legitimate way guard against the disclosure of unfavorable facts. 
 As intimated above, he must answer any pertinent question, no 
 matter how much the answer may hurt his client, but if there 
 is any possibility of such a question, in cross-examination, being 
 irrelevant, or improper, he should give his own attorney plenty 
 of time to object before replying, and if he is instructed to 
 answer, his duty lies solely in telling the truth, and there should 
 be no volunteering of information for which the question does 
 not specifically call. 
 
 (4) Conclusions and Opinions : Practitioners differ as to 
 how far an accountant is justified in testifying as to his opinions 
 where the facts at hand may not be conclusive enough for him 
 to state positively that his testimony is founded on conclusions 
 based solely on facts and figures contained in the records offered 
 in evidence. 
 
 Frequently the records are incomplete, but enough data may 
 have been compiled to warrant a definite opinion as to certain 
 results. Where the witness is acting in good faith, and is inter- 
 ested only in seeing that, as far as he is concerned, substantial 
 justice is being done, it may be urged that his duty to his client 
 requires the presentation of all the evidence possible, and that 
 the other side can be depended upon to object to anything going 
 in unless the ground work of relevancy has been laid. 
 
 On the other hand, it is contended that an accountant, as a 
 witness, should be absolutely impartial and disinterested, that 
 he should state the bare truth and be oblivious of which side it 
 might affect. The author has heard this argument for many 
 years, but in the course of his experience, which has brought 
 him into contact, on one side or the other, with the leading 
 
THE DUTIES OF AN AUDITOR 53 
 
 accountants in this country, he has invariably found that the 
 accountants are more or less interested in their side and the pre- 
 sentation of the facts favorable to their side, and he has failed 
 to detect any signs of pure disinterestedness on the part of any 
 one of them. 
 
 Furthermore, he has found in many instances that the ac- 
 countants have been better advocates for their clients than the 
 attorneys themselves, this being demonstrated not only by their 
 testimony under oath, but by their skill in suggesting questions 
 to the attorneys, and these questions have been directed to all 
 witnesses, and not to those only who are examined on the 
 accounts. 
 
 To sum up : the present practice seems to be for accountants 
 to promote in all legitimate ways the success of the side of liti- 
 gation on which they are retained, and they are not found to be 
 unconcerned and oblivious of results; that the attorneys and 
 parties to the cases know that this is the practice ; that they are 
 relying more and more on professional auditors to assist in the 
 preparation of matters in litigation ; and that the attorneys and 
 others who have a first-hand knowledge of the present practice 
 do not see any impropriety in it. 
 
 The author has no criticism to make of this procedure, but 
 on the contrary believes that the accountants who have in many 
 cases signally helped their clients by extra zeal would have fallen 
 short of their full duty if they had maintained the attitude of 
 a machine which shows final results, but which cannot make 
 suggestions as to how those results may be used. 
 
 THE AUDITOR OF AN INSTITUTION OR SIMILAR 
 ORGANIZATION 
 
 In recent years there has been a noteworthy advance in the 
 practice of employing professional auditors for universities, 
 schools, hospitals, clubs, churches, and many other quasi-public 
 organizations. 
 
 Frequently one of the auditor's clients will be interested in 
 the afifairs of one of these enterprises and requests that an audit 
 be made for his personal information. This is usually followed 
 by formal appointment by the board of managers or directors 
 
54 AUDITING 
 
 and the auditor secures an opportunity to submit a certificate 
 which finds its way into the annual printed report. Because such 
 publicity is desirable and apt to increase his clientele, especially 
 among those directly connected with that particular institution 
 and because he feels under some obligation to his client, these 
 audits are rarely remunerative. The auditor is sometimes forced 
 seriously to consider the advisability of declining such engage- 
 ments. 
 
 The investing public must be taught that corporations which 
 do not publish certified statements of their condition and earn- 
 ings should be looked upon with suspicion, and charitable or reli- 
 gious institutions should for the same reason be compelled to 
 publish certified balance sheets and certified statements of their 
 income and expenses. The giving public can then discriminate 
 against the institution which does not fully disclose its affairs 
 and so indicate that all of its financial transactions are beyond 
 reproach. 
 
 During the last year the Chicago Association of Commerce 
 considered this subject, and a committee appointed for the pur- 
 pose arrived at the conclusion that all institutions inviting sub- 
 scriptions from the public should submit to an annual audit. 
 The Subscriptions Investigating Committee of the Association 
 now gives its unqualified indorsement only to such institutions 
 as, in addition to satisfactorily meeting all the other require- 
 ments of the Committee, have their accounts audited annually 
 by public accountants. A plan was worked out under which a 
 considerable number of public accountants in Chicago cooperate 
 with this Committee by making audits of charitable and philan- 
 thropic institutions at a nominal rate per diem. The plan has 
 now been in effect for a year; further details concerning it can 
 be secured from Walter A. Staub, C. P. A., Secretary of the 
 Accountants Association for the Audit of Local Charitable and 
 Philanthropic Institutions, First National Bank Building, Chicago. 
 
 SPECIAL AUDITS 
 
 The professional auditor will find himself called upon for 
 work of a special character, as, for instance, by a creditor's com- 
 mittee, or by a retiring partner, or by a dissatisfied beneficiary 
 
THE DUTIES OF AN AUDITOR 55 
 
 under a will. His duty under these varying circumstances is 
 uniform, that is, his duty to himself and his profession is para- 
 mount, and he cannot avail himself of technicalities and evasion 
 to conceal the true state of facts. 
 
 It is, however, not unprofessional to assure the payment of 
 his fee, and as disputes frequently arise on this point in these 
 special audits, a word of caution may be in order. 
 
 Where it is agreed by both sides of a dispute that an exam- 
 ination shall be made by an independent auditor, the latter is 
 called upon, performs the services, and makes his report. But 
 when he renders his bill, both sides disclaim it. This occurs so 
 often that there is no excuse for an auditor getting caught twice, 
 while those who have not so suffered can avail themselves of 
 this warning. 
 
CHAPTER V 
 ETHICAL DUTIES— LEGISLATION 
 
 The Auditor's Ethical Duties: Codes of ethics may be 
 written or unwritten, but whether written or not they form a 
 basis on which to judge the worthiness of the aspirant for pro- 
 fessional standing. Just as a professional man is known by the 
 ethics he observes, so is the profession itself known by the stand- 
 ard of ethics it sets up for the guidance of its members. 
 
 The medical profession has perhaps the most definite code, 
 the observance of which has been made compulsory upon its 
 members. It will probably be many years before accountancy 
 ethics will reach the same degree of development, but the subject 
 is receiving more and more consideration and careful study. 
 
 Following is that part of the by-laws of the American Asso- 
 ciation of Public Accountants prescribing a code of ethics for the 
 profession, including the amendments submitted at the Sep- 
 tember, 1912, annual meeting in Chicago. 
 
 ARTICLE VI 
 Precepts of Professional Conduct 
 
 (o) A profession is an employment requiring a learned education, a 
 vocation in which a professed knowledge of some department of science or 
 learning is used by its practical application to the affairs of others in advis- 
 ing, guiding, or teaching them or in serving their interests or welfare in the 
 practice of an art founded on it. Professed attainments and special knowl- 
 edge as distinguished from mere skill; practical dealing with affairs as dis- 
 tinguished from mere study or investigation; the application of such knowl- 
 edge to use for others as a vocation as distinguished from its pursuit for 
 its own purposes. 
 
 (6) Professional conduct necessarily implies honorable conduct; and 
 unprofessional, dishonorable. 
 
 (c) Public policy requires that certain occupations must be subject to 
 legislative control due to the special scholarly and moral qualifications re- 
 quired of a practitioner and the injurious consequences likely to result from 
 a lack thereof. 
 
 (i) The study of the sciences of higher accounting, finance, and indus- 
 trial economics and the practical application of such acquired knowledge as a 
 
 56 
 
ETHICAL DUTIES— LEGISLATION 57 
 
 life career as such services may be demanded must be regarded as the prac- 
 tice of a profession. 
 
 (e) Every practitioner should aid in guarding the profession against the 
 admission to the profession of candidates unfitted or unqualified because de- 
 ficient in either education or moral stamina. 
 
 (/■) A practitioner cannot offer his services for sale or vaunt his own 
 abilities without violating the canons of good taste and professional ethics. 
 No one invested with the dignity and prestige implied by such intimate rela- 
 tions with clients should be permitted to degrade it by mere cupidity. A 
 wholesome regard for such dignity forbids an accountant advertising his 
 talents or skill as a merchant does his wares. 
 
 (g) It is an undignified resort to low artifice to advertise under an 
 actual or fictitious corporate name. 
 
 (h) An accountant should not speak slightingly or disparagingly of his 
 profession, or pander to unjust prejudice on the part of the laity, and should 
 scrupulously refrain from inciting or fostering such prejudice as a reflection 
 upon a brother accountant. 
 
 Rules of Conduct 
 
 1. No member shall allow any person to practice in his name as a public 
 accountant who is not a member of this association, in partnership with him 
 or in his employ on a salary, nor. shall he practice under an impersonal desig- 
 nation or corporate title. 
 
 2. No member shall directly or indirectly allow or agree to allow a com- 
 mission, brokerage, or other participation by the laity in the fees or profits 
 of his (the member's) professional work, nor shall he accept directly or in- 
 directly from the laity any such commission or brokerage for professional or 
 commercial business turned over to others as an incident of his service to 
 clients, nor perform accountancy work payment for which is contingent upon 
 the result of litigated or arbitrated issues. 
 
 3. No member shall engage in any business or occupation conjointly with 
 that of a public accountant, which in the opinion of the Board of Trustees is 
 incompatible or inconsistent therewith. 
 
 4. No member shall certify to exhibits, statements, schedules, or other 
 form of accountancy work which have not been verified entirely under the 
 supervision of himself, a member of his firm, one of his staff, a member of 
 this association, or of a similar association of good standing in foreign 
 countries. 
 
 5. No member shall in his business advertisements use any initials as an 
 aflbc to his name that are not either authorized by statutory enactment of 
 this country or by the well-known associations established for a similar pur- 
 pose in the British empire, nor shall he affiliate with or substantially recognize 
 any society that is designated or in aiiy way sets itself out to be a so-called 
 certified public accountant society unless the State in which such society is 
 organized has the requisite statutory enactment in full force and effect. 
 
 6. No member shall take part in any effort to secure the enactment, altera- 
 tion, or amendment, of any State or Federal law affecting the profession 
 
S8 AUDITING 
 
 without giving immediate notice thereof to the secretary of the association, 
 who in turn shall at once advise the secretary of the State or district society 
 concerned. 
 
 LEGISLATION 
 
 The question of legislation looking to compulsory audits has 
 been discussed frequently, chiefly by accountants, however, and 
 as they are believed to be the chief beneficiaries, little progress 
 has been made. But as soon as investors and stockholders, gen- 
 erally, come to realize that the protection is great and the ex- 
 pense small, legislation may be expected. 
 
 The following bill was introduced in a recent session of the 
 Pennsylvania Legislature at the request of the then President of 
 the Pennsylvania C. P. A. Board : 
 
 An Act 
 
 Requiring the certification of a certified public accountant of the State of 
 Pennsylvania as to the correctness of any financial statement issued by any 
 corporation of this State or by any foreign corporation or corporation of 
 other States doing business in the State of Pennsylvania, for public informa- 
 tion or for purposes of taxation, and to provide a punishment for the violation 
 of this act. 
 
 Section i. Be it enacted by the Senate and House of Representatives of 
 the Commonwealth of Pennsylvania in General Assembly met, and it is hereby 
 enacted by the authority of the same, that all corporations of the State of 
 Pennsylvania or foreign corporations or corporations of other States doing 
 business in the State of Pennsylvania, upon issuing any financial statement 
 inviting the purchase of their stock or bonds, or in issuing any monthly, 
 quarterly, semiannual, or annual statements of the condition or business of 
 such corporations, or any financial statements given to the newspapers, finan- 
 cial agencies, or other financial statements for the purpose of public informa- 
 tion in the State of Pennsylvania, or upon furnishing statements to the offi- 
 cials of the State of Pennsylvania for the purpose of taxation, shall be re- 
 quired to have such statements verified by a certified public accountant of 
 the State of Pennsylvania. 
 
 Sec. 2. If any such corporation fails to have such certification made, it 
 shall be deemed and held guilty of a misdemeanor, and upon conviction there- 
 of shall be fined not more than one thousand dollars, nor less than five hun- 
 dred dollars, and any officer, agent, or employee of such corporation fur- 
 nishing a false statement, or any certified public accountant certifying to the 
 correctness of a statement issued by any corporation, when it is vitally in- 
 correct or misleading, the officer, agent, or employee making such false 
 statement, and the certified public accountant certifying to such false state- 
 ment, shall be deemed guilty of a misdemeanor, and, on conviction thereof, 
 shall be sentenced to imprisonment for a term not exceeding two years and 
 
ETHICAL DUTIES— LEGISLATION 59 
 
 not less than one year, or a fine not exceeding five thousand dollars nor less 
 than three thousand dollars, or both. 
 
 The bill, of course, did not pass, and is not referred to here as 
 an ideal measure, but it is at least suggestive and should be of 
 interest to all who contemplate legislation along similar lines. 
 
 It is suggested that a more desirable State law would compel 
 all corporations to furnish annual reports to their stockholders, 
 with a balance sheet and profit and loss statement duly certified 
 to by recognized professional accountants. This suggestion 
 brings up the question as to how much information should be 
 furnished to stockholders. 
 
 The time-honored excuse for withholding information from 
 stockholders is the expressed fear that competitors may take 
 advantage of it. Many factors enter into the discussion, but it is 
 becoming a well established custom that a corporation with a 
 considerable number of stockholders is under an obligation to 
 furnish such an annual report as will give the stockholders an 
 opportunity to judge for themselves whether to hold their stock 
 or sell it, and the report must be complete enough so that the 
 opinion so formed will have a true basis. 
 
 Some of the most prosperous corporations in the country 
 publish the most complete reports. They know that their com- 
 petitors cannot get the slightest advantage from such state- 
 ments, and they ignore the childish and silly excuses offered by 
 corporations which do not publish reports. 
 
 The stockholder must be educated to discriminate between 
 a report which is certified to and one which is not. 
 
 Legislation Proposed in New York State : Several years ago, 
 in response to a demand for legislation which would afford 
 greater security to investors, Dr. Jeremiah W. Jenks prepared a 
 draft bill which was introduced in the New York Legislature but 
 which did not pass. It was entitled "New York Business Com- 
 panies Act." It is extremely suggestive, and portions thereof 
 are inserted at this point as a reminder to professional auditors 
 that constant agitation will ultimately result in favorable legis- 
 lation, and any statute which safeguards the interests of the 
 investing public will be even more beneficial to the profession. 
 The auditor's duty to his clients happily includes missionary 
 work along the line of compulsory audits. 
 
6o AUDITING 
 
 The sections of the bill referred to which are of interest to 
 the profession are as follows: 
 
 Officers* 
 
 Besides the usual officers, an auditor or auditors shall be chosen by 
 ballot by the stockholders at their annual meeting, and no person or firm or 
 corporation, a member, director, or officer of which is a director of the com- 
 pany to be audited, shall be eligible. Gjrporations organized under this act 
 with a capital stock of one hundred thousand dollars or upward must select 
 as auditor or auditors a person, firm, or corporation duly qualified and en- 
 gaged in the practice of public accounting and auditing in this State. And 
 the auditor or auditors selected by a corporation whose capital stock amounts 
 in all to one million dollars or more must have his or their financial responsi- 
 bility secured by a bond of fifty thousand dollars of some surety company 
 authorized to do business under the insurance laws of this State; and for a 
 corporation whose capital stock is less than one million dollars, by a bond 
 amounting to at least five per centum of the capital stock and approved by 
 the shareholders either at a meeting or through a committee selected for 
 this purpose. The above provisions regarding bonds may be waived by the 
 written consent of every shareholder. 
 
 Any stockholder shall be entitled, upon payment of cost of copying at 
 not over ten cents a folio of one hundred words, to a statement at any time 
 of all salaries paid to any officer or officers of the corporation, together with 
 a statement of all contracts or agreements in which any officer of the corpora- 
 tion may be interested either as a contracting party with the corporation or 
 as an officer or stockholder in any other corporation contracting with the 
 company. 
 
 The salaries of the officers shall be fixed at the annual meeting unless 
 the articles of incorporation provide otherwise. In case, however, salaries 
 shall be increased at any time by the board of directors under provision of 
 the articles of incorporation, report thereof must be made at the next annual 
 meeting to the stockholders and laid before them for ratification. Their 
 action shall be conclusive in all. particulars. 
 
 If any certificate made, or any public notice given by the officers or 
 directors of any corporation in pursuance of the provisions of this act, shall 
 be false in any material representation, all the officers or directors who shall 
 have signed the same, knowing it to be false, shall be jointly and severally 
 liable for all the debts of the corporation contracted while they were directors 
 or officers thereof, as a penalty enforceable in the courts of this State only. 
 
 Meetings 
 
 At the regular annual meeting, for which provision must be made in the 
 certificate of incorporation or in the by-laws, the shareholders' balance sheet, 
 
 1 The provisions regarding auditors are intended to protect shareholders against misuse of 
 power by directors. Every effort is made to identify the interests of auditors and shareholders. 
 The provisions regarding bonds ot auditors will make their responsibility a real one. The fur- 
 ther provisions regarding officers are likewise needed to hold them responsible to shareholders. 
 
ETHICAL DUTIES— LEGISLATION 6i 
 
 prepared and certified by the auditors as provided later, must be presented 
 to the shareholders. If the directors or other officers of any corporation 
 organized under this act shall fail or neglect to call, in the manner provided 
 by law, the annual stockholders' meeting at the time appointed in the certifi- 
 cate of incorporation or in the by-laws and shall not hold the same accord- 
 ingly, thereupon, from the time when said meeting was appointed to be held, 
 until the meeting shall actually be held thereafter, all salaries of president, 
 vice-presidents, secretary, treasurer, and directors shall cease and determine, 
 and it shall be unlawful for any corporation or its officers or directors to 
 pay directly or indirectly any salary or compensation to any of the above 
 named officers or to any director for services rendered in the interim. 
 
 At the annual meeting any shareholder shall be entitled to require from 
 the company and the directors shall be bound to furnish him with a copy of 
 all or any parts of the directors' records of meetings. 
 
 Balance Sheet' 
 
 Every company and the directors and managers thereof 
 
 1. Shall cause to be kept proper books of account in which shall be kept 
 full, true, and complete accounts of the affairs and transactions of the com- 
 pany; and 
 
 2. Shall once, at least, in each year cause the accounts of the company 
 to be balanced and a balance sheet in this act referred to as the shareholders' 
 balance sheet to be prepared, which balance sheet, after being duly audited, 
 shall be laid before the members of the company in. next general meeting; 
 and 
 
 3. Shall cause a copy of such shareholders' balance sheet so audited to 
 be sent to the registered address of every member of the company at least 
 seven days before the meeting at which it is to be laid before the members 
 of the company, and a copy to be deposited at the registered office of the 
 company for the inspection of the members of the company during a period 
 of at least seven days before that meeting, and every shareholder in the com- 
 pany or any person acting in his behalf shall be entitled to other copies 
 thereof on payment of twenty-five cents each. 
 
 The shareholders' balance sheet shall be in such form as is directed by 
 the certificate of incorporation, or the by-laws, or by a resolution of the com- 
 pany, and shall show in every case 
 
 1. The amount of share capital authorized, the amount issued, and the 
 amount paid up thereon, distinguishing the amount of share capital paid up 
 in money and the amount paid otherwise than in money, with a statement 
 of nature of the consideration and the arrears of calls due, and the specific 
 amounts issued during the two years next preceding; 
 
 2. The amount of debts due by the company, specifying the security, if 
 any, allocated for each debt and distinguishing the amount of mortgages, 
 
 1 If will be observed that this balance sheet is not published, but is given to the shareholders. 
 Of cou«e in case of larg? companies whose stocks are on the stock market, th.s is equivalent 
 r ■SiZLtSlJ^ i^hYu a small onvate corooration with but few members would be able to con- 
 fi%''kn^leds4 of it? affa™At?"ts{?w stockholders and the proper officers of thp State. 
 
62 AUDITING 
 
 debentures, and floating charges against the general assets of the company, 
 the amount of the reserve fund, if any, and the amount of any contingent 
 liabilities ; 
 
 3. The amount of all current assets, after making a proper deduction for 
 debts considered to be bad or doubtful. Any debts due from directors or 
 other officers to be separately stated ; 
 
 4. Whether the assets other than debts due to the company are taken at 
 cost price or by valuation, or on what other basis they are reckoned, and 
 whether any and if so what amount of percentage has been written ofif and 
 what other provision, if any, has been made for depreciation; 
 
 5. The gross amount of the year's earnings, the deductions made from 
 the same for fixed charges of interest and taxes and the surplus, if any, avail- 
 able for dividends ; 
 
 6. The amount by which the gross value of the assets of the company 
 has been increased since the last balance sheet in consequence of any increase 
 in the valuation of real or personal property belonging to the company; 
 
 7. The amount of property, if any, for which shares were issued which 
 has been sold since the last report, with a full disclosure of the consideration 
 therefor in detail, the parties to the contract, and the real parties in interest 
 
 The shareholders' balance sheet shall be accompanied by a certificate, 
 signed by two or more of the directors on behalf of the board, stating that, 
 in their opinion, the balance sheet is drawn up so as to exhibit a correct view 
 of the state of the company's affairs and that, in their opinion, the statement 
 is correct. 
 
 A copy of the balance sheet shall be sent to each director at least ten 
 days before the annual meeting, and unless he formally at or before the 
 meeting makes statement to the contrary, he shall be held to have also signed 
 the report 
 
 Duties of Auditors 
 
 The auditors of every company 
 
 1. Shall use reasonable diligence with the view of ascertaining that the 
 books of the company have been properly kept and record correctly the affairs 
 and transactions of the company; 
 
 2. Shall examine the shareholders' balance sheet and any accounts pre- 
 sented to the members of the company, and shall report in writing to the 
 members of the company when the balance sheet is transmitted, that the 
 balance sheet and accounts have been drawn up in accordance with the pro- 
 visions of the New York Companies' Act, and when taken together, with 
 any explanations attached thereto, present a correct view of the state of the 
 company's affairs. Or, if the auditors are unable to make such a report, 
 they shall report in writing when the balance sheet is transmitted in what 
 respects the balance sheet and accounts fail to comply with these require- 
 ments, and shall sign a certificate at the foot of the balance sheet, stating 
 whether of not all their requisitions as auditors, including their requisitions 
 with regard to the private balance sheet hereinafter mentioned, have been 
 complied with; and 
 
ETHICAL DUTIES— LEGISLATION 63 
 
 3. Shall report in writing to the members all material information which 
 they have observed or have become acquainted with with regard to the books, 
 accounts, securities, vouchers, papers, writings, and documents examined by 
 them, and for this purpose they shall at all times have access to all the books, 
 accounts, and records of the company, and to the minute book, and shall be 
 empowered to require from the directors and other officers such information 
 and explanation as may be necessary for the performance of their duties. 
 
 If for any reason it prove impossible for the auditors to prepare their 
 report before the date mentioned above, then they shall submit at the general 
 meeting the reasons for their failure. The shareholders shall then take 
 action and fix a later date at which a report shall be submitted either by the 
 said auditors or by their successors in office. 
 
 If the auditors, or any one of them, think there is just cause to disapprove 
 of any part of the said accounts presented to the members of the company, 
 they, or any one of them, may disallow any part of the said accounts so dis- 
 approved of and shall report their or his disapproval in writing on the ac- 
 counts and balance sheet. 
 
 Every such report and balance sheet shall be read before the company at 
 the next general meeting. 
 
 Any auditor who shall willfully or through gross negligence certify that 
 any false or fraudulent balance sheet or account is correct, shall be civilly 
 responsible to any party injured. 
 
 Private Balance Sheet 
 
 The auditors of every company before making a report pursuant to the 
 last preceding section shall require, and the directors and president of the 
 company shall, without unnecessary delay, supply to the auditors a balance 
 sheet, in this act referred to as the private balance sheet, giving the details 
 on which the shareholders' balance sheet is founded and showing among other 
 things the amount of deduction, if any, for debts considered to be bad or 
 doubtful. 
 
 The private balance sheet must be signed by the president, treasurer, and 
 by at least two of the directors of the company when there are not more 
 than three directors, and by three, at least, when there are more than three 
 directors. 
 
 The auditors may require the directors, treasurer, and president of the 
 company to supply in writing, signed as hereinbefore provided, any further 
 details or information affecting the balance sheet or any particular item com- 
 prised therein, and shall sign a certificate at the foot of the private balance 
 sheet, stating whether or not all their requisitions as auditors have been 
 complied with. 
 
 The private balance sheet shall not be issued to the members of the com- 
 pany, but shall, together with all such further details and information as 
 aforesaid, be kept by the directors as part of the records of the company. 
 
 In this connection it may be interesting to note some of the 
 provisions with respect to auditors which are contained in the 
 
64 AUDITING 
 
 English Companies (Consolidation) Act, 1908 (8 Edw. VII, 
 ch. 69). 
 
 Section 112. (i) Every company shall at each annual general meeting 
 appoint an auditor or auditors to hold ofSce until the next annual general 
 meeting. 
 
 (2) If an appointment of auditors is not made at an annual general meet- 
 ing, the Board of Trade may, on the application of any member of the com- 
 pany, appoint an auditor of the company for the current year and fix the 
 remuneration to be paid to him by the company for his services. 
 
 (3) A director or officer of the company shall not be capable of being 
 appointed auditor of the company. 
 
 (4) A person, other than a retiring auditor, shall not be capable of being 
 appointed auditor at an annual general meeting unless notice of an intention 
 to nominate that person to the office of auditor has been given by a share- 
 holder to the company not less than fourteen days before the annual general 
 meeting, and the company shall send a copy of any such notice to the retiring 
 auditor and shall give notice thereof to the shareholders, either by advertise- 
 ment or in any other mode allowed by the articles, not less than seven days 
 before the annual general meeting; 
 
 Provided, that if, after notice of the intention to nominate an auditor 
 has been so given, an annual general meeting is called for a date fourteen 
 days or less after the notice has been given, the notice, though not given 
 within the time required by this provision, shall be deemed to have been 
 properly given for the purposes thereof, and the notice to be sent or given 
 by the company may, instead of being sent or given within the time required 
 by this provision, be sent or given at the same time as the notice of the 
 annual general meeting. 
 
 (5) The first auditors of the company may be appointed by the directors 
 before the statutory meeting, and, if so appointed, shall hold office until the 
 first annual general meeting, unless previously removed by a resolution of the 
 shareholders in general meeting, in which case the shareholders at that meet- 
 ing may appoint auditors. . 
 
 (6) The directors may fill any casual vacancy in the office of auditor, but 
 while any such vacancy continues, the surviving or continuing auditor or au- 
 ditors, if any, may act. 
 
 (7) The remuneration of the auditors of a company shall be fixed by the 
 company in general meeting, except that the remuneration of any auditors 
 appointed before the statutory meeting, or to fill any casual vacancy, may be 
 fixed by the directors'. 
 
 ~ Section 113. (i) Every auditor of a company shall have a right of access 
 at all times to the books and accounts and vouchers of the company, and 
 shall be entitled to require from the directors and officers of the company 
 such information and explanation as may be necessary for the performance 
 of the duties of the auditors, 
 
ETHICAL DUTIES— LEGISLATION 65 
 
 (2) The auditors shall make a report to the shareholders on the accounts 
 examined by them, and on every balance sheet laid before the company in 
 general meeting during their tenure of office and the report shall state 
 
 (o) Whether or not they have obtained all the information and ex- 
 planation they have required; and 
 
 (6) Whether, in their opinion, the balance sheet referred to in the report 
 is properly drawn up so as to exhibit a true and correct view of the state of 
 the company's affairs according to the best of their information and the ex- 
 planations given to them, and as shown by the books of the company. 
 
 (3) The balance sheet shall be signed on behalf of the board by two of 
 the directors of the company, or, if there is only one director, by that director, 
 and the auditors' report shall be attached to the balance sheet, or there shall 
 be inserted at the foot of the balance sheet a reference to the report, and the 
 report shall be read before the company in general meeting and shall be open 
 to inspection by any shareholder. 
 
 Any shareholder shall be entitled to be furnished with a copy of the 
 balance sheet and auditors' report at a charge not exceeding sixpence for 
 every hundred words. 
 
 (4) If any copy of a balance sheet which has not been signed as required 
 by this section is issued, circulated, or published, or if any copy of a balance 
 sheet is issued, circulated, or published without either having a copy of the 
 auditors' report attached thereto or containing such reference to that report 
 as is required by this section, the company, and every director, manager, secre- 
 tary, or other officer of the company who is knowingly a party to the default, 
 shall, on conviction, be liable to a fine not exceeding fifty pounds. 
 
 (5) In the case of a banking company registered after the fifteenth day 
 of August, eighteen hundred and seventy-nine 
 
 (a) If the company has branch banks beyond the limits of Europe, it 
 shall be sufficient if the auditor is allowed access to such copies of and ex- 
 tracts from the books and accounts of any such branch as have been trans- 
 mitted to the head office of the company in the United Kingdom ; and 
 
 (6) The balance sheet must be signed by the secretary or manager (if 
 any), and where there are more than three directors of the company by at 
 least three or four of those directors; and where there are not more than 
 three directors, by all directors. 
 
 Section 114. (i) Holders of preference shares and debentures of a com- 
 pany shall have the same right to receive and inspect the balance sheets of 
 the company and the reports of the auditors and other reports as is pos- 
 sessed by the holders of ordinary shares in the company. 
 
 (2) This section shall not apply to a private company, nor to a company 
 registered before the first day of July, nineteen hundred and eight. 
 
CHAPTER VI 
 
 HOW TO BEGIN AN AUDIT 
 
 The importance of knowing how to begin an audit cannot 
 be overestimated. Until the business public is educated to a 
 point where it knows just what is required and can ask for 
 specific service, which in turn the auditor can perform without 
 violating his rules of practice, his employment is more or less 
 general in its nature and the scope of the work is left to the 
 auditor. 
 
 For this reason many practitioners commence the work 
 before they have a clearly defined line of procedure in their own 
 minds. 
 
 Based on personal experiences of over twenty years, the 
 author suggests the following preliminary program: 
 
 (i) As to the Client: Attention has been called to the 
 uncertainty which sometimes exists as to the actual client whom 
 the auditor is serving and to whom he is responsible. It may be 
 a banker or a prospective borrower, a corporation or a dissatis- 
 fied stockholder, a trustee in bankruptcy or the petitioning cred- 
 itors, or a creditors' committee, a municipality or an aldermanic 
 committee, a State or an investigating committee of the Legis- 
 lature. In all of these cases and many more, differences of opin- 
 ion have arisen as to the legal status of the client ; therefore, this 
 word of caution addressed particularly to the beginner is in 
 order : 
 
 Fix the legal responsibility of the client before work is com- 
 menced. 
 
 (2) Do not start until you are sure you will finish: Some 
 auditing engagements have ended disastrously for the auditors 
 because the work was undertaken blindly. It is not enough that 
 some one should say, "Here are certain books and records; I 
 want them audited and a report made to me of what they con- 
 tain." The client may think he knows what he wants, he may be 
 financially able to pay, and to a young practitioner the tempta- 
 tion to jump in and follow instructions is strong indeed. But the 
 
 66 
 
HOW TO BEGIN AN AUDIT 67 
 
 client may and does change his mind as the work progresses, 
 and even if the instructions are in writing, he will find some 
 excuse for his change of mind. He may still be able to pay, but 
 he may not want to. There are several notable examples of 
 work done along the lines indicated the bills for which have 
 never been paid. 
 
 Therefore, spend some time with the client reviewing the 
 work before it is commenced. Map out as definite a program 
 as possible and overstate, rather than understate, the probable 
 time which will be required. The client may have a vague 
 knowledge of details, but he should know pretty well what the 
 work should cover, and if the auditor cannot come to a fairly 
 definite agreement with him as to the scope and extent of the 
 work, the responsibility of making good is placed definitely on 
 the auditor. 
 
 A few hours' talk of this nature may subsequently eliminate 
 many days of useless work — useless because there may have 
 been a mistaken idea as to the results wanted; or the results 
 striven for might be very valuable and interesting if the work 
 could be completed as originally planned. 
 
 In most cases the auditor's wide experience enables him to 
 know better than the client just what should be done, and what 
 may be safely omitted, but this does not relieve an auditor from 
 his obligation to assure himself whether in the particular case 
 before him the client's more intimate knowledge of the business 
 does not justify him in indicating the general lines along which 
 the audit should be made. 
 
 A full and frank talk with a client cannot do any possible 
 harm and may insure cooperation and harmony, which might be 
 lacking if the auditor shows too much of a disposition to run the 
 whole job himself. 
 
 (3) Try to secure the friendly cooperation of the client's 
 staff : A successful auditor told the author recently that in every 
 audit he endeavored to attract, interest, instruct, and convert 
 the office stafif, and in so doing he not only made his own work 
 pleasanter and more satisfactory in a professional way, but that 
 he made them co-workers with him, and in many ways they aid 
 the growth of a proper opinion of the value of the public ac- 
 countant. Many instances are known where auditors have an- 
 
68 AUDITING 
 
 tagonized an office staff and sent them out to an extensive 
 acquaintance charged with a desire to criticize most unfavorably 
 not only the offending auditor (which would not be unfair), but 
 also professional auditors as a class. 
 
 Some very large engagements have resulted directly from 
 a word of commendation to others from a bookkeeper or clerk 
 who has had a satisfactory experience with the auditor of his 
 accounts. 
 
 All auditors of experience agree that the majority of men are 
 honest — not a mere majority only, but most men are honest. 
 Furthermore, most men are sensitive about having their honesty 
 questioned even indirectly. The successful auditor does not 
 conduct himself in such a manner as to indicate to anyone that 
 suspicion exists. He must radiate his belief in the good faith 
 and honesty of purpose of those whose accounts he is examin- 
 ing; but he will be none the less thorough and he will just as 
 surely land any guilty man. 
 
 The honest man is also sensitive to criticism of his work. 
 Here the auditor's task is harder, because the duty to one's client 
 must be placed above everything else, and while it is sometimes 
 unpleasant to condemn carelessness and mistakes on the part of 
 the office staff, yet if it is evident that the client's business is 
 suffering therefrom, failure to report actual conditions would be 
 a breach of professional duty. 
 
 But the auditor who prepares his report and sends it in to 
 the client without considering its effect on the office staff may 
 be doing a positive injury to his client as well as to himself. 
 The clerk whose work is criticized may be one of the most valu- 
 able on the staff. His merits may vastly outweigh his short- 
 comings, yet if he is sensitive he may resign forthwith, thus 
 weakening the client's organization and subjecting the auditor 
 to the wrath which he in a measure deserves. 
 
 Or again, the clerk or clerks whose work is criticized may 
 not resign, but being in the confidence of the cHent and having 
 his ear every day, may easily offset all of the good effect which 
 the criticisms and suggestions might have, and, in addition, prej- 
 udice the client against the further employment of the auditor. 
 
 Naturally, the auditor is not informed as to what is taking 
 place, and if his services are not called for when another audit is 
 
HOW TO BEGIN AN AUDIT 69 
 
 due, he is ignorant of the true reason for the decision against 
 him. 
 
 Hundreds of business men have retained a professional au- 
 ditor once as an experiment, because they had been told it was 
 the proper thing to do, and would have become regular cHents 
 had the auditor been able to secure the sympathy and coopera- 
 tion of the office staflf. 
 
 Who can blame a busy man, necessarily dependent upon an 
 organization of trusted employees, for heeding their opinion of 
 an auditor? 
 
 All That is Required is Tact: The auditor need not stultify 
 himself by failure to criticize. As a matter of fact, an honest 
 staff resents gratuitous commendation if they know it is not 
 deserved. All they want is a square deal. In practically all 
 cases the methods in force were initiated by the client himself 
 or by the predecessors of the present staff. They are simply 
 following precedents or instructions and should not be person- 
 ally blamed for unsatisfactory methods or results. 
 
 Let the auditor proclaim his gospel of helpfulness and ask 
 for cooperation in the interest of the staff and in that of the 
 client. Let him demonstrate quietly that he knows more than 
 they do, but let it be done unobtrusively. Show them that fail- 
 ure to be up to date is detrimental to success, and that modern 
 methods must justify themselves. Get them interested and ask 
 their help in preparing an unbiased report on actual conditions, 
 and obtain their approval of the suggested changes. 
 
 If this spirit prevails throughout the audit the client will 
 be benefited, the office staff will be enthusiastic over the innova- 
 tion, and the auditor will receive a unanimous invitation to come 
 again. 
 
 (4) As to Fees : Compensation must depend on service ren- 
 dered : The professional accountant offers his services to the busi- 
 ness public as an adviser as well as an analyst or auditor ; there- 
 fore it is obvious that the matter of compensation and status 
 cannot be determined as it can in those occupations where the 
 matter of output or results can be measured. You cannot gauge 
 an output of brains as you can a stated amount of manual labor. 
 
 Great harm has been done to the profession by certain adver- 
 tisers who, for the purpose of selling correspondence courses in 
 
70 AUDITING 
 
 accountancy, have exaggerated the compensation of professional 
 accountants. There is no reason why the profession should be 
 better paid than any other which serves the public to an equal 
 degree. The implication in these advertisements that there is 
 some fixed scale of fees which an accountant can charge is 
 more or less correct, and it is unfortunate that such is the case, 
 for it tends to place the profession on a par with day laborers. 
 
 If all accountants are to charge alike for their services, where 
 is the incentive to excel and what kind of profession would it 
 be if there were no premium on ability and experience? The 
 best lawyers and the best doctors sometimes charge lower fees 
 for the same service than less experienced and less competent 
 practitioners, but such reduction is none the less professional. 
 
 So with accountants, as time goes on there will be less and 
 less uniformity in charges, and the more skillful, capable, expe- 
 rienced accountant will not consider it necessary to place a fixed 
 per diem rate on his- services. Nevertheless, under present con- 
 ditions per diem rates yield the greatest compensation. Where 
 Hat fees are charged it almost always means that some conces- 
 sion has been or will be made in the per diem rate, so that the 
 auditor who can always command liberal day rates will reap the 
 greatest financial reward. 
 
 The one good argument for a stated fee (and it is a strong 
 one) is that the client prefers it in perhaps nine cases out of ten. 
 Professional men should place the adherence to the ethics 
 of their profession and the satisfaction of their clients above 
 pecuniary gain. Therefore, if the work is fully and properly 
 performed and the client is satisfied, the method or rate of 
 compensation should be secondary, and a round fee, under such 
 circumstances, is quite as ethical as a per diem rate. 
 
 If the fee has not been arranged beforehand and litigation is 
 necessary, the auditor will receive the usual professional fee, pro- 
 vided, of course, that witnesses can be obtained to testify that 
 the work measures up to the usual standard of professional work 
 and that the fee is a reasonable one. 
 
 Juries, however, are apt to be more unreasonable than clients 
 with respect to professional charges, and the rule of arranging 
 fees beforehand should not be deviated from except in special 
 cases. 
 
HOW TO BEGIN AN AUDIT yi 
 
 Several years ago an inquiry into the actual rates charged 
 by accountants was conducted in New York City. There was, 
 of course, a wide divergence between the fees named by well- 
 established firms having a large clientele and the accountant just 
 starting in practice. The result of the inquiry is mentioned here 
 for what it is worth, and without any attempt to set it up as a 
 standard for other parts of the country, nor even for accountants 
 practicing in New York City. 
 
 The questions and answers, with slight modifications in the 
 form, were as follows: 
 
 Q. What is the maximum rate received per day, and for what class of 
 work? 
 
 A. $100 per diem was the maximum rate received, and that only for a 
 special class of work, such as an investigation calling for particularly expert 
 knowledge. In one case, however, $250 per day was charged for a few days' 
 service. 
 
 Q. What is the minimum rate per day received? 
 
 A. $10 per day. 
 
 Q. What is a fair average rate for accountants of the highest class? 
 
 A. $50 per day. 
 
 Q. What is a fair average rate for accountants who might be considered 
 as not of the highest class? 
 
 A. $25 per day. 
 
 Q. What, in your opinion, would be a standard rate for investigations 
 requiring first-class ability as a minimum ? 
 
 A. $25 per day. 
 
 Q. What, in your opinion, should be the rate for ordinary audits and 
 examinations not requiring the highest ability, as a minimum? 
 
 A. $15 per day. 
 
 Q. If you were establishing standard rates, taking all circumstances 
 fairly into consideration, what rates would you advise? 
 
 A. For standard rates the minimum fee for the man in charge should 
 be |2S per day; for ordinary assistants, $15; and for juniors used in clerical 
 checking, $10 per day; but the restriction of this compensation is not advo- 
 cated, especially for those in charge of work, to $25 per day. 
 
 Q. To what extent are assistants used? 
 
 A. Probably 90 per cent of accountants in active practice use assistants. 
 
 Q. What are the maximum and minimum per diem rates received for 
 the services of 
 
 (o) Senior assistants? 
 
 (6) Junior assistants? 
 
 A. Senior: maximum, $25; minimum, $15. Junior: maximum, $15; 
 minimum, $10. 
 
 Contingent Fees: One of the proposed amendments to the 
 
72 AUDITING 
 
 by-laws of the American Association of Public Accountants pro-, 
 vides that: 
 
 No member shall agree to perform accountancy work payment for which 
 is contingent upon the result of litigated or arbitrated issues. 
 
 It is proper that the auditor should avoid even the appear- 
 ance of evil, but it is a debatable question as to whether this rule 
 is not so strict that literal compliance therewith is impracticable. 
 If this is the case, the rule should be reframed in order to prop- 
 erly express the thought that it is always wrong for an auditor 
 to undertake work which he cannot conscientiously certify to, 
 or to submit figures which may reflect his prejudices rather than 
 his honest convictions. 
 
 As a matter of fact, auditing work may be performed upon 
 the basis of a contingent fee, the propriety or honesty of which 
 can no more be questioned than if it were undertaken upon a 
 basis of per diem rates. 
 
 An actual experience will illustrate the point. A cashier 
 who had access to the books of a corporation forged the indorse- 
 ments on certain customers' cheques and misappropriated the 
 proceeds. The president discovered the fraud and attempted to 
 locate the items in order to recover from the banks which cashed 
 the cheques, but he was unfamiliar with bookkeeping methods 
 and was only partially successful. He suggested to a profes- 
 sional auditor that the books be carefully audited and that the 
 full amount for which the banks could be held responsible be 
 ascertained. He had an unreasonable fear that the work might 
 be very expensive and the results unfruitful, so he suggested to 
 the auditor that the latter should receive one half of the net 
 amount recovered in full payment for his services. The auditor 
 accepted the proposition, unearthed claims aggregating several 
 thousand dollars, and received for his services something in 
 excess of his regular per diem rates. 
 
 The banks did not pay willingly and required the most com- 
 plete proof before making settlement. The auditor could not in 
 any possible way have improperly influenced the results, so that 
 if he had refused the engagement because his compensation de- 
 pended upon a contingency, he would have suffered an unneces- 
 sary pecuniary loss and his client might have lost an equal 
 amount. 
 
HOW TO BEGIN AN AUDIT 73 
 
 In the opinion of the author, the auditor should subject each 
 engagement to scrutiny to discover any possible reasons why 
 he should not undertake it. Work which involves his integrity 
 should always be declined. But if he can conscientiously accept 
 work where his fee depends upon a contingency, he should not 
 refuse the required service. 
 
 (5) As to Where the Work is Done: This question receives 
 but little consideration in the usual audit until it is too late to 
 make a change. Most audits are made in the office where the 
 general books of account are written up. Provided there are 
 ample space, adequate light, satisfactory and sanitary working 
 conditions such as pure air, etc., and reasonable freedom from 
 interruption by unauthorized persons, this is the ideal place. 
 
 When the audit is being arranged for, all of these points can 
 be discussed, and few clients will hesitate to modify or improve 
 existing conditions in order that the audit work may be per- 
 formed under favorable auspices. But if this matter is left in 
 abeyance until the audit is actually commenced, changes are 
 almost impossible to effect, or if not impossible, the auditor usu- 
 ally deems it inadvisable to open up the subject. 
 
 Therefore, stipulate for the best possible working conditions 
 before work is commenced. 
 
 Oa) Working Papers: It may sound paradoxical, but the 
 time to arrange working papers is before the actual work of the 
 audit begins. 
 
 The most important point to emphasize is that the more inex- 
 perienced an auditor is, the more working papers he produces, 
 so that the student or practitioner who aspires to a high place in 
 his profession will avoid all unnecessary compilations and com- 
 ments; he will try to settle his doubts relative to questionable 
 transactions immediately, for the majority of his questions will 
 be answered satisfactorily ; he will eliminate the copying of trial 
 balances, statements, etc., unless he has a clear idea as to their 
 ultimate use, and he will ruthlessly destroy his papers as soon 
 as their value is questionable. 
 
 It is a pity that the limits of this book make it impracticable 
 to include detailed illustrations of how things should be done 
 and how they should not be done. Perhaps the assertion that 
 the skill of an accountant can always be ascertained by an inspec- 
 
74 AUDITING 
 
 tion of his working papers is too sweeping, but it will hold good 
 in so many cases that it may as well be called a general rule, and 
 therefore prospective auditors should take notice that some day 
 they may be so judged. 
 
 If the professional man were as careful with his tools as is 
 the mechanic, he would do better work and he would save him- 
 self many hours of duplicated labor. The average lawyer, for 
 instance, makes his notes on scraps of paper and in such an 
 unsystematic way that an orderly filing of them is impossible. 
 Subsequently (in many cases) the notes cannot be found, or if 
 found, they cannot be understood. Fortunately for the lawyer, 
 his notes are, in a majority of cases, not required later, which 
 accounts perhaps for his carelessness. 
 
 But an accountant must be the personification of order and 
 system; his business is to criticize careless methods in others 
 and construct proper systems for those who have none. There- 
 fore he must convey the impression that he appreciates order 
 and good methods and be able to demonstrate this by an exhibi- 
 tion of the highest degree of perfection in his own working 
 papers. 
 
 Stationery is cheap, far cheaper in proportion than the imple- 
 ments used by mechanics, yet many accountants will use a scrap 
 of paper or the back of an envelope to make a record in connec- 
 tion with an audit, when the items so noted are important enough 
 to be set down in an orderly way on a whole sheet of specially 
 ruled paper. It really seems absurd to devote much space to 
 this matter, and it is only because there is such a widely pre- 
 valent looseness in this respect that emphasis is given to the use 
 of good stationery and importance placed on plenty of stationery 
 always being available. 
 
 An accountant or a bookkeeper should have on hand at all 
 times a complete assortment of specially ruled paper of all sizes. 
 Let him consider this as part of his plant, if need be, for a very 
 small expenditure will secure a large supply of paper. The spe- 
 cial rulings should cover every form for which there may be 
 the slightest call. 
 
 With respect to money columns, paper should be ruled hav- 
 ing from three to eighteen columns. The former will be the 
 most used, but there is a constant call for the latter. Then, of 
 
HOW TO BEGIN AN AUDIT 75 
 
 course, ledger-ruled paper will frequently be used, and it is very 
 desirable to have ledger paper with two money columns on both 
 sides. The paper should be put up in pads of fifty sheets each. 
 
 In commencing an audit, a full assortment of paper, together 
 with various colored pencils or ink, etc., will be gathered together 
 and carried preferably in a stout leather portfolio with a first- 
 class lock on it and containing convenient pockets for papers, 
 pencils, rubber stamps, etc. Is it not obvious that a client or a 
 client's clerk will have more respect for an auditor who is fully 
 equipped than for a man who is compelled to borrow first a 
 sheet of paper and next a pencil in order to record details of the 
 petty cash as counted ? 
 
 It is no excuse to urge that many offices of comparatively 
 wealthy concerns are woefully lacking in good stationery and 
 that a little pile of carefully cut used envelopes for making mem- 
 oranda is still in evidence in many offices. In most cases such a 
 supply is sufficient for the bookkeeper who is not in possession 
 of ruled paper, and who probably does not see any necessity for 
 having it on hand. He is so blissfully unconscious that there are 
 scores of uses to which he might put some well-ruled paper for 
 the edification and financial benefit of his employer, and which 
 would almost surely result in an increase in his own salary, that 
 it is not fair to the wide-awake man to say too much about it. 
 The benighted user of old scrap paper will simply make way 
 some day for a more competent successor. 
 
 The professional auditor, however, cannot afford to start 
 wrong, for he does not have the same opportunity for concealing 
 his incompetency. Stock up, therefore, and keep stocked up, 
 for a few extra dollars invested in a big supply of stationery will 
 be the greatest possible help to the young practitioner. Having 
 the paper, use it. That is, don't even try to economize, for it is 
 not safe to temporize and think that a particular memorandum 
 is unimportant and, therefore, just as well recorded on a scrap 
 as on a whole sheet which may have cost a quarter of a cent. 
 
 It will be a great convenience to head up several sheets of 
 paper at the commencement of .an audit along the following 
 lines : 
 
 Cash Vouchers lacking. 
 
 Errors in footings — Cash Book. 
 
76 AUDITING 
 
 Errors in footings — Sales Book. 
 
 Errors in postings — Private Ledger, etc., etc., etc. 
 
 There should be an absolute rule strictly adhered to, forbid- 
 ding the writing of more than one class of errors on the same 
 sheet of paper. If, for instance, an audit develops but three 
 errors in footings and postings, one being in the cash book, one 
 in the journal, and one in the sales ledger, there should be three 
 sheets of paper submitted at the close of the work, one error 
 appearing on each. The reason for this is evident. The work 
 covered is assumed to be a test only, and no one can tell how 
 many errors may develop if additional verification is required. 
 
 It is almost criminal for an accountant to write and rewrite 
 and classify and reclassify his memoranda during the course of 
 an audit, when every bit of the rewriting and reclassification 
 could have been avoided by using one sheet of paper for each 
 class of errors or queries. 
 
 There is a general habit to minimize the importance of work- 
 ing papers, and while the client suffers most because his affairs 
 are not properly looked after, yet the auditor who starts in 
 wrong does himself positive harm by not getting the most out of 
 each engagement. 
 
 An auditor who is careless about his working papers 
 has taken up an audit, and having forgotten to supply himself 
 with stationery, calls on the client's supply. Irregular pieces of 
 scrap paper are supplied to him, and on these he makes his vari- 
 ous notes and comments. He dislikes to ask too often for paper, 
 and so economizes by using both sides of some pieces and fills 
 others to the limit. By the time the audit is completed he has a 
 veritable mess of scraps. He then vainly attempts to make sense 
 out of a lot of notes which were considered of great importance 
 when made and which would have been written out properly if 
 the means had been at hand. How is it possible for such a man 
 to write a report of the greatest possible value to his client? 
 Even if he finally deciphers all of his notes and does not forget 
 to look on the back of every scrap, he has made so much trouble 
 for himself that in consequence thereof he has written a report 
 in a troubled and irritated frame of mind and his careless style 
 has, of course, permeated the text. 
 
 Consider the case of an auditor who takes the trouble to pro- 
 
HOW TO BEGIN AN AUDIT ^j 
 
 vide himself with an ample supply of paper; who uses a separate 
 sheet for each class of error, suggestion, or comment. When he 
 is ready to write the report he merely sorts his working papers, 
 and with full notes before him, with no irrelevant matters con- 
 stantly interrupting his train of thought, has simply to proceed 
 in an orderly manner to the close. 
 
 Is it worth while? Who has the better chance for another 
 engagement from the client so served? 
 
 Permanent Filing: After a report has been written great care 
 must be taken to file working papers intelligently and according 
 to a well-laid-out and thoroughly understood plan, or serious 
 inconvenience may be sustained on subsequent occasions when 
 a particular schedule or reconciliation sheet is required in a 
 hurry. 
 
 A plan which has been followed with success is the follow- 
 ing: 
 
 Commencing with the balance sheet submitted to the client 
 each item thereon is assigned a letter. For instance, if Plant is 
 the first item among the assets, the letter A is assigned thereto. 
 Each schedule relating to Plant would be marked Ai, A2, A3, 
 etc., and all papers containing information bearing thereon are 
 grouped accordingly. 
 
 The same plan applies to the Profit and Loss statement, and 
 to any other schedules where the supporting papers are numer- 
 ous. 
 
 When the single letters are exhausted, double letters may be 
 used as AA, BB, etc. Variations of this plan will suggest them- 
 selves to the auditor who has had difficulty in locating working 
 papers. 
 
 (7) Familiarity With System in Use : In considering the au- 
 ditor's qualifications, stress was laid on the importance of a knowl- 
 edge of different classes of businesses. During his early training 
 he will have had an opportunity to acquire special knowledge 
 with respect to many lines of commercial activity, so that many 
 of his engagements will cover undertakings, the special features 
 of which will be familiar to him. It is impossible, however, for 
 any auditor to have experience in every line of business, and 
 engagements will have to be made to audit accounts of which he 
 \\s,% no technical or special knowledge. 
 
78 AUDITING 
 
 An admission as to his unfamiliarity will win greater respect 
 than an attempt to conceal his ignorance; progress cannot be 
 made without asking many questions, and it will not take a 
 client long to discover the ignorance if an attempt is made 
 to conceal it. In any event, and despite long experience with the 
 same class of business, the auditor should ask questions about the 
 personnel and the special features of the business under review. 
 
 Local conditions and peculiarities may sometimes produce 
 strange results, and the auditor will find it easy to acquire a 
 broad knowledge of many things during his preliminary con- 
 ferences which would later take far more time to acquire. The 
 client and his staff expect to be asked a lot of questions (intelli- 
 gent and tactful ones, of course) at first, and the wise auditor 
 will make copious notes of the information so derived. The 
 client will probably volunteer the history of his life and the 
 progress of his business in great detail, and advantage should 
 be taken of such an opportunity to grasp the technical points of 
 the business. Later on it may be difficult to catch the client in 
 the same frame of mind. 
 
 (8) Schedules of Books, Records, and Names of Clerks: A 
 mastery of the general system in use includes a comprehensive 
 knowledge of the books and records which contain the transac- 
 tions of the business under audit. Books of account are the his- 
 tories of business enterprises. As a history is not complete 
 unless it records an unbroken narrative of facts, the auditor must 
 determine whether or not he will find such a continuous record 
 of the transactions of the business in the books submitted to him. 
 
 The time to determine this is before the audit begins, and at 
 the time of the inquiry a full description of the records should 
 be made and the names of the clerks responsible therefor care- 
 fully noted. 
 
 In England, it is customary in most cases, and compulsory 
 in others, for the auditor to be supplied with a list of the books 
 in use. In this country the advantage of this precaution is 
 strangely neglected. 
 
 No book should be listed until its use, or abuse, is fully com- 
 prehended. This is a favorable opportunity to fill out any ^aps 
 in the complete survey of the business which the auditor must 
 possess. 
 
HOW TO BEGIN AN AUDIT 79 
 
 The answers to the preliminary questions and a detailed 
 schedule of all the books in use should form the basis for an intel- 
 ligent study of how to begin. 
 
 (9) Procedure where Previous Audits have been Made: A 
 prominent accountant estimates that not more than ten per cent 
 of the business concerns of this country have their accounts au- 
 dited. But as most of the work that is done is satisfactory, it is 
 only in rare cases that one auditor replaces another. 
 
 It is not considered ethical for one auditor to supplant an- 
 other where the only reason for the change is that of remunera- 
 tion. If a client expresses dissatisfaction with the work of one 
 auditor and announces his intention of retaining another, there 
 can be no objection to the appointment. 
 
 Wherever feasible, the auditor should receive a copy of his 
 predecessor's report, but if it cannot be had, his inspection of the 
 books, and the unsolicited remarks of the client's staff, will prob- 
 ably indicate the extent of the previous audit. 
 
 Of course, no auditor could be held responsible for the acts 
 or omissions of another auditor, but he would have no justifica- 
 tion for blindly following the procedure of a previous audit, even 
 though the client requested it. Therefore the auditor should 
 regard all that he learns of his predecessor's work as informa- 
 tion purely supplemental tc that already pointed out as impor- 
 tant, and weighing all together, he will proceed as his own best 
 judgment dictates. 
 
 Sometimes, from a feeling of delicacy, the auditor will not 
 insist on a full explanation as to why the previous auditor's 
 services have been dispensed with. In view, however, of the 
 fact that auditors have been displaced for failure to discover 
 specific weak spots, it is obvious that the succeeding auditor 
 would be at a disadvantage without this knowledge, so that in all 
 cases insistence on an explanation can do no harm and may be 
 very useful. 
 
 Shortly stated, a safe general rule is to proceed as if no pre- 
 vious audit had been made, unless complete reports of another 
 auditor, in whom the fullest confidence is placed, are in evidence, 
 and unless there is no question as to the reason for the former 
 auditor's displacement. 
 
 (10) Final Considerations: Detailed or Balance-Sheet Audit? 
 
8o AUDITING 
 
 It might be inferred that having studied the matter from so many 
 standpoints, and particularly after having had a final interview 
 with the client, there would remain nothing to do but to com- 
 mence the actual work. 
 
 This, however, is not the case. Now is the most important 
 time for calm reflection. Up to this point many features were 
 more or less uncertain. The client's understanding of the state 
 of his books and the detail therein and the explanations of the 
 clerks, together with a survey of the books themselves, all affect 
 the final decision as to what should be done. 
 
 Frequently a client will make the broad assertion that he 
 wants a complete and detailed examination of his books. Sub- 
 sequent inquiry may develop the fact that a first-class system of 
 internal check exists, or that the transactions are so numerous 
 that a detailed examination is quite out of the question. There- 
 fore the auditor should reserve final decision as to the scope of 
 his work until he has inspected the books and interviewed those 
 in charge thereof. 
 
 The final point to be decided is : Shall a detailed or a balance 
 sheet audit be made? These two classes of audits are discussed 
 fully in subsequent chapters, but it is desirable that a brief sur- 
 vey of each be made at this point in order that we may now com- 
 pletely cover every phase of preparation up to the actual physical 
 work of the audit itself. 
 
 The Detailed Audit: In all cases where a complete examina- 
 tion is desired or desirable a detailed audit should be made. In 
 those undertakings where there is no satisfactory internal check, 
 the detailed audit is the only one which will cover the income 
 and expenditures for the period under audit. This applies, there- 
 fore, chiefly to small enterprises, but as the organizations which 
 have a complete system of internal check are very much in the 
 minority, the auditor will most frequently have to undertake a 
 detailed audit. But a detailed audit in the sense in which it is 
 used here does not contemplate the verification of every item in 
 the books. 
 
 Not many years ago one of the principal features of every 
 audit was the inspection and verification of vouchers for cash 
 payments. In many instances certificates stated without reserve 
 th^t the "^ccoyntg have Ipeeij ^u^it^cj an4 found to be correct," 
 
HOW TO BEGIN AN AUDIT 81 
 
 when, as a matter of fact, absolutely nothing else was done but 
 to compare certain receipts purporting to represent payments ot 
 cash and acknowledgments thereof, with the payment side of 
 the cash book. The certificates appearing at the end of treas- 
 urers' statements in most published reports of charitable and 
 religious institutions show just such a state of affairs. 
 
 It seemed conclusive to many people that if a cashier or a 
 treasurer could furnish a voucher for every item of cash disburse- 
 ment, there simply could not be anything wrong about the ac- 
 counts as a whole. As the science of accounts developed, some 
 auditors were not satisfied with this, and they supplemented the 
 examination of the vouchers by a complete verification of the 
 footings and postings. Having done this, they were content, 
 and felt that great strides had been made in the art. Add to the 
 above the checking of the trial balance and you will have the 
 full program of a large percentage of audits — certainly up to ten 
 or fifteen years ago. Sad to relate, a considerable number of 
 present-day audits vary little from this procedure, in spite of the 
 fact that professional auditors now have an opportunity to profit 
 by the mistakes of their predecessors and to use more scientific 
 methods in their work. Some auditors, however, do all their 
 thinking after they start to work, and will not take the time and 
 trouble to plan ahead. 
 
 Careful consideration of a large number of defalcations 
 reveals the fact that most of them would not have been discov- 
 ered by a verification of the vouchers, footings, postings, or trial 
 balances. This fact does not eliminate the necessity for proper 
 attention to such work, but it does emphasize the greater neces- 
 sity for attention to the work which experience shows is pro- 
 ductive of the most satisfactory results. 
 
 An auditor must at all times study and think and must ap- 
 preciate the need of preparing all his plans on a relative scale. 
 Conceding the obvious conclusion that no audit can or should 
 embrace a complete verification of all the transactions of the 
 period under review, then the cutting-out process must proceed 
 along the lines of greatest resistance, and the points covered will 
 then coincide with the weak spots. 
 
 In the succeeding chapters the author will outline the pro- 
 cedure for a detailed audit in which proper weight is given to 
 
82 AUDITING 
 
 the verification of the routine bookkeeping, but laying more 
 stress on other phases of the accounts which have proven to be 
 those most susceptible to fraud, carelessness, and ignorance. 
 
 Where there is a satisfactory system of internal check, the 
 auditor is not expected, and should not attempt, to make a de- 
 tailed audit. The word "satisfactory," however, is used advis- 
 edly, for more than one large corporation with a comptroller and 
 a force of staff auditors lacks a complete system of internal 
 check. 
 
 When the staff auditor is also an official in the business, he 
 is seriously handicapped when he endeavors to check the records 
 of other departments of the organization. Thei'e are so many 
 opportunities to impose administrative functions upon him that 
 within a short time his supervisory and auditing duties are hope- 
 lessly entangled. Proof of the frequent existence of this condi- 
 tion of affairs is seen in the discovery of defalcations on the part 
 of officials who were not supposed to have access to funds or 
 securities. 
 
 If the staff auditor is a clerk, his position is still more diffi- 
 cult to maintain. If his superiors are dishonest, he soon has to 
 choose between dismissal or silence. Therefore the mere state- 
 ment that an auditing department exists is not enough evidence 
 in itself to obviate the necessity for a detailed audit. 
 
 Balance-Sheet Audit : If the auditor has satisfied himself that 
 the system of internal check is adequate, he will not attempt to 
 duplicate work which has been properly performed by some one 
 else. His duty will then be to verify the assets and liabilities, 
 and to make such an analysis of the Profit and Loss Account as 
 will enable him to certify that it has been properly stated. 
 
 But there is a much wider field for balance-sheet auditing 
 than this. Bankers are awakening to the value of certified state- 
 ments from borrowers or prospective borrowers, and there are 
 vast possibilities in this class of work. The auditor who can 
 undertake these engagements with a cjear outline of what is 
 to be covered, and more important still, what may be omitted, 
 has a tremendous advantage over the auditor who does not ap- 
 preciate the peculiar circumstances which surround this class of 
 work. Balance-sheet audits are also required in many other 
 cases. The author will, in another chapter, attempt to set forth 
 
HOW TO BEGIN AN AUDIT 83 
 
 as concisely as possible what, in his opinion, should be done in 
 a balance-sheet audit, and what need not be done, and what should 
 not be done. 
 
 System of Internal Check : Reference has several times been 
 made to the fact that the question of whether a detailed audit 
 should be made, or whether a balance sheet will accomplish the 
 desired end just as well, depends to a considerable extent on the 
 existence or lack of a satisfactory system of internal check. 
 
 Such a system consists in the accounting records, methods, 
 and system generally of an establishment being laid out in such 
 a way that no part of the accounts will be under the absolute and 
 independent control of any one person ; that, on the contrary, the 
 work of one employee will be complementary to that of another ; 
 that safeguards are thrown about the handling of all moneys, 
 particularly with regard to such transactions as cash sales, pay- 
 rolls, freights, etc. ; that the method of handling and recording 
 incoming and outgoing goods, especially the latter, is such_as to 
 insure all goods paid for being actually received and charges 
 being made to customers for all goods shipped ; and in general to 
 have in effect a continuous audit of the details of the business. 
 
 While the details of a system of internal check vary some- 
 what in different cases, the following general points usually 
 require to be covered : 
 
 (i) The Cashier: All cash payments shall be made by cheque, 
 signed by one of the principals, and supported by a duly author- 
 ized voucher. 
 
 All cash received, whether it is in the form of cheques or 
 cash, shall be deposited in bank daily. 
 
 Small payments that must be made in currency shall be 
 made from a petty cash fund set aside for that purpose. The 
 petty cashier shall take receipts or vouchers for all payments 
 and shall record them in a petty cash book or on a report form. 
 Monthly, or more frequently if necessary, he shall rule off his 
 book or sheets, certify to their correctness, and surrender them 
 together with the vouchers in exchange for a cheque for the same 
 amount. This should also be done at the close of every fiscal 
 period. 
 
 The cashier shall have no access to any of the individual 
 ledgers nor to the statements sent to customers. 
 
84 AUDITING 
 
 The bank pass-book shall be balanced, or a statement of 
 account secured from the bank, at least monthly; the outstand- 
 ing cheques shall be listed and the balance shown to be in bank 
 shall be reconciled with the balance called for by the cash 
 book. 
 
 (2) Vouchers : All goods purchased or expenses incurred shall 
 be evidenced by an invoice from the vendor or creditor. Such 
 invoices shall be checked as to extensions and additions, shall be 
 duly approved as to quantity and quality by the persofts receiv- 
 ing the goods, and as to price by the person authorizing the 
 purchase. They shall then be approved for payment by the exec- 
 utive in charge of the accounting department and turned over 
 to the treasurer for payment. 
 
 (3) Sales: The extensions and additions of all sales invoices 
 shall be checked at least once before the invoices are sent out. 
 
 When possible the duplicate copy method of writing the 
 salesbook should be used, the first carbon copy of the invoice 
 becoming the sales record. This gives in the sales book an 
 exact copy of the invoice sent out, and is admissible as such in 
 court. 
 
 (4) Ledgers: The general ledger shall contain a controlling 
 account with each subsidiary ledger, and each individual ledger 
 shall be balanced monthly. 
 
 The trial balances from the sales ledgers shall indicate the 
 age of all overdue accounts. 
 
 Accounts considered uncollectible which have been written 
 off shall be recorded in a Bad Debts register and followed up 
 just as persistently as if they were still on the books. 
 
 (•5) Other Considerations: Even though stock accounts are 
 kept — and this is, of course, very desirable — physical inventories 
 shall be taken at proper intervals to verify the balances appear- 
 ing on the stock accounts. 
 
 An adequate method of following up collections must be 
 provided. 
 
 Equally necessary is some provision^ for safeguarding the 
 incoming mail so that cash received shall reach the cashier. 
 
 Such a pay-roll system shall be devised as will render it most 
 difficult to "pad" the roll and will insure the detection of errors 
 in time, rates, or extensions. 
 
HOW TO BEGIN AN AUDIT 85 
 
 Every member of the office staff shall be required to take a 
 vacation each year. 
 
 Suggestions to Clients' Staff before Commencing Work: In 
 the great majority of audits which are made for the first time 
 the client will have informed his entire staff as to his intentions, 
 so that there is no possible chance of gaining any advantage by 
 surprising them. 
 
 Then, too, it may be that the audit is being made at the 
 request or on the suggestion of one or more of the staff. This 
 occurs very frequently where ambitious bookkeepers and 
 cashiers reahze that the methods in use in the office are obso- 
 lete. 
 
 If the auditor desires full cooperation, he should seek an 
 opportunity to ascertain the condition of the books and records 
 as soon as possible after the engagement has been made. He 
 will gain nothing whatever by jumping in before the books are 
 written up or balanced. 
 
 As he will probably be asked what he desires in the way of 
 vouchers, etc., the following memorandum has been prepared. 
 It is, of course, only suggestive, as the auditor must be governed 
 by local conditions : 
 
 (i) A correct trial balance, as of the date the audit is to be 
 made, should be prepared. If not ready by the time the audit 
 is to be commenced, the auditor should have a conference with 
 the client and the bookkeeper and determine (a) if the work is 
 to proceed at once; (b) if it is to be postponed until the differ- 
 ences are located ; (c) if the auditor, acting as an accountant, is 
 to locate the errors. 
 
 (2) Controlling accounts in the general ledger should be in 
 agreement with the subsidiary records ; if not in agreement, the 
 matter should be discussed with the client and an understanding 
 reached as to whether the errors are to be located or allowed to 
 stand. 
 
 (3) Schedules of Notes Receivable (whether or not dis- 
 counted), Notes Payable, Bonds, Stocks, etc., should be pre- 
 pared. 
 
 (4) Monthly statements from creditors should be preserved. 
 
 (5) Paid bank cheques and all other vouchers should be 
 taken from the files and arranged as requested by the auditor. 
 
86 AUDITING 
 
 The auditor should not disclose the use he proposes to make 
 of the vouchers. 
 
 (6) If an inventory has been taken, the auditor will state to 
 what extent he desires the certification of those responsible 
 therefor, and he will insist on the original sheets being preserved 
 and submitted. 
 
 (7) If there are many accounts receivable, it may be wise to 
 request that they be divided into groups, showing all those over- 
 due, etc., so that an estimate of the reserve for bad debts may 
 readily be made. 
 
CHAPTER VII 
 
 BALANCE-SHEET AUDIT— ASSETS 
 GENERAL— CURRENT ASSETS 
 
 General Principles. The underlying principles of a balance- 
 sheet audit may be reduced to writing and are not subject to 
 change to fit particular businesses or special systems of account. 
 They are few in number and can be applied generally. 
 
 The principles upon which all balance-sheet audits are based 
 are as follows : 
 
 (i) The auditor must ascertain that all of the assets shown 
 by the books to have been on hand at a certain date were actually 
 on hand. 
 
 (2) He must ascertain whether any other assets, not on the 
 books, should have been on hand. 
 
 (3) He must ascertain that the liabilities shown by the books 
 to be owing at a certain date were actual liabilities. 
 
 (4) He must ascertain whether or not all liabilities were in 
 fact shown by the books. 
 
 (5) He must ascertain whether or not the liabilities so shown 
 were properly incurred. 
 
 In the following pages these theories will be discussed and 
 the work incident to a balance-sheet audit will be explained. 
 
 Limitations of Balance-Sheet Audits Must be Understood: 
 In arranging for a balance-sheet audit, the distinction between an 
 audit of that character and a detailed audit should be pointed out 
 to the client. 
 
 It sometimes happens that after a balance-sheet audit, specif- 
 ically provided for in writing, has been made and the report 
 rendered it is discovered that petty defalcations have been going 
 on for a long time. It is natural for the client, in such event, to 
 criticize the auditor, but if the latter has a written ofifer, to which 
 he can refer, it can be clearly shown that the detection of the 
 small theft was not within the scope of the engagement. If, 
 
 87 
 
88 AUDITING 
 
 however, the auditor has been careless about the preliminary 
 arrangements and has not explained, nor put in writing, the limi- 
 tations of a balance-sheet audit, he will find himself in an embar- 
 rassing position and is fortunate if the worst that happens is the 
 loss of that client. 
 
 While an auditor cannot be held liable in money damages 
 unless negligence is proved, yet a jury might find that a client 
 who instructed a professional auditor to "make an audit," with- 
 out any limitations being mentioned, could reasonably expect 
 the details of his accounts to be fully covered. For instance, an 
 auditor making a balance-sheet audit would rarely prove the 
 footings of the petty cash book ; but if it were afterwards found 
 that these footings had been systematically overstated and the 
 client defrauded, an auditor's freedom from, or liability for, 
 negligence might rest entirely on the conditions of his employ- 
 ment. 
 
 Assets. One definite point to be kept in mind in a balance- 
 sheet audit is that an entry on the books which purports 
 to record an asset is nothing more than a hook record, and there 
 can be no good excuse for accepting such entry as final. The data 
 supporting the entry may be in order, but it is the auditor's duty 
 to verify independently, as far as possible, the fact that the asset 
 still exists, or did exist at the date of the balance sheet. 
 
 CURRENT ASSETS 
 
 The current assets will be discussed first. These are 
 called "quick," or "floating," or "liquid." The author prefers 
 the term "current" as applied to all of those assets which 
 are for sale. If any doubt exists, it can be settled by the answer 
 to the question: Is it the purpose of the business to convert 
 these assets into cash at the earliest practicable moment? 
 
 If the audit occurs some time after the closing date, numer- 
 ous changes are apt to have been made in the current assets and 
 the subsequent entries and changes will have to be carefully 
 scrutinized. 
 
 At the outset the auditor should carefully read the schedule 
 of assets to be verified and outline a specific plan which has for 
 its basis the connection between the entries supporting the 
 asset accounts and the things themselves. In other words, all of 
 
BALANCE-SHEET AUDIT— ASSETS 89 
 
 the assets which should be on hand must be accounted for, includ- 
 ing those on the books and those which may have been omitted 
 from the books. 
 
 Liens and Hypothecations: Throughout the verification of 
 the current assets the auditor should be vigilant in his endeavor 
 to ascertain whether the title to the accounts, the stock-in-trade, 
 the machinery and other items is free and clear, or whether a 
 lien exists thereon which is not fully disclosed on the books and 
 in the financial statements. 
 
 Insurance policies are often good guides to title. The holder 
 of a lien on merchandise or the owner of a chattel mortgage is 
 usually careful to protect his security, and wherever an insurance 
 policy is payable to more than one party "as their interests may 
 appear," the auditor is put on notice that the property insured 
 is not free and clear. 
 
 Any information secured relative to liens or encumbrances 
 must be reflected in the report on the audit, or on the face of the 
 balance sheet if no report is made. 
 
 Proportion of Current Assets to Other Liabilities and Cap- 
 ital: The rules call for a verification of the assets which are on 
 hand and those which should be on hand, but the latter term applies 
 to physical existence only and does not mean that the auditor 
 must necessarily pass upon the propriety of the aggregates of 
 the various classes of assets. At the same time, in order to be 
 as valuable as possible to a client, whether a borrower or a 
 banker, the auditor should endeavor to determine whether or not 
 the relative proportions of cash, accounts, and stock compare 
 favorably with those of the most successful concerns in the same 
 line of business. 
 
 This thought is admirably expressed by the eminent banker 
 Mr. Joseph B. Martindale, President of the Chemical National 
 Bank of New York, who said at the last Bankers' Convention : 
 
 I have always claimed that under normal business conditions a stated 
 amount of capital (borrowed as well as invested) should allow a concern in 
 any line of business to carry a certain amount of merchandise. This mer- 
 chandise later is converted into bills and accounts receivable; later on into 
 cash; and upon these transactions, subject to the charges of conducting the 
 business, there should be realized a certain amount of net profit. All of 
 these items in a well-organized and well-conducted business should be in 
 
90 AUDITING 
 
 relative proportion one to the other. And if the best results are to be at- 
 tained, the management of any concern will see to it that each dollar of its 
 capital carries its proportion of merchandise, and will also see to it that the 
 merchandise is moved rapidly and converted into a bill or account receiv- 
 able, and that its outstanding debts are promptly collected, and that its cash 
 is used to reduce materially, or entirely liquidate, its indebtedness, thereby 
 saving interest and expense. We have in a number of instances followed 
 this natural sequence in business and have found any number of instances 
 where each dollar of capital (invested or borrowed) was not performing its 
 full duty, and following the matter still further, we found it due to either 
 extraordinary expenses, or losses, or due to indolence and a lack of an 
 aggressive policy in handling the affairs of the concern. These are "ear- 
 marks'" which will denote a condition of this kind, and we believe that it is 
 our duty to examine these conditions thoroughly. 
 
 As an illustration of this, some years ago, a certain firm reported in 
 their statement an invested capital almost equal to the amount of their annual 
 sales. At the same time their statement showed a substantial liability for 
 borrowed money. It seemed incredible that a working capital invested and 
 borrowed of more than the amount of the annual sales could be correct, but 
 that is what this report showed. Upon closer analysis and further informa- 
 tion, it was found that in the accounts receivable of the firm there were many 
 old accounts running years back, which they were carrying as good accounts, 
 and also substantial sums due the firm from the partners, which were, in 
 other words, overdrafts. When the statement was all boiled down, it was 
 found that their actual capital was less than one half that reported in their 
 statement. These are the "earmarks'' which, upon close observation and the 
 knowledge of credit, prove invaluable to one's institution. 
 
 It is vitally important in examining and passing upon a statement that 
 one should be thoroughly familiar with the conditions surrounding the busi- 
 ness during the year. Conditions may have made it impossible for any con- 
 cern to make money, and where a concern reports a gain in its capital, one 
 owes it to himself and to his institution to inquire thoroughly and closely 
 as to the causes which produced such a result when all the conditions were 
 adverse. 
 
 As an example, we have the accounts of a number of houses in the same 
 interior city in identically the same line of business, and while the amount of 
 their capital varies (and, consequently, their volume of business), we can 
 each year, by working out the percentages, see which concern is obtaining the 
 best results upon its volume of business and the amount of its capital. 
 
 From the standpoint of good banking it is not in the province of any 
 bank to furnish permanent working capital for any one of its depositors. A 
 bank whose liabilities are all payable on demand should observe closely the 
 well-established rule that its borrowers should at some time during each 
 twelve months liquidate their indebtedness to the bank for a reasonable 
 period of time. In my opinion, this is neither unjust nor arbitrary, and is 
 dictated by well-demonstrated and sound banking and business logic. 
 
 I have always believed that an independent audit by a firm of certified 
 
BALANCE-SHEET AUDIT— ASSETS 91 
 
 public accountants is desirable. And from the standpoints both of the bor- 
 rower and the lender, it is wise at least once a year to have the affairs of a 
 firm or corporation examined and audited by a high-class firm of auditors. 
 
 It is obvious that no concern can have a "clean up" annually 
 or oftener unless its current assets are susceptible of being turned 
 into cash within a reasonable time. Therefore, before the auditor 
 commences his verification of the current assets, he should ascer- 
 tain as accurately as possible the normal proportion of each class 
 of such assets in the average concern in the same line of business 
 as that under audit. 
 
 With this as a starting point he will be able to determine, as 
 his work progresses, how far from normal the concern may be, 
 and an opinion so formed should be of . the greatest possible 
 value to his client. 
 
 CASH 
 
 Cash in Bank: If no notice has been given to the client's 
 staff, the cash should be balanced immediately, the bank balances 
 being verified by independent confirmation. The cash transac- 
 tions since the date of the balance sheet should be scrutinized 
 and the footings proved in order that the balance on hand as 
 stated therein may be shown to be correct. 
 
 When the audit occurs a considerable time after the date of 
 the balance sheet, it is customary to secure certificates from the 
 banks covering the balances as of the closing date. These are 
 reconciled with the books, accepting as a basis the schedule of 
 outstanding cheques shown by the books. 
 
 Many auditors accept bank pass-books as conclusive evi- 
 dence, but the author has encountered several cases of fictitious 
 pass-books and two cases where the genuine pass-books were 
 very cleverly altered. Therefore, to be safe the auditor should 
 have one of his own staff secure the pass-books or statements 
 from the bank, or preferably have the confirmation of the bal- 
 ances mailed direct to him by the banks. 
 
 The auditor should satisfy himself that the cash in banks is 
 free from any liens or offsets and may be withdrawn on demand. 
 
 The auditor may very properly inquire into the average bal- 
 ance carried, as it is possible that the concern is overconserv- 
 
92 AUDITING 
 
 ative and maintains a cash balance in excess of its requirements. 
 If all purchases are discounted and nothing is borrowed, it may 
 not be worth while to criticize, but instances are known where 
 large borrowers have carried cash balances considerably in 
 excess of the requirements of sound business financing. The 
 cost in such cases is large enough to attract attention, and the 
 auditor should tactfully investigate the circumstances leading 
 up to the custom. It may be found that those in charge of the 
 finances are ignorant of the general usage, in which case the 
 auditor can suggest what, in his opinion, would represent an 
 adequate average balance to be maintained throughout a given 
 period. 
 
 Auditors of broad experience frequently suggest that where 
 the balances in commercial banks are larger than necessary to 
 secure the maximum line of credit, some funds be transferred to 
 trust companies where interest is allowed on inactive accounts. 
 Some of the largest trust companies now accept active com- 
 mercial accounts and even allow interest on daily balances. The 
 rule with National and State Banks is by no means uniform, but 
 many of them allow interest to desirable depositors. 
 
 Cash on Hand : Where the petty cash balance or fund called 
 for by the balance sheet is small, it may be unnecessary to 
 attempt to account for it, as it might require considerable time 
 to inspect and prove all of the entries between the closing date 
 and the time of the audit. Usually a scrutiny of the subsequent 
 entries will be sufficient. 
 
 If the balance is, say, over $ioo, it had better be verified by 
 actual count and proof. In an English case an auditor who failed 
 to verify a petty cash balance of nearly $4,000 was held to have 
 committed a breach of duty. The actual balance was $150. 
 
 The balance should consist of actual cash, not memoranda or 
 "cash items." A cashier who is carrying questionable items as a 
 part of his cash balance may borrow money enough on the clos- 
 ing date to enable him to pay the entire balance into bank, or to 
 exhibit the cash to an executive; after doing so the cashier will 
 immediately put the items back into the cash drawer and again 
 withdraw the cash. If there is any suspicion that this is being 
 done, a second count of the cash on hand should be made toward 
 the close of the audit. 
 
BALANCE-SHEET AUDIT— ASSETS 93 
 
 It depends on the auditor whether this part of the work 
 proves pleasant and satisfactory. It is quite possible that an 
 auditor will, in his desire to jump in without notice, really upset 
 a cashier who has certain routine methods of handling the cash 
 and cash records. First impressions are very important, and it 
 never pays to disarrange the work of a single person in a client's 
 office unless a definite reason exists for proceeding ofifhand and 
 without giving notice. Where the cUent does not inform his 
 staff that the accounts are about to be audited, it is, of course, 
 desirable for the auditor to take advantage of the chance to sur- 
 prise the man in charge of the cash. Probably more petty frauds 
 are disclosed in this manner than in any other, for too many men 
 are unable to distinguish between their personal funds and those 
 of their employers. Many of these discrepancies are under one 
 hundred dollars, and if the cashier were given time to put his 
 cash drawer in order, the shortage would disappear. It may be 
 argued that in such a case no great harm would ensue, as there 
 would be no actual money loss to the client. No greater mistake 
 could be made, however, for a man whose moral sense is so 
 blunted that he will pilfer a few dollars is on the highway to 
 further frauds and needs only a good chance to misappropriate 
 anything of larger value on which he can lay his hands. 
 
 In practice the auditor's appearance is usually expected. If 
 the audit is a periodical one, an approximate time of commenc- 
 ing is known in advance, and if it is a special engagement, in 
 most cases the negotiations with the auditor are known to all 
 in the client's office. Here the auditor can exercise a little tact 
 or diplomacy. The cashier may, for instance, balance his cash 
 late in the day, and if it is much of a task he will be anxious to 
 hurry off home upon the striking of a balance. The wise auditor 
 will make it a point to tackle him first thing in the morning at a 
 time when the memoranda of the day have not commenced to 
 accumulate and when the cash book is written up and the foot- 
 ings shown. 
 
 Very often slips of paper, tickets, and so-called vouchers will 
 
 make up a large portion of the "cash" in the drawer. In all cases 
 
 . count the actual money first and then list the memoranda. This 
 
 record should be full and complete, for there may be some delay 
 
 before it is used again, and cases have been known where unau- 
 
94 AUDITING 
 
 thorized tickets carried as cash have mysteriously disappeared 
 immediately after an auditor's count of the drawer. 
 
 If there is a difference between the amount on hand and the 
 balance called for by the cash book or the round sum carried in 
 the ledger as a petty cash fund, it is not wise to assume at once 
 that there is something wrong. The auditor should note the 
 cash-book footings, and with this information in his possession, 
 together with his count of the cash drawer, he can afford to give 
 the cashier a chance to hunt for the difference. If the cashier 
 balanced the night before, the error may be in the auditor's own 
 figures. If a shortage exists, it should develop at this point. 
 
 ^ , When the cash balance consists of several bank accounts or 
 
 funds, care must be taken to see that the entire balance is veri- 
 
 » fied simultaneously. Instances are known where auditors have 
 
 f been deceived through one balance, after being inspected, having 
 been transferred and used on a later day in connection with 
 
 ; another balance. 
 
 ACCOUNTS RECEIVABLE 
 
 f Trade Debtors: In a long-established business where the 
 
 I sales are fairly constant, the accounts can be valued on a basis 
 of past results. Ascertain the percentage of bad debts in past 
 years and apply this percentage to all sales up to the closing date. 
 The sales, for, say, the last month, should be scrutinized (not 
 
 : footed) in order to ascertain whether or not there is any evi- 
 
 dence of predating, billing to fictitious customers, or including 
 consigned goods or goods sent on approval as sales at full 
 
 I prices. 
 
 Consigned goods may be includejl among the current sales 
 in good faith, if it has been the custom of the concern to do so, 
 but this, of course, does not justify the practice, which results in 
 anticipating profits that have not been earned. 
 
 Accounts current should be obtained for all consignment 
 accounts, and any unsold goods at time of closing should be 
 added to the inventory and priced at cost or market, whichever 
 is the lower. If the goods are salable and practically sure to be 
 sold, accrued charges thereon may be added to the inventory 
 prices. 
 
 If past experience is not available the outstandings will have 
 
BALANCE-SHEET AUDIT— ASSETS 95 
 
 to be valued on their merits, because the auditor cannot hope to 
 have reliable statistics of other concerns or for a series of years 
 upon which to base his conclusions. The auditor of experience 
 will have a general familiarity with the normal volume of out- 
 standings which various classes of business may be expected 
 to carry, and he should, for his own information, compare the 
 relative outstandings of each business to the gross sales, and of 
 different concerns in the same line of business. The value of 
 such a comparison may be apparent at a glance, and negligence 
 and laxity may stand revealed which might not be apparent in a 
 routine audit. The best method of collating such data is to com- 
 pile statistics covering gross and net figures and the percentages 
 produced thereby, at the close of each audit. In the course of 
 time a vast quantity of information will be at hand and available 
 at a moment's notice for comparative purposes. 
 
 When the list of open balances is compared with the sales 
 ledgers it should be noted that the balances are represented by 
 specific invoices of a recent date ; otherwise, the balances should 
 be analyzed. An old item in a running account or a bill partly 
 paid, followed by others fully paid, usually means that an allow- 
 ance has been or will be made. 
 
 Schedules should be made of all overdue accounts classified 
 according to age. Those quite old cannot be considered as worth 
 anything unless a very strong argument is presented, supported 
 by documentary evidence. 
 
 It is a rule of law that assent to the correctness of a balance 
 may be inferred from retaining an account rendered without 
 objection within a reasonable time, and the burden of impeach- 
 ing the accuracy of the account, for fraud or mistake, is cast 
 upon the party complaining of the balance, but the only proper 
 test of ability to pay is payment, and where this is delayed an 
 unreasonable length of time, the inference is that "abiUty to 
 pay" is lacking. 
 
 Accounts ranging from long overdue to those just over the 
 "net" period should be depreciated as may be determined after 
 proper inquiry has been made. 
 
 The auditor must ascertain whether any accounts have been 
 pledged or assigned. This is frequently done without any record 
 being made in the books. 
 
96 AUDITING 
 
 The following suggestions will be found useful in fixing a 
 valuation upon trade accounts which are overdue : 
 
 (i) Have the terms of credit been habitually ignored? Even 
 so, the debtors may be perfectly good, but such accounts should 
 have special attention from the credit manager. 
 
 (2) If payments on account are being made, is the balance be- 
 ing increased or decreased? If the former, this is prima facie 
 evidence that debtor is approaching the time when all payments 
 will stop. This is a "class of account which deserves more atten- 
 tion than it receives. The auditor should keep this point in 
 mind, and a word of advice from him may save ultimate loss. 
 Salesmen relinquish these accounts very reluctantly, but they 
 are not the best authorities on the ability of a debtor to pay. 
 
 (3) If credit has been stopped and no recent collections appear, 
 ascertain if account has been placed with attorneys for collection. 
 
 (4) If in hands of attorneys, ask for correspondence. Accounts 
 are frequently placed with lawyers who are not equipped for col- 
 lection business and who do not keep after the debtors. Unless 
 frequently checked up, the debtor will not pay. So long as his 
 money lasts, or he desires to preserve his credit, a debtor will 
 pay those who press him the hardest. 
 
 (5) If a debtor who has paid cash commences to give notes, 
 ascertain if a sound reason therefor has been offered and whether 
 the change has been approved by some one in authority. 
 
 In all, except the rarest cases, those in charge of the out- 
 standing§ will be found to be optimistic to an unreasonable and 
 undependable degree. Nevertheless, their knowledge must be 
 utilized by the auditor, who can discount their estimates as much 
 as seems necessary and finally draw his own conclusions. 
 
 A certificate as to outstandings ought not to be given unless 
 the schedules of accounts have been compared in detail with the 
 customers' ledgers, and the footings of the schedules verified. 
 The procedure in this case should be the same whether or not a 
 controlling account is kept, except that this rule may be modi- 
 fied in the case of a concern having a very large number of open 
 accounts which are subject to internal check. 
 
 Discounts which will be deducted by customers and which, 
 while called cash discounts, are greater than a concern would 
 pay for the use of money, must be allowed for. In a stable busi- 
 
BALANCE-SHEET AUDIT— ASSETS 97 
 
 ness it is usually possible to deduct a fixed percentage from all 
 the outstandings. Where special discounts are given, it may be 
 necessary to classify the balances before determining the deduc- 
 tions to be made. If freight allowances are permitted, care must 
 be taken to see that adequate provision is made therefor. 
 
 Rents, etc., Receivable: The foregoing comments refer to 
 what are known as trade debtors and apply chiefly to mercantile 
 and manufacturing concerns. The same principles govern the 
 verification of the outstandings in enterprises which are not gen- 
 erally classified as mercantile or manufacturing. 
 
 For instance, real estate agents, as well as manufacturing 
 establishments, may show on their balance sheets large items 
 which represent real estate rentals uncollected. Likewise, stock- 
 brokers carry very large items of assets which represent balances 
 due by customers. The balance sheets of financial institutions, 
 and of enterprises where investment securities are owned, will 
 contain items of interest and dividends due but not collected. 
 The balance sheets of commission houses will show commission 
 and other charges as accounts receivable. 
 
 In all cases the auditor must satisfy himself : 
 
 (o) That the items constituting the balances are bona fide 
 and 
 
 (b) That the balances have not been liquidated in part or in 
 whole. 
 
 The means of verifying these requirements do not dififer in 
 principle from the rules enumerated for testing the accuracy of 
 balances due from trade debtors. 
 
 In the chapters on different classes of business concerns the 
 reader will find suggestions bearing on the special attention, if 
 any, demanded by circumstances which are peculiar to a partic- 
 ular business. 
 
 Miscellaneous: In many balance sheets, accounts receivable 
 from customers are mingled with other debit balances. The 
 latter may include advances to salesmen and others ; overdrafts 
 of officers ; claims against railroads, creditors, or the government 
 for alleged overcharge of duties ; prepayments on purchase con- 
 tracts ; guarantees ; etc. Not infrequently considerable amounts 
 will be included which represent charges to vendors for goods 
 returned. Such balances are rarely settled in cash. Where the 
 
98 AUDITING 
 
 open items consist of cash debits, it may be assumed that pur- 
 chase invoices exist which have not yet been credited to the 
 account. The distinction to be drawn here is that instead of 
 dealing with the accounts in groups, each individual account must 
 be scrutinized and valued on its merits. 
 
 Sometimes these so-called accounts receivable are not "re- 
 ceivable" at all, but are merely advances under contracts where 
 the goods or materials purchased were not delivered at the date 
 of the balance sheet. One experience of the author's will illus- 
 trate this point. 
 
 An iron company was under contract to purchase large 
 quantities of ore and to make periodical payments irrespective of 
 actual deliveries, except that the ore was all to be delivered 
 within one year. After the payments commenced and before any 
 ore was received, its books were closed. The payments were 
 included among the regular accounts receivable in the balance 
 sheet. The author separated the items and set up a new balance 
 sheet showing the advances under their proper caption. 
 
 The balance sheet was to be used as a basis of credit, and a 
 banker or creditor would have been grossly deceived if the 
 adjustment had not been made, as the item "accounts receivable" 
 in a balance sheet, stated without modification, indicates one of 
 the best quick assets, whereas in this case not one cent could 
 be realized on this item until the ore was shipped and received, 
 converted into iron, the iron sold, and the proceeds col- 
 lected. In other words, it was a deferred asset of the most ex- 
 treme kind. 
 
 The president of the company strenuously objected to the 
 restatement of the balance sheet, saying that it had always been 
 done in the old way and that the change, if made, would attract 
 unfavorable attention. 
 
 While changes in the form of annual statements due to pre- 
 vious erroneous practices are always to be regretted, neverthe- 
 less it is clear that the facts must be shown when they are 
 known. In this instance the balance sheet was restated in cor- 
 rect form, and has been so stated from that time. 
 
 In another instance a silk merchant had made advances to a 
 manufacturer. These advances amounted to several hundred 
 thousand dollars and were included in the aggregate of his 
 
BALANCE-SHEET AUDIT— ASSETS 99 
 
 accounts receivable without any explanation. He had secured 
 a large line of credit based chiefly on his outstandings. 
 
 Investigation disclosed the fact that the advances carried 
 with them the ownership of several mills which were being con- 
 ducted at a loss, so that the accounts, instead of being current 
 accounts receivable worth their face value, represented real 
 estate, machinery, raw material, manufactured and finished 
 goods, the highest total value of which fell far short of the aggre- 
 gate advances. 
 
 The caption "Accounts Receivable" is sometimes used to cover 
 deferred charges to operating, such as rents paid in advance and 
 similar items. In no sense of the word are these accounts receiv- 
 able. The test is : Will the balances be liquidated in cash in due 
 course? Of course nothing will be realized by a going concern 
 from such accounts, and in the case of a liquidation no funds aris- 
 ing therefrom will be available for the payment of debts. 
 
 Deposits: Another class of items sometimes mingled with 
 the current assets is that of cash deposits put up as security 
 under a lease for the faithful performance of a conti-act; as 
 security for costs, etc., in an appeal to a higher court ; by agents 
 who have ordered goods in advance, such as automobiles; with 
 public utility companies, etc., etc. 
 
 In all of these cases and many others the proprietors of a 
 going business feel that the cash so paid out is a good asset. 
 Frequently they either count on getting back the cash itself or 
 they know that the deposits will be applied on purchases. 
 
 In the former case the cash may be returned, but the period 
 of realization is most uncertain and cannot be depended upon as 
 a source of funds available for other purposes than the special 
 one for which the deposit was made. The landlord who holds a 
 cash deposit as security under a lease will probably require 
 the same or a larger amount upon renewal. If there is no 
 renewal, he may hold deposits for several years pending the 
 settlement of a claim for injury to the premises. 
 
 In the latter case it is true that the deposits will be ap- 
 plied on purchase contracts, but this is in effect a prepay- 
 ment and no cash will be returned which can be paid to other 
 creditors. 
 
 For all practical purposes, therefore, these items are a part 
 
lOO AUDITING - 
 
 of the fixed or deferred assets and furnish very poor security for 
 unsecured creditors. 
 
 Verification of Outstandings by Correspondence : There is but 
 one absolute method of ascertaining the accuracy of the aggre- 
 gates shown on the balance sheet as due from trade and other 
 debtors, and that is to procure an acknowledgment of the debt 
 from the debtor. This, of course, is impracticable in most cases, 
 but wherever the opportunity affords, the auditor should verify 
 the correctness of the outstandings by requesting confirmations 
 by direct correspondence with the debtors. 
 
 This subject is discussed more fully oh page 263 hereof. 
 
CHAPTER VIII 
 
 BALANCE-SHEET AUDIT— ASSETS (Continued) 
 
 CURRENT ASSETS (Continued) 
 
 Notes Receivable: This account ought to include unmatured 
 notes only, free from liens. 
 
 In almost all respects the valuation of notes receivable should 
 be made along the lines indicated for accounts receivable. 
 
 In some trades notes are given by concerns of the very high- 
 est standing, as for instance, in the silk and jewelry trades. In 
 other lines, as for instance, the automobile and grocery trades, 
 notes are considered a sign of weakness. The first considera- 
 tion, therefore, must be as to the custom of the particular busi- 
 ness under review. If it is usual to accept notes from first-class 
 debtors, the notes will be valued in the same manner as book 
 accounts. (See page 94.) 
 
 If notes have been accepted from other than trade debtors, 
 or if it is not the general custom of the trade to give notes, then 
 each individual note must be valued on its merits. The examina- 
 tion should, of course, cover notes under discount as well as 
 those on hand. The former should be verified by correspondence 
 with the bankers, or by inspection of the discount records, and 
 the latter by actual inspection. 
 
 The balance sheet should show the notes under discount, as 
 a contingent liability therefor exists. They represent an asset, 
 hypothecated as it were, against which a loan has been secured 
 from the bank, therefore the aggregate under discount should 
 appear as a footnote on the liability side of the balance sheet. 
 
 Instances have been known where notes for large sums, but 
 with makers of little responsibility, have been discounted and 
 renewed as long as the banks would take them. Where the facts 
 are not known and several bank accounts are kept, it is com- 
 paratively easy to shift discounts from one bank to another. 
 
 It is obvious that such notes are in reality notes payable. 
 
 lOI 
 
102 AUDITING 
 
 The auditor is not justified in certifying to the balance-sheet 
 item of notes receivable unless he believes that all of the notes 
 will be paid when due, or unless a sufficient reserve is created to 
 cover probable losses in realization. 
 
 Where notes have not been paid at maturity, they should, as 
 stated above, be taken out of the notes receivable account, as the 
 latter account should represent unmatured notes only. It might 
 be feasible to carry dishonored notes in a separate account, but 
 it is considered proper accounting practice to debit the personal 
 account of the debtor with the amount of the note and the protest 
 fees and include the debt among those of the class to which it 
 belonged before it was converted from an account into a note 
 receivable. 
 
 Thus if a grocer sold sugar to a customer, took a note for 
 the amount of the sale, was unable to collect when due and 
 charged the note and protest fees back to the customer's account, 
 then he would include the new balance among other trade 
 debtors. This is the proper way to handle the transaction. The 
 auditor, in valuing the accounts, will estimate the actual worth 
 of this account, taking into consideration the facts as shown on 
 its face. 
 
 Protested notes are frequently paid thereafter, but they can- 
 not be classed with accounts not due, nor with those overdue 
 from chronic slow payers. The maker of a note who fails to 
 meet his obligation at maturity is never a desirable customer, 
 and in the long run subsequent credit extended to such customers 
 invites ultimate loss. 
 
 There are exceptions to this rule in the case of such concerns 
 as agricultural implement manufacturers where it is the custom 
 to take notes for a large part of the sales, and many are not paid 
 during years of crop failures. These overdue notes are consid- 
 ered almost as collectible (so far as ultimate realization is con- 
 cerned) as the unmatured ones, and, as it is more convenient for 
 the collection department to handle them as notes than as part 
 of open accounts, they are not charged back to the customer's 
 accounts. 
 
 Under such circumstances in stating the item "Notes Re- 
 ceivable" in the balance sheet, the auditor may not consider it 
 necessary to separate the overdue and not due notes, but he 
 
BALANCE-SHEET AUDIT— ASSETS 103 
 
 should be sure that one class- is as good as the other, or that a 
 sufficient reserve has been created for the probable loss. 
 
 Stock Subscriptions: The uncollected balances due from 
 stockholders in respect to their subscriptions to the capital stock 
 of a corporation are undoubtedly accounts receivable, but it is 
 not considered proper to include such balances with the receiv- 
 ables of any other class. The reason for this is obvious. If the 
 subscriptions are overdue, the fact of their noncollection indi- 
 cates poor management or undesirable stockholders. If not due, 
 it affords those who use the balance sheet an opportunity to 
 inquire into the financial standing of the debtors. If good, it 
 not only means that a certain amount of liquid capital will be 
 forthcoming at a certain date, but it furnishes evidence that the 
 capital stock is being paid for in cash, and is reassuring as to the 
 future, because the connection of financially responsible stock- 
 holders with a company usually means that they are prepared 
 to stand by it and protect their interests. 
 
 Installment Contracts: In several lines of business sales are 
 made or contracts are executed under conditions which require 
 time to consummate, or which are payable in installments. It is 
 customary to charge the total contract to the debtor and credit 
 the collections on account as they are made. Experience has 
 demonstrated that many of these contracts are not carried out, 
 in which case balances due are uncollectible. If a business has 
 been established for a number of years, past results can be used 
 as a guide in valuing the outstandings, but where the business 
 has been recently established, great care must be taken. The 
 first point to consider is the character of the contract and descrip- 
 tion of the subject matter. 
 
 In the case of piano contracts where a material first payment 
 is collected, and where the piano can be taken back without 
 excessive cost, the loss would be small; but the reverse is the 
 case with the class of contracts for correspondence courses and 
 books. It is not usually considered worth while to attempt to 
 reclaim books and lesson papers, although title does not pass 
 until the final payment is made, nor is it usually worth while to 
 enter suit for collection of the balance due. Therefore, in all 
 cases where this class of contracts is entered at the full purchase 
 price, a considerable reserve must be provided for bad debts. 
 
104 AUDITING 
 
 INVENTORIES 
 
 Raw Materials, and Stock Purchased to be Resold in the Same 
 Form: Under this caption should be included only stocks of 
 goods owned and under the control of the owner. Stocks are 
 often hypothecated, and if this is the case, the fact should be 
 stated on the face of the balance sheet. 
 
 The basis of value should be cost or market, whichever is 
 the lower. If purchases have been made on a falling market, it 
 is not conservative to place a higher value on an inventory item 
 than the price at which the same thing can be duplicated in the 
 open market. It deceives the banker, creditor, and stockholder, 
 who have a right to believe that the values stated are real values 
 as of the date of the balance sheet. 
 
 It may seem inconsistent to advocate a somewhat different 
 principle when purchases have been made on a rising market and 
 where the goods cannot be duplicated, except at a higher price. 
 In this case, however, the conservative course is to carry the 
 items at cost and thus do away with the objectionable practice of 
 anticipating a profit. 
 
 In this connection raw materials are dealt with as being the 
 first stage of a manufacturing process. If bought and sold with- 
 out alteration in form, there is some merit in the contention that 
 the difference between cost and market is a loss or gain properly 
 applicable to the period preceding the closing of the books, but 
 the fact, nevertheless, remains that the goods in the inventory 
 have not been sold and no profit has been earned. 
 
 The safest rule is the better one to follow, and this is unques- 
 tionably cost or market, whichever is the lower. If the market is 
 higher than cost, and cost is used, it is quite in order to indicate 
 this fact (if it is important) in a footnote on the balance sheet, 
 and no criticism will follow, whereas bankers are never pleased 
 to learn that an inventory has been marked up and a profit taken 
 which is not yet realized. 
 
 The physical condition and salability of the stock must also 
 be considered. If there is deterioration or if part of the stock is 
 out of date, or otherwise unsalable, the asset loses its most 
 important aspect, availability. This is a most difficult fact for 
 the auditor to determine, but he must depend upon his own intui- 
 tion and inquiries to determine whether or not the stock is in 
 
BALANCE-SHEET AUDIT— ASSETS 105 
 
 good condition or merchantable, supplementing this, of course, 
 by certificates from those in charge of the departments con- 
 cerned covering this point fully. 
 
 The price placed upon raw materials can be checked in 
 nearly all cases by recent purchase invoices, while with all staple 
 goods reports as to current values are readily obtainable. 
 
 The extensions should be tested and all large items scrutin- 
 ized. Exceptionally large quantities of particular items deserve 
 special inquiry, and some general familiarity with the normal 
 stock, which any well-conducted concern in the same line of 
 business should carry, is very desirable. 
 
 The footings, too, should be verified, or at least be thor- 
 oughly tested. Many instances have been found where serious 
 errors have existed in both calculations and footings, so that an 
 auditor who fails to cover this point fully is open to criticism. 
 
 In a celebrated English case it was held by the Court that 
 an auditor is not a valuer ; that it is not his duty to take stock ; 
 that in the absence of suspicious circumstances he is entitled to 
 rely upon the representations of responsible officials ; and that he 
 is not guilty of negligence if he accepts the certificate of such 
 persons to the value of the stock-in-trade. 
 
 The auditor's course, therefore, is to secure all the evidence 
 within his power to demand, and lacking any part of the proof 
 which he deems necessary, his only course is to qualify his certi- 
 ficate accordingly. 
 
 The author thinks the accountants in England rely too much 
 on the decision of a Lord Chief Justice that the auditor "is not 
 called upon to be suspicious, nor even to make inquiry, provided 
 that nothing comes to his notice to cause him to think that there 
 is need." This may be law, but it is a poor rule to insert in an 
 audit program. 
 
 It may be that the borrowers and debtors in the United 
 States overstate their inventories and deceive their creditors to a 
 greater extent than is the case in England, in which case an 
 auditor there may be justified in accepting the certificate of some 
 one else as the sole check on the stock, but the auditor here who 
 would acquire a reputation for dependability will not be content 
 with this measure of his duty. 
 
 Is it not true that the stockholder or banker is being taught 
 
io6 AUDITING 
 
 to look on the professional auditor as a sort of watchdog, one 
 who will detect all irregularities, insist on businesslike methods, 
 see that the accounts are stated clearly and correctly, and pre- 
 vent unsatisfactory conditions generally? 
 
 Now what more important element of business is there than 
 "stock-taking"? Is it not the most important of all? On it may 
 depend financial success or failure ; on it dividends may be paid 
 or passed. Is it not then, in every sense of the word, a financial 
 transaction to be audited? 
 
 The English law says that the auditor is using reasonable 
 care and skill when he accepts the certificate of a responsible 
 official. The profession will not advance in usefulness and stand- 
 ing if this is to be the standard on this side of the Atlantic. 
 
 The author dififers from those who maintain that an auditor, 
 not being a valuer, has no right to attempt to pass upon physical 
 valuations, including stock-in-trade and plant; his opinion is 
 that an auditor's duty is not properly performed unless he does 
 all that his experience and skill enable him to do. 
 
 Numerous instances might be cited where professional 
 auditors, without any special knowledge whatever in particular 
 lines of business, have detected overvaluations, excessive state- 
 ments of quantities, and misstatements as to the condition of 
 the stocks, some of these discoveries being of sufficient impor- 
 tance to stop the sale of a business or the extension of a line of 
 credit by a banker. 
 
 In many of these cases the inclusion in the certificate by the 
 auditor of a statement to the efifect that he has accepted the 
 inventory valuations without verification would have been 
 acceptable to his client at the time, but subsequent events would 
 have demonstrated tHe worthlessness of the report from a prac- 
 tical point of view. 
 
 Looking at it from another angle, it may be asked : Why not 
 as well accept a certificate from the cashier that the cash balance 
 is duly accounted for as to accept the certificate of the stock- 
 keeper that the materials and goods under his care are on 
 hand? 
 
 The author has compiled some simple directions for use by 
 those who desire to make a real test of what is frequently the 
 largest item on a balance sheet. If these are followed with care. 
 
BALANCE-SHEET AUDIT— ASSETS 107 
 
 the auditor need have no hesitancy in certifying to the accuracy 
 of the inventory item in the balance sheet. 
 
 These rules rest upon the assumption that, since an auditor 
 is not a valuer, he is not charged with a special or technical 
 knowledge of the elements surrounding stock-in-trade, so that 
 if he exercises due care and skill he may feel that he has con- 
 scientiously discharged the duties imposed upon him. They are 
 submitted as a guide to the auditor who desires to do all that he 
 can do to inform his clients as to the exact conditions of the 
 business under examination. 
 
 RULES FOR VERIFYING INVENTORIES 
 
 ( 1 ) Secure original stock sheets, no matter how rough or soiled 
 they may be. Decline to accept "fair" copies unless originals 
 have been destroyed, in which case consider that a prima facie 
 case of concealment has been made out and require strong affirm- 
 ative proof to account for the missing records. 
 
 (2) If not certified to or initialed by the persons who took the 
 stock, by the persons who made the calculations and the, footings, 
 and by those who fixed the prices, have this information supplied 
 and see to it that the persons who made the certificates or who 
 supply the information are dependable and take the matter seri- 
 ously. Insist on a clear and detailed statement in writing as to 
 the method followed in taking and pricing the stock. 
 
 (3) Test the calculations, including all large items, and prove 
 the footings. If the inventory is a very extensive one and made 
 up largely of small items, prove the footings by sight, i. e., foot 
 a page or two and use the totals of those pages as a mental guide 
 in looking over the other pages. 
 
 (4) Where stock records of prices and quantities, or either 
 one, are kept, compare the totals of the physical inventory with 
 the book figures and trace any material discrepancy. 
 
 (5) Where stock records are kept and no physical inventory 
 has been taken, the former must be very carefully investigated 
 as to the method in use, the care taken in carrying out the system, 
 and all other features connected therewith which will assist in 
 forming a conclusion. Ascertain when the last physical inven- 
 tory was taken and compare same with book records. If no 
 recent comparison is possible, select a few; book items of impor- 
 
io8 AUDITING 
 
 tance and personally compare with the things themselves. If dis- 
 crepancies are found, do not assume, without further proof, that 
 they are clerical errors only. Large thefts of goods have been 
 discovered by tests of this kind. 
 
 (6) 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. 
 
 (7) Ascertain that nothing is included in the inventory which 
 is not owned, but which 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 to the head office. Ascertain 
 that nothing is included which has been sold, billed, and is simply 
 awaiting shipment. 
 
 (8) If duties, freight, insurance, and other direct charges have 
 been added, test same to ascertain that no error has been made. 
 Duties and freight are legitimate additions to the cost price of 
 goods, but no other items should be added except under unusual 
 circumstances. 
 
 (9) Select a fair number of items and compare the inventory 
 prices with the most recent purchase invoices for the same kind 
 of goods. If the prices vary, ascertain the average cost of recent 
 purchases. 
 
 (10) Make an independent inspection of the inventory sheets 
 to determine whether or not the qitantities are reasonable, and 
 whether they accord in particular instances with the average 
 consumption and average purchases over a fixed period. 
 
 In re Kingston Cotton Mill Company: In an English case, 
 the judge's opinion, which will be found in Chapter XIX hereof, 
 the auditor had failed to discover inflation of some years' stand- 
 ing of both quantities and values in the inventories of cotton and 
 yarn on hand. It appears to have been admitted that a com- 
 parison of the quantities of cotton purchased and of yarn sold 
 with the quantities in the inventories certified to the auditors by 
 the managing director would have disclosed the fact that the 
 quantities as stated in the inventories could not be correct, yet, 
 despite this, the court held that the auditors were not guilty of 
 
BALANCE-SHEET AUDIT— ASSETS 109 
 
 negligence. The inventories were entered in the balance sheets 
 "as per manager's certificate," and the court appears to have 
 taken the view that there was no obligation on the auditors to 
 go back of the manager's statement. Most prominent American 
 accountants would now, however, probably agree that such a 
 failure to discover the true state of affairs when the means for 
 doing so were available is inexcusable. 
 
 Remember that in many classes of goods of which full stocks 
 must be kept the sale of a few articles at a large gross profit is 
 depended upon to offset the probable loss on the goods unsold in 
 the same class. The residual stock of such classes may have 
 little or no value. 
 
 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 business 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 dis- 
 crepancy cannot be satisfactorily accounted for by a rise or fall 
 in the cost of production or of the selling price, the cause of 
 difference will usually be due to errors in stock-taking or to the 
 improper inflation of values. 
 
 (11) Compare the inventory sheets in a general way with 
 those of the previous period for the purpose of noting any varia- 
 tion in the prices at which similar classes of stock are taken. 
 
 (12) After this is completed and other parts of the examina- 
 tion about concluded, apply the knowledge so acquired to answer- 
 ing the following questions : 
 
 (a) Is any of the stock damaged, depreciated in quality, or 
 have the styles or shapes changed? 
 
 (5) Is any of the stock obsolete, out of date, of a size or 
 quality no longer used ? Have purchases been made in gross or 
 dozen lots to secure a low price, leaving many odds and ends of 
 broken lots? 
 
 (13) Scrutinize sales since inventory date and compare some 
 of the items to determine whether there is ample margin between 
 the two prices to cover all expenses of sale and handling, plus a 
 profit. Otherwise it may be inferred that the inventory was 
 padded, and that just cause exists for a more comprehensive 
 examination. 
 
no AUDITING 
 
 These suggestions may seem unduly extended and not appli- 
 cable to a small business, or in the case of a quick examination to 
 ascertain the condition of the business. Close study and slight 
 modification to meet particular circumstances will, however, 
 prove their practicability. 
 
 Goods in Process: If an adequate cost system is in use, and 
 is accurately kept, it will be found that monthly, or more fre- 
 quent, book inventories can be consulted. Comparisons should 
 be made of some of the items with actual physical inventories, 
 and if any material discrepancies exist, they should be investi- 
 gated. 
 
 Where a good cost system is not in force it is almost impos- 
 sible for an auditor to verify the goods-in-process section of the 
 inventory to his satisfaction. Where applicable, the rules cited 
 above for inventories should be followed, but most of the items 
 will have lost their identity. The difificulty of the task must not 
 excuse the auditor from further inquiry. He will find in nearly 
 every case some information bearing on the most important 
 thing he wishes to know, viz., is the inventory fairly priced, or 
 is it overstated? 
 
 The financial standing and profits of the undertaking must 
 also be taken into consideration. The concern which realizes 
 good profits is not so apt to overstate its inventories as the one 
 which is hard pressed for capital or which is unprofitable. In 
 the latter cases nearly every one connected with them may be 
 depended on to bolster up a weak statement as much as possible, 
 and no item in the inventory is easier to juggle with than that 
 of partly manufactured merchandise. The most practical test is 
 an examination and test of such cost records as may exist. No 
 matter how crude the accounting system may be, no concern of 
 any size will be without some sort of cost records. It may be 
 difficult to get access to them, as many so-called practical super- 
 intendents are strangely noncommunicative as to how they 
 arrive at their costs. They will support, with much vigor, the 
 contention that modern cost systems are complicated and no 
 good, and that they can calculate their costs exactly without so 
 much detail, but they rarely consent, voluntarily, to open up 
 their records. But there must be some one who makes up the 
 costs, and the production of these records should be insisted 
 
BALANCE-SHEET AUDIT— ASSETS in 
 
 upon. The cost sheets should show the successive steps of each 
 article manufactured, and some of the stages may be identified 
 with the inventory items. 
 
 The auditor should probably leave this part of the audit until 
 the last. If the valuations of raw materials, manufactured goods, 
 plant and machinery, accounts receivable, etc., are conservative, 
 he is not called on to make an exhaustive inquiry into goods in 
 process. On the other hand, if other items are overvalued, the 
 chances are that this item will be even more so, and he can be 
 governed accordingly in making his recommendations as to 
 reductions in inventory valuations. 
 
 It is urged by some accountants, where goods are being 
 made to order, or under contract, and are therefore practically 
 sold, that in addition to direct costs and a proportion of such 
 general expenses as heat, light and power, depreciation and rent, 
 there should be added administration and selling expenses. The 
 author does not agree with this view and believes that in no 
 event will conservative methods admit of any part of administra- 
 tion and selling expenses being added to the cost of goods. 
 
 It seems hardly necessary to add, that in passing upon the 
 valuations of all stocks of partly finished goods it should be 
 definitely ascertained that all of the stock will be completed 
 within a reasonable time. 
 
 Finished Goods: If a good system of cost accounts is not in 
 force, difficulty will be experienced in passing upon the prices 
 placed upon stock-in-trade which has been manufactured or 
 partly manufactured. Where the cost system is accurate and 
 dependable, care must be taken to ascertain that the results 
 shown thereby are used as the basis for the inventory. A prac- 
 tice which deserves condemnation is that of pricing finished 
 goods at sales prices, less an estimated cost of delivery and 
 similar charges. This, of course, anticipates the entire profit on 
 such sales, for it cannot be said that a profit is ever earned until 
 delivery has been made and a cause of action established against 
 a solvent debtor. The fact that goods may be made up on the 
 order of a responsible purchaser in no way alters the principle. 
 Until delivery has been made and the goods accepted, the sales 
 contract is not complete. It is not uncommon for orders to be 
 canceled or goods refused for so many reasons that they cannot 
 
112 AUDITING 
 
 be enumerated here, therefore no conservative manufacturer con- 
 siders that any profit is earned on undelivered goods. 
 
 Some cost systems include ordinary overhead charges and 
 others go so far as to include rent and interest. No definite rule 
 can be laid down on this point, because special circumstances 
 must always be considered, and the purpose of the audit has a 
 direct bearing upon the subject. The auditor, therefore, must be 
 governed by his best judgment in passing the principle upon 
 which the prices are based. 
 
 The author suggests, however, that in verifying a balance 
 sheet which is to be used as a basis of credit, the item of interest 
 should not be considered as a part of the cost of the goods 
 unsold, and that other items nearly as questionable, such as rent, 
 administrative salaries, etc., be excluded, unless he is fully con- 
 vinced that their inclusion is in order. In other words, do not 
 certify to an "inventory at cost" item in the balance sheet unless 
 assured that "cost" in that particular case carries with it its own 
 explanation, and that subsequent criticism cannot arise. "Cost" 
 may include all expenses incurred in manufacturing, except sell- 
 ing and managerial expenses, but no profit may be included. 
 The selling and administrative expenses continue after the 
 inventory date, and profit should never be anticipated. 
 
 It is obvious that the "inventory at cost" item should be so 
 certified only where the cost price is below the net selling price, 
 allowing for all expenses of sale and carrying, and where similar 
 goods cannot be duplicated in the market at a less cost. This 
 may be a difficult point to pass upon, but it must nevertheless 
 be dealt with. One test is the general result of the business. If 
 conducted at a loss, it might easily be true that costs are exces- 
 sive, so that to use such figures would be to overvalue the assets 
 to that extent. If a factory is running on part time only or if it 
 is a new enterprise, the actual cost of production may be in 
 excess of the market value of similar goods. In such cases the 
 stock should be marked down to the market price. 
 
 In other respects the procedure in verifying the inventory of 
 finished goods is the same as that suggested for "raw materials." 
 (See pages 104 to 107.) 
 
 The Turnover: While the inventory is being verified, the 
 auditor should ascertain the aggregate sales for the last year, 
 
BALANCE-SHEET AUDIT— ASSETS 113 
 
 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 pur- 
 chase new goods. The inventory and the gross sales may, there- 
 fore, have a direct connection. 
 
 An auditor should always seize an opportunity to compile 
 data with respect to the number of times various stocks of goods 
 are or should be turned over in a year. 
 
 Supplies, Stores, etc.: In addition to the regular stock-in- 
 trade, other supplies are usually on hand and should, of course, 
 appear in the inventory, unless the total value is very small. 
 
 These items should be separated from the merchandise stock, 
 as one class represents an asset which it is expected will be con- 
 verted directly into the equivalent of cash; whereas such items 
 as fuel, office and factory supplies, repair parts, and similar 
 materials and stores, represent expenditures about to be made 
 for maintenance, and therefore not to be included in a calculation 
 as to how much can be realized within a given time to pay debts. 
 
 The general rule of valuation also applies, i. e., cost or 
 market, whichever is the lower. Care must be taken that noth- 
 ing is included except usable items. The auditor should demand 
 the original stock sheets and test their accuracy sufficiently to 
 satisfy himself that the item is a genuine one. 
 
 It is sometimes found that articles partly used are included 
 under this caption, but it is not proper to include anything 
 except new and usable materials, which would have to be dupli- 
 cated at the same or a greater cost if they were not on hand. 
 
 Investment Securities : As we are now discussing current or 
 quick assets, it must be understood that the term "investment 
 securities" does not include any securities the sale of which 
 would affect the normal operation of a business. 
 
 Where stocks or bonds represent control or a material inter- 
 est in other enterprises, the ownership of which carries more or 
 less value to the holder outside of the direct return thereon, they 
 should be designated as fixed and not current assets. 
 
 Securities, as Stock-in-trade: Where the purchase and sale 
 of securities is part of the regular business of the firm or corpora- 
 
114 AUDITING 
 
 tion, an inventory thereof should be taken as with the stock-in- 
 trade of other concerns. 
 
 It is usually easier to ascertain market values than is the 
 case with other inventories, but greater care must be taken with 
 the individual items. The rule of cost or market, whichever is 
 the lower, also applies and governs each item rather than the 
 aggregate. That is, any security which has depreciated in value 
 should be written down to the market, but an apparent rise in 
 value should not be taken advantage of unless the securities are 
 in active demand and the market continues in an equally satis- 
 factory condition after the date of the balance sheet and up to 
 the time of the report. 
 
 It frequently happens that a few sales of an inactive security 
 may appear to fix a higher valuation than that at which they are 
 carried, but these sales and quotations are exceedingly uncer- 
 tain. The auditor, in pricing securities, must be sure of his 
 evidence. 
 
 The securities must be examined by the auditor in person 
 or he must secure confirmations of their existence from those 
 who hold them. It is needless to say that the securities should 
 be counted as soon as possible after the audit starts, and that all 
 should be submitted to the auditor at one time. If this is not 
 practicable, the auditor should place one of his assistants in a 
 position where all changes between the commencement of the 
 audit and the completion of the verification of the securities can 
 be noted. 
 
 Certificates out for transfer should be verified by correspond- 
 ence. 
 
 As coupons due at future dates may be detached and sold, 
 the careful auditor will note that bonds have all unmatured 
 coupons attached. Where investments are supposed to remain 
 unchanged, it is suggested that the auditor note the serial 
 numbers of a few representative ,stocks and bonds and check 
 these numbers on subsequent visits. Instances have been known 
 where securities have been sold immediately after an audit and 
 replaced before the commencement of another. 
 
 A director of a bank told the author that in examining secur- 
 ities the same lot of bonds had been handed to him four or five 
 times at each examination during a period of some years. If 
 
BALANCE-SHEET AUDIT— ASSETS 115 
 
 ordinary precautions had been taken and all the securities or- 
 dered into the directors' room at one time — a feasible and simple 
 plan in this instance — a large defalcation would have been pre- 
 vented or discovered at an early stage. 
 
 Temporary Investments: Considerable publicity has been 
 given in recent years to the desirability of trading and manu- 
 facturing concerns purchasing and carrying a reasonable line of 
 marketable securities to provide for unforeseen contingencies, or 
 for extensions of the business or other extraordinary needs 
 which require funds on short notice. 
 
 The theory is that many businesses which have expanded 
 rapidly, and which are apparently prosperous, have invested all 
 of their available capital and surplus in extensions of their plant, 
 etc., and a sudden call for cash finds them in a vulnerable posi- 
 tion. This argument is sound enough from a conservative point 
 of view, but it may be urged that the merchant who is too con- 
 servative will never buy, for fear he cannot sell, and that he may 
 as well invest his surplus earnings in his own business and thus 
 earn a much higher return than is realized from securities. 
 
 This is pecuHarly a question to be decided on its merits in 
 each case, but it may be remarked in passing that the principal 
 exponents of this plan for business men are periodicals, the suc- 
 cess of whose financial advice departments depends on the adver- 
 tising patronage they receive from bond houses. 
 
 These investment securities, to fulfill their function properly, 
 should be on hand (not hypothecated) and be presented to the 
 auditor for his inspection. 
 
 As the whole theory of these security holdings lies in their 
 availability, they should be priced at their fair market valuation 
 as on the balance-sheet date, irrespective of cost. Otherwise, 
 they cannot be considered as the equivalent of cash. This, how- 
 ever, is not a hard-and-fast rule. Where the variations in market 
 prices are slight and the tendency is upward, no adjustment in 
 values need be made. Where the tendency is downward the 
 auditor should insist on a revaluation unless the variation is so 
 small that the difference is trifling. 
 
 A further test of the availability of this class of securities is 
 the existence of a firm market and stable quotations. If not 
 listed on the stock exchange the bankers who make a specialty 
 
ii6 AUDITING 
 
 of the particular issues should be asked for a "bid and asked" quo- 
 tation as of the date of the balance sheet. 
 
 Postage and Other Stamps: In most audits this item will be 
 unimportant, but in some classes of business the stamps on hand 
 will be sufficiently large to require attention. This is particu- 
 larly the case with stockbrokers in New York, who usually carry 
 large quantities of transfer stamps. 
 
 The principal reason for presenting the matter at this point 
 is that it gives an auditor an opportunity to inquire about the 
 stock of stamps on hand and to look into the method of handling 
 them. So much carelessness exists in this matter that it is well 
 worth investigating. 
 
 Deferred Charges to Operation: In nearly all balance sheets 
 items will appear which can be classified under this caption, 
 although in many cases where there are only one or two accounts 
 such as prepaid insurance, rents, etc., there is no grouping, but 
 the items are stated in detail. 
 
 The auditor cannot verify the accuracy of the book figures 
 unless an analysis is made of the charges to the various accounts. 
 As this subject is discussed fully in the chapter on the detailed 
 audit (page 241), no comment is here required. 
 
CHAPTER IX 
 
 BALANCE-SHEET AUDIT— ASSETS (Continued) 
 
 FIXED ASSETS 
 
 As distinguished from current assets, those more or less per- 
 manent with which the business is carried on are generally 
 known as fixed assets. Instead of being ofifered for sale they are 
 maintained, or renewed, and their use provides the means of 
 carrying on the business. 
 
 Period to be Covered: Where an audit covers several years, 
 or the entire life of the undertaking, an analysis of the items of 
 fixed plant will be made in due course and the auditor will have 
 before him all of the facts upon which to base an opinion as to 
 whether or not the accounts represent fair cost of the existing 
 assets. In a balance-sheet audit, however, the period to be cov- 
 ered usually rests with the auditor, and a serious question arises 
 as to how far the book valuations may be accepted as a basis 
 for actual values, assuming that the concern is to be valued as 
 a going business, and that cost, less proper depreciation, is the 
 result desired. 
 
 The auditor may as well accept the position here, as with 
 inventories, that he is expected to report the facts about the 
 plant account ; where he cannot secure reliable information with 
 respect to plant values he should state in his report that real 
 estate, machinery, and similar assets are stated at book valua- 
 tions. He should, however, attempt to ascertain whether these 
 book valuations honestly reflect present conditions. His serv- 
 ices 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 items of fixed assets as shown by the books to ascer- 
 tain the principles upon which they have been created. In a few 
 large enterprises an item of "plant" will appear which represents 
 an aggregate valuation covering the purchase price of perhaps 
 
 117 
 
ii8 AUDITING 
 
 the entire fixed property. It may be largely overvalued to offset 
 common capital stock issued in payment therefor. In such cases, 
 and in the absence of an appraisal of actual physical values, the 
 problem is difficult and requires more detailed attention than 
 can be devoted to it in a general treatise of this nature. The 
 auditor, of course, cannot intelligently criticize such a valuation, 
 even if it is absurdly excessive, unless he can secure an appraisal, 
 approximate or actual. A statement that the plant is obviously 
 greatly overvalued might lead bankers or others interested to call 
 for an appraisement. 
 
 Auditors whose practice is chiefly with large corporations 
 meet this problem frequently. Mergers and reorganizations lead 
 to "lump" sums among fixed assets and any analysis thereof is 
 out of the question. The records are not, as a rule, available, and 
 if they were there would be so many changes in the principal 
 items that the auditor would not be much better off. The prop- 
 erty of large corporations is apt to depreciate or appreciate to a 
 considerable extent; it rarely stands still. In the case of rail- 
 roads the Interstate Commerce Commission desired an analysis 
 of the property accounts of all roads reporting to it, but frankly 
 gave up the problem and finally settled on the requirement that 
 all additions subsequent to July i, 1907, be analyzed in detail. 
 
 This course may be followed to advantage in industrial cor- 
 porations. The lack of past data is no excuse for a continuance 
 of poor bookkeeping, and the auditor who has any influence in 
 the matter should request that intelligent analyses of all capital 
 expenditures be preserved. 
 
 In many corporations the property accounts represent merely 
 the securities issued and their actual value is not of prime 
 importance to the auditor. He is greatly interested, however, 
 in the operation and development of the enterprises and must 
 assume the responsibility of classifying subsequent expenditure 
 between capital and income. 
 
 In a great many balance-sheet audits data can be secured 
 without much trouble which will show the component elements 
 of the values, viz., the book cost of the various divisions of the 
 plant and equipment accounts, whether the charges appear to 
 include only items of additions and betterments, and if deprecia- 
 tion has been provided for. 
 
BALANCE-SHEET AUDIT— ASSETS 119 
 
 In brief, in all balance-sheet audits the auditor must, if pos- 
 sible, secure an analysis of the existing book valuations, even 
 if it is necessary to go back over the transactions of many 
 years. 
 
 The borrowers whose books do not lend themselves readily 
 to an audit by professional accountants are usually the ones 
 whose financial statements need serious scrutiny on the part of 
 prospective lenders and creditors. 
 
 Value as a Going Concern : We are dealing with enterprises 
 which are continuing in business, and of which a forced sale or 
 liquidation is not contemplated, so that in attempting to fix the 
 net value to a concern of its fixed assets we may say that, as a 
 general rule, the correct basis is cost, less adequate depreciation 
 for wear and tear and obsolescence. 
 
 It need not be considered that the dismantling of a plant or 
 a forced sale under unfavorable circumstances would seriously 
 disarrange the book values, provided the latter were based on 
 the foregoing rule. This aspect of the case is well known to all 
 who are interested, but no one, not even a banker, would contend 
 that the balance sheet of a live enterprise should exhibit its 
 assets at a "scrap" valuation. 
 
 Land and Buildings : Many auditors are too apt to take it for 
 granted that real estate, a record of which appears in the books 
 of accounts as owned, is actually the property of the business 
 under audit, and that it is free and clear unless a mortgage also 
 appears on the books. As a matter of fact, serious flaws have 
 developed in the title to real estate which has been carried on 
 balance sheets as an asset and which has been relied upon as a 
 basis for credit. 
 
 This is not a difficult matter to cover, much easier, in fact, 
 than many of the other items on the balance sheet of consider- 
 ably smaller amount. The most practicable method, and one on 
 which an auditor is entitled to rely, is to secure from the regular 
 attorney or a title company a letter or certificate, properly signed, 
 stating : 
 
 (i) Whether the title to the real estate as it appears, or is de- 
 scribed, on the books is in the name of the individual, firm, or 
 corporation whose name appears at the top of the balance sheet 
 or in the auditor's certificate. 
 
I20 AUDITING 
 
 (2) That the said real estate is free and clear of any liens 
 whatever, including the following : 
 (a) Mortgages. 
 (&) Judgments, 
 (c) Taxes, water rent, and other municipal liens. 
 
 While the foregoing liens, if disclosed, would appear among 
 the liabilities, yet the place in an audit to cover this point is in 
 connection with the verification of the asset side of the balance 
 sheet. 
 
 It may be urged that an auditor should not depend upon the 
 certificate of an attorney when there is no special difficulty in 
 having a search of the public records made by his own staff, or 
 by some one not connected with the enterprise, but in practically 
 all cases the result would not be any more satisfactory, and in 
 most cases difficulties present themselves which make it in- 
 advisable for the auditor to attempt to assume the work of a 
 lawyer. 
 
 An important distinction which must not be lost sight of is 
 the classification of the real estate. A balance sheet should 
 always show 
 
 (i) Real estate used in the business. 
 
 (2) Other real estate (if any). 
 This segregation applies to all concerns except those in which 
 real estate is dealt in as a commodity. Taken in connection 
 with the profit and loss account it shows at a glance whether the 
 outside real estate is producing enough revenue to warrant hold- 
 ing it, and taken into consideration with respect to the indebted- 
 ness, it will afford an opportunity to decide whether it is wise to 
 hold it indefinitely. 
 
 (i) Land: Land should appear in the balance sheet at cost, and 
 should not be written up, although it may be clearly established 
 that values have increased. As a matter of fact, an increment in 
 the value of land usually means higher taxes, with no increase 
 in earning power, so that the increased valuation is a detriment 
 so far as current operations are concerned. The business does 
 not receive any benefit therefrom except in case of a sale or a 
 liquidation, and an adjustment of the book value need not be 
 considered till these actually occur. 
 
 Similarly, if the land has apparently depreciated in value. 
 
BALANCE-SHEET AUDIT— ASSETS 121 
 
 custom justifies the carrying of this item at cost until realiza- 
 tion, at which time only can the actual value be determined. 
 
 A distinction must be made between improved and unim- 
 proved property. With the latter taxes and other carrying 
 charges are sometimes added to the cost. The auditor should 
 make a careful analysis of the items for use in his report. The 
 facts speak for themselves so strongly that the auditor need do 
 no more than refer to the items. All carrying charges, including 
 interest, should be treated as revenue expenditures unless it is 
 obvious that there is a continuous increase in the actual value 
 of the property. When this is affirmatively shown, the carrying 
 charges may be capitalized. 
 
 The largest realty company in the United States observes 
 the following rule, as stated in its last annual report: 
 
 The company's real estate is carried on its books at its original cost. The 
 entire expense of carrying the unproductive real estate is charged out of in- 
 come, but in order to show the amount which the respective properties have 
 actually cost us, this expense has been added to book value and a like amount 
 has been set aside as a reserve. 
 
 This is conservative practice and is to be commended. 
 
 Where the auditor finds that an adjustment has been made 
 increasing the book value of land, the fact should be noted on 
 the balance sheet. Otherwise, a situation like the following may 
 arise : 
 
 A corporation had accumulated an operating loss of about 
 two hundred thousand dollars. Its land was within the limits 
 of a large city and had obviously increased greatly in value, bjit 
 no adjustment of the same had been made in the books. The 
 company was at times a borrower up to about a million dollars, 
 and the banks required periodical financial statements. The 
 banks did not, however, require, and the corporation did not 
 furnish, the certified statements furnished by the auditors (which 
 exhibited the land at cost and the deficit mentioned above) , but 
 did furnish a balance sheet in which the land value was marked 
 up several hundred thousand dollars— enough to wipe out the 
 deficit and produce a surplus. As the land valuations were not 
 excessive, the banks were not put upon notice that the company 
 was losing money and that the books showed a deficit. 
 
122 AUDITING 
 
 Property may be situated in or near a city and as time goes 
 on may appreciate greatly in value based on transfers or ap- 
 praisements of land similarly located. It must be remembered, 
 however, that it is a fallacy to assume that the value of land avail- 
 able for any kind of improvement can be directly compared with 
 the value of land upon which a manufacturing plant has been 
 erected. The value of the plant cannot be separated from the 
 value of the land itself, because, based upon the assumption that 
 the land could be sold for general purposes, in ninety-nine cases 
 out of one hundred the buildings (being adapted for one purpose 
 only) would have to be demolished and the capital loss thus 
 sustained would more than offset the appreciation in the value 
 of the land. 
 
 Therefore an apparent rise in the value of the land is not the 
 equivalent of an increase in assets unless the proportion the 
 improvements bear to the entire investment is a small one. The 
 auditor can readily test the propriety of such a statement of 
 increased land value by asking the question : Is the land available 
 for sale aside from the improvements? 
 
 Bankers are strangely negligent in accepting such state- 
 ments, when they could without cost just as well have the facts. 
 No borrower could afford to refuse to furnish a certified state- 
 ment when called upon to do so by the lender. 
 
 (2) Buildings : The valuation of buildings opens up the question 
 of depreciation, which is discussed fully in Chapter XXI. Fol- 
 lowing the suggestions there made, buildings should appear on 
 the balance sheet at cost and a reserve should be created suffi- 
 cient to cover the wear and tear and obsolescence thereof, 
 accrued to the date of the balance sheet. 
 
 As an aid to forming an opinion upon the value of buildings, 
 the auditor should personally inspect the plant and note whether 
 it appears to be in good condition. 
 
 Leaseholds: Very few manufacturing plants in the United 
 States are built on leased premises, but inquiry as to this should 
 be made, however, in every audit where real estate appears as an 
 asset. In a surprisingly large number of cases hotels, theaters, 
 office and "loft" skyscrapers, and other business buildings are 
 erected on land which is leased for a definite term of years. 
 
 So far as the author has been able to discover, it is not cus- 
 
BALANCE-SHEET AUDIT— ASSETS 123 
 
 tomary for the owners of such buildings to provide a sinking 
 fund to take care of the diminishing value of their property, nor 
 even to charge depreciation as one of their expenses. There are 
 two reasons for this : first, the term is usually a long one, run- 
 ning from twenty-one to ninety-nine years. In this age of start- 
 ling changes such a long term, or one of sixty-three or eighty- 
 four years— the latter being the most popular in New York City 
 — is equivalent in the minds of real estate operators, to a free- 
 hold, and no provision for the far distant future seems necessary. 
 The second reason is that in the great majority of cases land has 
 appreciated in value faster than the buildings thereon have 
 depreciated. For instance, a building on upper Fifth Avenue, 
 New York, built twenty years ago on leased ground, with, say 
 forty-three years to run before the lease expires, could be demol- 
 ished and the vacant land sub-let for a great deal more than the 
 building was worth, in addition to the rental under the original 
 lease. With similar experiences in other cities it is difficult to 
 persuade the builder that a sinking fund should be created, 
 although he will probably admit that the building is depreciat- 
 ing in value. 
 
 The auditor should use this admission as a basis for the 
 argument that the depreciation in value of a building, computed 
 on its life and on the expiration of the lease, is an annual charge 
 against the revenue which the building produces; that, unless 
 and until the leasehold is sold or parted with, the only facts at 
 hand are that the building is diminishing in value, slowly but 
 surely, from the two causes stated. 
 
 An auditor should not set off one against the other without 
 so stating the fact in his certificate or showing it on the balance 
 sheet, otherwise he is guilty of conniving at a practice shunned 
 by all conservative men, viz., taking credit in a current period 
 for a prospective profit. Nevertheless, he must not ignore the 
 question of a rise in value, as it may have an important bearing 
 on the borrowing capacity of the concern. Therefore, whenever 
 an auditor is met with a claim that the unexpired portion of a 
 leasehold is of great value, he should secure an appraisal thereof 
 from a reliable and disinterested real estate agent. 
 
 If a lease has been purchased, and the purchase price appears 
 on the books as an asset, the expired portion should be written 
 
124 AUDITING 
 
 off periodically. If an appraisal should establish the fact that 
 the price paid was too high, it would be wise and conservative to 
 increase the installments to such an extent that the cost would 
 be written off before the expiration of the lease. But if this is 
 not satisfactory to the lessee, the auditor would not be justified 
 in insisting upon it any more than he would be in requiring a 
 tenant who, under a long lease, is paying more rent than similar 
 space could be secured for later, to set up a reserve for excessive 
 rent. 
 
 Machinery and Equipment: As with buildings, machinery 
 should be valued at cost and a sufficient reserve provided to cover 
 depreciation. In determining the sufficiency of the machinery 
 reserve, consideration should be given to the question of obso- 
 lescence. -No general rule can be found which will govern the 
 rates of depreciation applicable to any particular plant. Much 
 depends upon the way the machinery is used and cared for. The 
 life of a lathe in one plant may be twenty years ; in another the 
 same lathe will be out of commission in ten years. 
 
 The auditor must apply the general principles of deprecia- 
 tion to the item of machinery and then bring to bear the special 
 knowledge he has gained of the plant under review before 
 expressing his opinion as to the accuracy, or otherwise, of the 
 book values. 
 
 The auditor should not fail to inquire whether a detailed 
 record is available showing the particulars of the cost, etc., of 
 the machinery. In many factories such a record exists, being 
 kept for insurance purposes or as a check on depreciation 
 charges. This record is found usually on cards or in a loose-leaf 
 book, and as it is not considered one of the regular books of 
 account, it will not be submitted to the auditor unless he asks for 
 it. If accurate, it is an invaluable aid in determining the value 
 of the machinery. The record .should show how and when ac- 
 quired; cost, including installation; amount reserved each year 
 for depreciation ; position in factory, etc. 
 
 Strange as it may seem, there is a tendency towards exces- 
 sive depreciation reserves, particularly with respect to certain 
 machinery the important parts of which can be and are renewed 
 from time to time and where the cost of such renewal is not 
 charged to the reserve. A manufacturer who wants to be con- 
 
BALANCE-SHEET AUDIT— ASSETS 125 
 
 servative will allow, say, fifteen per cent per annum on machin- 
 ery. He may set aside this rate for three or four years and make 
 no charges for renewals against it. Now when it is applied to 
 any particular machine it will be apparent at once that it is impos- 
 sible for the machine, so long as it is not obsolete, to depreciate 
 more than, say, thirty per cent. In other words, the machine 
 could not be operated properly if it were allowed to deteriorate 
 below seventy per cent of its normal condition. There is a 
 standard below which it cannot go or it could not be operated 
 at all. 
 
 There is some basis of reason in a factory manager!s conten- 
 tion that his plant is as good as new. He knows that every 
 machine is working to its effective capacity, and that any consid- 
 erable depreciation thereof is a physical impossibility or he could 
 not produce a normal output. 
 
 There is, of course, accrued depreciation on every machine, 
 and this is usually admitted, sometimes after a strenuous argu- 
 ment, but the auditor who argues that a five-year-old plant has 
 depreciated, say, fifty per cent, fails to obtain a respectful hear- 
 ing, because, if it were true, the plant could not be running, and 
 that fact is stronger than his theories. 
 
 The real point at issue is that a considerable reserve for 
 obsolescence is necessary in every plant where machine tools 
 and similar equipment are used. Depreciation, as such, cannot 
 exceed a definite limit, but a machine which would never require 
 more than thirty per cent or forty per cent reserve for deprecia- 
 tion, no matter what its age may be, should have an obsolescence 
 reserve of perhaps as much or more. 
 
 Constant changes are being made in factories and mills. 
 Machinery which is comparatively new is set aside or discarded 
 for improved models, and this possibility should influence the 
 auditor who passes upon the value of such assets. 
 
 In some cases the argument is advanced that the superseded 
 machinery is as good as ever and is always available in case of 
 emergency or a sudden demand for an increased output. This 
 sounds plausible, but does not work out well in practice. The 
 proper value to place upon such discarded machinery, designated 
 as "reserve plant," is the nominal sum of $1. 
 
 Small Tools : As a rule the practice of depreciating this item 
 
126 AUDITING 
 
 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 at periodical intervals and all the tools on hand 
 revalued for balance-sheet purposes. 
 
 If this has not been done, the auditor can fix his valuation 
 only from the best evidence available, but he should insist on a 
 material writing-off from the book values unless liberal depre- 
 ciation has been provided for. 
 
 Furniture and Fixtures: This is an asset which has little 
 residual value, and conservative concerns charge off the larger 
 proportion of the cost. 
 
 In most establishments many items, such as partitions, spe- 
 cial shelving, etc., are charged to the fixture account, and fre- 
 quent alterations and changes are made. For this reason most 
 of such expenditure is in the nature of repairs and should be 
 charged off at the time. If charged to an asset account, it should 
 be distributed ratably over one or more years' operations. 
 
 Where alterations are made in leased premises, the auditor 
 must be careful to see that if the lease is about to expire nothing 
 is carried as an asset except movable fittings, etc., and that if 
 removable, ample allowance is made for deterioration. 
 
 The auditor should not pass the item of furniture and fixtures 
 without giving some thought to its physical condition. His 
 experience should furnish data as to the actual value of this item 
 and it should be impossible to induce him to certify to an over- 
 valuation. 
 
 Packages: In certain lines of business, such as breweries, 
 milk depots, spring-water dealers, bakers, etc., a considerable 
 number of packages, such as casks, kegs, bottles, cases, cracker 
 tins, etc., are owned, which are used for convenience of transpor- 
 tation only and are supposed to be returned when empty. At 
 balancing time an accurate inventory should be taken, if possible, 
 but if not practicable, the auditor will be under the necessity of 
 making his own calculations as to the number required for the 
 normal operation of the business. He should then inspect the 
 reserve supply and decline to certify to a greater number than is 
 thus disclosed, unless furnished with unquestioned proof as to 
 such larger quantity. 
 
 In many cases concerns go on the assumption that all such 
 
BALANCE-SHEET AUDIT— ASSETS 127 
 
 packages are in possession of some one who will in due course 
 return them, but experience proves that a considerable percent- 
 age are lost, broken, or stolen, and that to carry purchases as 
 stock on hand is a misstatement of fact. 
 
 Deposits of cash are frequently received as security for the 
 return of packages, and the aggregate of such deposits may be 
 large. If so, the auditor should note the relation of this liability 
 to the cash on hand. The deposits constitute a trust fund and 
 should not be used for working capital, although it is hardly 
 necessary to keep a separate bank account therefor. The cus- 
 tomers of a large cracker company returned empty tins in such 
 numbers during the panic of 1907 that the cash required to return 
 their deposits seriously affected the financial condition of the 
 company ! 
 
 Horses: Horses not only become less valuable through age, 
 but depreciate according to the manner in which they are worked. 
 A revaluation on the basis of the age of the horses and the nature 
 of the business is more satisfactory than the writing off of a 
 fixed percentage annually. The auditor should, if feasible, count 
 the horses called for by the inventory, although he may be unable 
 to pass upon their condition. 
 
 Wagons, Automobiles, etc.: While these depreciate rapidly, 
 and in the case of automobiles the apparent life is short, yet it 
 must be realized that the nature of the items permits repairs to 
 be made which largely take the place of renewals. In an auto- 
 mobile, for instance, tires are renewed, the motor may be 
 replaced, and taxicab companies entirely rebuild the bodies. De- 
 preciation, therefore, as distinct from repairs and renewals may 
 be a smaller factor than is apparent at first glance. Of course, 
 full allowance may be made for "accrued" wear and tear, but 
 any such rate of depreciation for taxicabs as has been advocated, 
 viz., three years, is manifestly excessive in view of the fact that 
 many eabs are in daily use which are four or five years old. 
 
 Patterns, Drawings, Lasts, etc.: These items frequently 
 represent large outlays by manufacturing concerns and form a 
 difficult class to value. Where they are used for stock or regular 
 output, their value depends upon their life and upon the prob- 
 ability of renewed use. Where acquired or made for special 
 jobs, the residual value is small, and the book value should have 
 
128 AUDITING 
 
 been a charge against the jobs themselves. In every case these 
 items should be looked upon with suspicion and overwhelming 
 proof must be adduced before passing any material sum on their 
 account as an asset. The auditor may meet with strong opposi- 
 tion in his efforts to reduce this item to a reasonable basis, for it 
 represents the skill and often the affections of the proprietors, 
 who dislike to hear its value depreciated. 
 
 The auditor must, however, be firm and decline to set up 
 sentimental values as tangible assets. The auditor of consider- 
 able experience will, upon reflection, recall the small actual value 
 which this item represents. 
 
 The facts are not difficult to ascertain. The public demands 
 change, and patterns, etc., must be made to suit the changing 
 taste. Likewise, what appear to be standard patterns for stable 
 businesses change rapidly. Engineers make about as many alter- 
 ations in their "styles" as do milliners. As soon as demand 
 ceases most of the old patterns may as well be scrapped, and 
 this rule applies to hardware designs as well as to patterns for 
 ladies' dresses. More than one balance sheet of a hardware 
 manufacturer or a maker of dress patterns shows a valuation 
 placed on designs entirely out of favor. 
 
 The charges against this account are usually cumulative, 
 i. e., they follow the output almost automatically, whereas, if any 
 considerable percentage of the old patterns, etc., were available 
 for use, the additions to the account would not keep pace propor- 
 tionately with the production, but would increase very siowly. 
 It is incumbent upon the auditor to apply these tests before 
 accepting the book valuations. 
 
 Wherever feasible he should advise a conservative course 
 such as writing down the book value to $i. 
 
 Electrotypes, Woodcuts, etc.: The arguments just urged as 
 to patterns apply with equal force to these items. Conservative 
 publishers charge almost the entire cost of plates as a direct cost 
 of a first edition, and are careful to revalue the balance of the 
 account at frequent intervals. If a book or other publication is 
 successful, the cost of plates, etc., can be readily absorbed in its 
 cost, while if it is not successful, no reorders can be looked for 
 and it would be folly to carry the plates in the balance sheet at 
 any valuation except as scrap metal. 
 
BALANCE-SHEET AUDIT— ASSETS 129 
 
 A number of bankruptcies have occurred in the publishing 
 business through a disregard of this fact. 
 
 Patents: Patents are granted in this country for seventeen 
 years, so that a proportionate part of their cost should be 
 charged ofif periodically to provide for the vsrriting off of the 
 entire cost by the expiration date. 
 
 In many cases a residual value remains through the building 
 up of good will in connection with the handling of the patent, 
 but this is a different class of asset, and the auditor is not justi- 
 fied in ignoring the diminishing period. Other instances of de- 
 preciation affecting patents are obsolescence, the impossibility 
 of producing the article as a commercial or workable success, or 
 failure to induce the public to buy the patented article. It by 
 no means follows, therefore, that a patent remains of value dur- 
 ing its whole life, and consequently revaluation in such cases 
 should be resorted to. 
 
 In no event should the value be written up, even though it 
 appears to be much in excess of the cost price. 
 
 The auditor should see the patent papers, or secure a certifi- 
 cate from the patent attorneys to support the item. 
 
 The ledger caption of the "Patents" account sometimes is 
 the nearest approach to evidence which is called for or sub- 
 mitted. If the ledger account has been arbitrarily so named to 
 offset an issue of capital stock, and is not represented by actual 
 patents of any value, the auditor should insist on a renaming 
 to accord with the facts. 
 
 He has no more right to certify to a large asset item of 
 "Patents," where the value is. not substantiated, than of any 
 other item the meaning of which is reasonably clear to the public, 
 or which they think is clear to them. 
 
 As a matter of fact, an auditor can form a fairly close opin- 
 ion on the value of a patent. From a commercial point of view, 
 if it is an old one, past results have a distinct bearing on the 
 point. Pending litigation furnishes another clue. If it is a new 
 patent, an auditor is as well qualified as anyone else to guess the 
 outcome of the future. This is not an argument to place any- 
 thing but facts in the written report, but this good rule does not 
 bar an auditor from discussing the matter with his client, and, if 
 requested, stating his experience in connection with the subject. 
 
I30 AUDITING 
 
 Copyrights: The same considerations apply to copyrights 
 as to patents, except that the term is forty-two years or fifty 
 years after author's death. As most copyrights diminish stead- 
 ily in value, depreciation should not be based on their life. 
 
 Revaluation of each one is the only satisfactory solution. In 
 all cases the auditor should be furnished with a list of copyrights 
 owned, and inquiry based on this list will develop evidence as 
 to the actual worth of the asset. 
 
CHAPTER X 
 
 BALANCE-SHEET AUDIT— ASSETS 
 
 FIXED ASSETS (Continued) 
 
 Good Will : This asset is in a class by itself. The question of 
 depreciation certainly cannot be applied to it as to other items. 
 If earnings decline for any reason, the value of good will declines 
 correspondingly, because by its very nature its value depends 
 on earnings of a certain amount being maintained. Good will, 
 however, always appears, or should appear, on the balance sheet 
 as a separate item, and well-established practice permits it to 
 appear at cost, irrespective of fluctuations which affect its value. 
 As a matter of fact, its actual value changes from day to day, 
 and there would be so much uncertainty in any attempt to adjust 
 its book value that by common consent it is left alone, except in 
 cases where earnings are unusually large, and it is considered 
 advisable to write it off. In such cases the very fact of there 
 being sufficient earnings to write it off would justify its reten- 
 tion, whereas earnings not up to expectations, and insufficient 
 to enable a concern to write it off, would indicate that its book 
 value is inflated. As good will does not suffer wear and tear, does 
 not become obsolescent, is not used up in the operation of the 
 business, depreciation, as such, cannot be charged against it. 
 
 When it is written off, a secret reserve may be created, so 
 that no criticism can be sustained where it is permitted to stand 
 at cost. 
 
 The intangible nature of good will has made this item an 
 easy excuse for manipulation. Not long ago an able judge held 
 that the use of the term "good will" to describe overvaluations 
 had been sadly overdone. In the particular case then before him 
 stocks and bonds had been issued to owners for their, several 
 enterprises and it was obvious that such payments included all 
 the good will which could possibly be ascribed thereto, and that 
 further, large blocks of stocks and bonds handed to the pro- 
 moters for "services" constituted overissues thereof. He also 
 
 131 
 
132 AUDITING 
 
 said that the dummy directors who solemnly voted that the prop- 
 erties acquired were worth the price fixed by the promoters were 
 neither competent to pass thereon nor independent enough to 
 make their decision binding. 
 
 Computation of Good Will: The following comments and the 
 charts appearing on page 133 are reproduced by permission from 
 System for January, 1912 : 
 
 Despite all the sound reasoning of advertising experts and accountants, 
 despite all the beating of tomtoms by underwriters and passionate promoters, 
 good will is still the fourth dimension of business. It is there, but the diffi- 
 culty lies in making another see it where you see it and in making him see 
 it as large as you see it. For, like the fourth dimension, you can't feel it 
 with your hands. The courts protect it, declare it to be as tangible an asset 
 as real estate ; hard-headed business men, as well as luminous theorists, insist 
 that it be regarded as so much property. It is. It should be. But how 
 many business men have any that they can sell for cash in hand? Propor- 
 tionately, very few. Negotiable good will is the exception rather than the rule 
 in business. Every man is positive he has some until he tries to exchange 
 it for cash. Then the majority discover that either they have much less 
 than they dreamed or none that is salable. 
 
 Lately, the proprietor of a big New York department store suffered a 
 shock. He had an excellent location, he had been a heavy advertiser, but he 
 paid his bills in four or five months. Consequently, he paid more for standard 
 stock than did his competitors; manufacturers and jobbers came to him 
 with only riffraff and odds and ends not to be placed elsewhere, and the 
 public tired of his goods. In short, the good will bought and paid for in 
 location and advertising foundered and sank on a sea of ill-favored goods. 
 He had to choose between selling out at the precise cost value of his stock 
 and bankruptcy. He sold. 
 
 Can the value of good will be anything more than each man's guess? 
 Yes, there are rules for estimating it, and these are coming more and more 
 into use. First, however, it is not unwise to make sure that you have some 
 negotiable good will, for this depends upon varying contingencies : upon the 
 degree to which it can be transferred, upon the public favor of each in- 
 dividual business, upon numberless other factors whose vital value may 
 change with the moon. The most significant of these other factors which go 
 to make up good will can be listed. They are trade marks, trade names, 
 competition, advertising, merit of goods, location, franchises, patents. Loca- 
 tion sometimes counts for more than all these other factors put together — 
 and, again, is dwarfed to insignificance by a single one of them. 
 
 These, then, are the props upon which good will is reared. But how can 
 its value be determined in dollars and cents? 
 
 The first steps are as sound and firm as those in a government building. 
 The net earnings of the business must be learned. 
 
 One normal year may be taken by itself or from three to five years of 
 
BALANCE-SHEET AUDIT 
 
 133 
 
 /- V 
 
 />* 
 
 CCMP N 
 
 
 
 PA P H 
 
 
 RCPU ON 
 N C 
 
 Some of the factors that enter into a computation of the "good will" of a bueineBs. For obvious 
 
 reasons these factois vary greatly in Importance, dependent upon the peculiar conditions that affect 
 
 the buBlnesB that enters into the transaction. 
 
 Burplns Profits for 
 One Year 
 
 Usual Estimate of 
 **Good Will" 
 
 For FrofeBsionai 
 Practice 
 
 For Manufacturing 
 Business 
 
 For Wholesale or Re- 
 tail Trading Business 
 
 For Quasi Monopoly 
 or Similar Business 
 
 The first in computing "good will" is determine net earnings of a bulsiness, from which sum 
 is deducted the interest on capital actually employed and the value of the owner's services. The result 
 multinlled ordinary by two, but sometimes by many times that amount, has been accepted as the 
 iuuxLii<u J Value of the "good will.". 
 
134 AUDITING 
 
 uneven earnings may be averaged. It matters not so long as the probable 
 net earnings for the forthcoming year are at hand to serve as a basis. From 
 these, all authorities agree, two deductions should now be made: one is the 
 interest at six or seven per cent upon capital actually employed, the other, 
 a sum equivalent to the owner's services to the business. 
 
 Here we have the actual surplus profits of the business, and right here 
 we have to take to the ladder of theory. How many times these surplus 
 profits is good will worth? 
 
 In the case of a large retail dry goods store this is what actually hap- 
 pened: The business was taken over at one hundred cents on a dollar of the 
 cost value of stock, at fifty cents on a dollar for fixtures. Then the purchaser 
 agreed to pay $50,000 annually for the next five years for the good will. This 
 $250,000 may loom large to you, but the business netted $125,000 annually on 
 a working capital of a million. Hence, the good will was figured at only 
 twice the yearly net profits — somewhat less, in fact, considering the interest 
 lost through partial payments. 
 
 At the risk of disappointing many who are figuring their good will 
 higher because they have never attempted its sale, I must state that, in prac- 
 tice, the favorite multiplier in use appears to be 2. The business brokers, 
 accountants, adjusters, and lawyers with whom I talked seemed to settle 
 upon this figure, regardless of the nature of the business, provided only it 
 were not a monopoly. One New York lawyer whose firm formerly nego- 
 tiated the sale of many large businesses said : "Most people figure their good 
 will at twice the annual profits. If their stock is worth $40,000' and they 
 net $20,000, they want $80,000 for their businesses." 
 
 The good will of many a business is computed at twice its earnings with- 
 out making the prescribed deductions for interest on capital and for owner's 
 services. Thus the accredited rules for computing it are constantly being 
 broken and exceptions discovered. An investigation of the actual value of 
 good will is largely, at best, a study of exceptions. Average sales of good 
 will at normal prices take place all the time, but nobody hears of them; the 
 abnormal ones alone are reported and serve to mislead. Business men hear 
 of these exceptional prices, have no knowledge of the average ones, and 
 tend to make their own estimates too high. This increases the difficulties of 
 a subject of itself easily the most difficult in all business. Last summer one 
 of the leading members of the New York bar served as referee on a case in 
 which it was necessary to set a doUars-and-cents' value on good will. He 
 reported to the court: "Sales of such a commodity are so rare that the in- 
 quiries that were addressed on the trial to the experts who testified brought 
 no help." The good will this attorney was compelled to value was that of 
 a firm of architects who had planned, among other structures, the Manhattan 
 Opera House. This lawyer ended by averaging the earnings for the entire 
 five and one half years these architects had been carrying on business, and 
 then multiplying these average yearly earnings by 2. It is indicative to 
 observe how often one finds this figure 2 used in practice, particularly in 
 nearly all the varied forms of retail business. 
 
 Most buyers of small stores are paying, through ignorance, a higher 
 
BALANCE-SHEET AUDIT 135 
 
 price for good will than they perhaps realize. When they neglect to deduct 
 for owner's services and interest on working capital, it amounts to multiply- 
 ing the actual profits by a larger number than two. But these small stores 
 are generally taken over by men untrained in these lines, by men eager to 
 invest their small capital where it will earn them a living, and, hence, willing 
 to pay a premium for the good will. But in pursuits for which a special 
 training is necessary, the market is narrow and the owner usually has to sell 
 to a competitor, thoroughly informed and not likely to overvalue any one's 
 good will except his own. 
 
 Just what is good will? 
 
 No one definition has ever been fashioned fully to clothe it in all its 
 varying forms — ^not since advertising became the pacemaker in this age of 
 speed and guided business to new and quicker thoroughfares. One knows 
 that it exists. In special instances one can determine definitely just what 
 caused it to be, but whim as well as habit sometimes has a hand in its mak- 
 ing. You may catch it or you may lose it with a slogan. One candy manu- 
 facturer may gain it by advertising; another without. This storekeeper may 
 secure it by manifesting a partiality and personal interest in the affairs of 
 his customers; that one may achieve the same end by caring for nothing 
 except the merit of and the satisfaction given by his goods. 
 
 Usually, good will represents the industry, judgment, tact, and courage 
 of the man at the top as reflected in his clerks, salesmen, or workmen. As 
 Emerson put it : "Every successful business is the lengthened shadow of some 
 one man." Long after the Fifth Avenue Hotel was left hopelessly down- 
 town by the mad race north of hotels and theaters in New York, it held its 
 own because its courteous clerks had made so many warm and personal 
 friends. These thought little of the increasing inconvenience of the hotel's 
 location. 
 
 In many respects good will is the life insurance of business. Annually 
 the shrewd merchant or manufacturer invests in this form his extra energies 
 and convictions. As a result, in the event of his own sudden death, some- 
 times something passes on to his heirs more highly valuable than his mere 
 store or plant. And on the other hand, if he lives to that ripe age when 
 he begins to think of retiring, he finds coming to him, as with an endowment 
 policy, the cash surrender value of his good will. 
 
 Sinking Funds: The caption "Sinking Fund," or any other 
 fund, should always represent an asset, and inquiry should 
 always be made (whenever the nature of the undertaking raises 
 the question) as to the disposition of this account. In many 
 mortgages, especially when secured by coal, ore, lumber, etc., it 
 is provided that a certain amount, based on the production, shall 
 be paid to trustees for the purpose of extinguishing the debt at 
 or before maturity. These amounts properly appear on the 
 balance sheet as assets, and it should be clearly shown what 
 
136 AUDITING 
 
 investments have been made and the cash, if any, which remains 
 uninvested. 
 
 This principle is not affected in theory by the fact that some 
 sinking funds instead of being actual assets, are deductions from 
 liabilities. For instance, a sinking fund may be used in buying 
 up a corporation's own bonds. The actual facts are better ex- 
 pressed if the bonds so held (and which may be canceled) are 
 deducted from the total outstanding, rather than shown as an 
 asset. 
 
 A certificate from the trustees as to the state of the fund is 
 sufficient evidence for the auditor, so far as the examination of 
 the cash and securities is concerned. 
 
 If the bonds have been surrendered to the company, the 
 auditor should examine them and note whether proper safe- 
 guards are provided to prevent improper use thereof. 
 
 The creation of sinking funds and other points in connection 
 therewith is discussed on page 177. 
 
 Fund and Other Permanent Investments: In this class are 
 included the securities, held for income purposes, or as invest- 
 ments of sinking, reserve, and other special funds. 
 
 The element of permanency consists in the purpose of the 
 investments, i. e., they are not bought and sold with a view to a 
 profit in the turnover, nor are they held as a temporary reserve 
 to be instantly converted into cash. 
 
 In many instances the market price at a particular date may 
 be fixed by a few small transactions which have little bearing 
 on actual values, owing to the limited demands, and perhaps an 
 urgent necessity to sell on the part of an unfortunate investor. 
 The plan of valuing bonds which have been purchased for per- 
 manent investment advocated by leading authorities on the 
 subject is to compute their value on the basis of the effective, 
 or actual rate of interest, if held to maturity as determined by 
 the prices at which they were originally purchased. 
 
 Bonds are rarely purchased at par or face value. To make 
 the amount of the purchase equal the par value at maturity 
 requires an adjustment of accounts. The scientific method of 
 adjustment is known as amortization or accumulation and 
 involves a debit or credit to interest accovint at each periodical 
 adjustment of the book value, in accordance with the effective 
 
BALANCE-SHEET AUDIT 137 
 
 rate of interest, on the basis of which the investment was 
 made. 
 
 The corporations in whose balance sheets marketable invest- 
 ments play a leading part are insurance companies, banks (more 
 particularly savings banks), and trust companies. State laws 
 require that the solvency of insurance companies be tested by 
 the sufficiency of the assets (valuing stocks and bonds at the 
 market prices) to meet the present value of policy contracts in 
 force and sundry other liabilities. Owing to the abnormal 
 decline in the market values of securities in the fall of 1907, the 
 statements of almost all the life insurance companies at De- 
 cember 31, 1907, showed a startling decrease in surplus as com- 
 pared with the close of the preceding year. This shrinkage 
 attracted considerable attention, and as the corporate bonds 
 owned (the fall in whose market quotations was largely respon- 
 sible therefor) were yielding the same rate of income as when 
 purchased, and as there was no serious question as to the secur- 
 ity of the principal of most of them, emphasis was given to the 
 question of whether the basis of so-called market value was not 
 an erroneous one. This rather startling object lesson resulted in 
 a more general appreciation of the advantages of amortization. 
 A professional auditor should be fully conversant with the prin- 
 ciples of amortization and recommend its adoption wherever 
 possible. 
 
 In preparing a balance sheet which shows investment secur- 
 ities at their amortized values, it is interesting and advisable to 
 mention, in a footnote or other suitable place, the market values 
 at the date of the balance sheet. 
 
 Where securities are purchased for a definite purpose, such 
 as the creation of a fund to retire maturing obligations, the ques- 
 tions of income and of amortization are both important. The 
 auditor should in all cases secure a copy of the board minutes or 
 trust deed provisions which govern the setting aside and hand- 
 ling of the fund. Any variation therefrom may be important 
 and should be fully investigated. 
 
 If the balance sheet does not disclose the fund properly, the 
 auditor must insist on its being corrected. Many corporate 
 officers neglect sinking fund and similar requirements where the 
 trustee fails to inquire periodically into the transactions of the 
 
138 AUDITING 
 
 corporation, and when their omissions are called to their atten- 
 tion they in turn point out the excellent financial condition of 
 the company and argue that the provisions are intended merely 
 to safeguard the bondholders from loss in case the company were 
 unsuccessful, and as the contrary is the case, there is no neces- 
 sity for bothering with the setting aside and investment of a 
 sinking fund. 
 
 Many bonds are secured by mortgages on personal property. 
 Failure to observe trust deed requirements occurs most fre- 
 quently where there is a sale of a part of the property pledged 
 under a mortgage. When obsolete or worn-out property is sold, 
 all proceeds of such sales are the property of the trustee, and any 
 use thereof by the corporation is conversion. 
 
 Therefore, wherever an auditor finds that there has been an 
 issue of bonds he should secure a copy of the mortgage securing 
 the same, examine its provisions, and note any apparent failure 
 to observe them. 
 
 It may be that resolutions will be found in the board minutes 
 requiring the investment of part or all of the surplus in specific 
 securities. The latter part of the requirement will not be diffi- 
 cult to verify. 
 
 Treasury Stock: When stock has been issued fully paid and 
 has been returned to the treasury of the company which issued 
 it through purchase or gift, it is known as "treasury stock" and 
 should appear on the books as an asset. It represents property 
 of more or less value and is not a deduction from the outstanding 
 capital stock unless it is retired by due process. 
 
 If purchased by the corporation, cost price is the correct 
 basis of book entry ; if acquired by gift, opinions differ as to the 
 form of entry. The best authorities sanction the setting up of 
 the stock as an asset at par value, offsetting this entry by the 
 creation of a reserve or surplus account which is designated as a 
 capital item, and is clearly differentiated from the surplus which 
 arises out of profits or which is available for dividends. 
 
 As treasury stock is sold or otherwise disposed of, the asset 
 account is credited and an adjustment made between this account 
 and the reserve or surplus account for the difference between the 
 book value and the proceeds of the sale. 
 
 For the purposes of a balance sheet the auditor should use 
 
BALANCE-SHEET AUDIT 139 
 
 his discretion and place such a value upon the stock as in his 
 opinion reflects its actual value. So long as the item is sepa- 
 rately and fully stated there is no good objection to using the 
 book figures. It is never proper to include among the current 
 profits or as a part of the surplus available for dividends any part 
 of the book value of treasury stock. This would not, however, 
 apply where stock had been resold at a profit and the profit real- 
 ized in cash. 
 
 In verifying the existence and location of the stock the same 
 rules should be observed as with other securities. 
 
 Unissued Capital Stock: This is to be distinguished from 
 treasury stock, and good accounting practice does not require 
 any entry therefor in the books of account until it has been sub- 
 scribed for. 
 
 WASTING ASSETS 
 
 Certain assets, such as mines, lumber, etc., are in a sense 
 both current and fixed in their nature, but almost invariably a 
 considerable degree of permanence attaches to them and as their 
 conversion into cash is a very gradual process, such assets should 
 appear as a subdivision of those which are known as "fixed." 
 
 Values to be Written Down: It is obvious that a mine or a 
 tract of timber from which ore is being taken or timber removed 
 is worth less at the end of a fiscal period than at its commence- 
 ment. Consequently the balance-sheet valuation should be 
 reduced in direct proportion to the depletion of the mine or the 
 cutting of the timber. The usual reserve for depreciation is, or 
 should be, superseded by a sinking or extinguishment fund 
 account. 
 
 There is, however, a decided difference between the necessity 
 for providing for the renewal of plant and making good the 
 diminishing value of a mine. In one case it must not and cannot 
 be assumed that there will be no new machinery to buy, whereas 
 the owners of a mine expect that the produce thereof will be 
 converted into cash and become available for distribution as 
 dividends, unless they as owners have decided to retain the pro- 
 ceeds and invest it in other ways. 
 
 In such cases the law will not prevent the payment of divi- 
 dends out of capital, but the by-laws of the board of directors 
 
140 AUDITING 
 
 of a corporation may make it illegal. The auditor must acquaint 
 himself with the facts relating to the phases of each particular 
 case. 
 
 Mines : The auditor should follow the suggestions relating to 
 land (page 119) so far as title and encumbrances are concerned. 
 
 In verifying the accuracy of the value placed upon the min- 
 ing property the auditor as a rule will not have much to guide 
 him. He must, however, keep in mind the fact that as operations 
 proceed the value decreases. An analysis of the original cost, 
 taken into consideration with the engineer's estimates of total 
 contents, will be a valuable check on the allowance for depletion. 
 It may not be custo'mary to submit the engineer's records to the 
 auditor, but the latter is on notice that no well-managed mining 
 company attempts operation on a large scale unless fortified by 
 the scientific calculations of skilled engineers. With these before 
 him and with the records of production as shown by the books, 
 an auditor can arrive at a reasonable conclusion as to how the 
 book valuations have been estimated. If his own figures vary to 
 any great extent from the books, the auditor should decide that 
 the matter demands further investigation. 
 
 Timber Land: It will be assumed that all timber prop6si- 
 tions which have arrived at a stage where an audit is in order 
 are conducted on a well-thought-out plan. The quantity of 
 standing timber will have been estimated and verified (cruised) 
 and, with this as a starting point, the auditor can estimate the 
 average depletion charge which should be provided for. 
 
 It is obvious that an attempt to certify to results based on 
 an examination of money values only would be hazardous to an 
 extreme. The books should show quantities as well. If they do 
 not, the auditor is warranted in having his suspicions aroused. 
 
 Contingent Assets : The auditor rarely discovers any trace of 
 assets which have been omitted from the books, but occasionally 
 he is fortunate enough to disclose tangible assets which, when 
 properly applied, increase the net worth of the business under 
 audit. 
 
 In addition to the assets discussed in the foregoing pages, 
 the auditor should consider the possibility of the indebtedness to 
 a corporation of any person or persons. 
 
 Capitcd Stock Calls and Assessments: In some states there 
 
BALANCE-SHEET AUDIT 141 
 
 is a statutory liability on the part of stockholders in business 
 corporations for an amount additional and equal to the par value 
 of the shares. This corresponds with the liability of stock- 
 holders in all National banks and some State banks and trust 
 companies. The possibility of such recovery is an asset which 
 should be taken into consideration wherever it exists ; the credit 
 of a company incorporated in a State having such a law should 
 be strengthened thereby, particularly if some or all of its stock- 
 holders are of recognized financial standing. 
 
 In other cases the auditor may find that the capital stock has 
 been only partly paid and that the uncalled installments are not 
 charged to the stockholders in the books, nor mentioned in the 
 statements. This occurs where the corporation is a close one 
 and the officers and directors are identical. The amount callable 
 should be ascertained and the probability of collection duly con- 
 sidered. 
 
 Liabilities of Directors: In another chapter (page 45) atten- 
 tion is called to the liabilities of directors for various shortcom- 
 ings. In many States directors are personally responsible for 
 debts contracted under certain circumstances and in excess of 
 certain sums. Where there is any possibility of this contin- 
 gency, the auditor should refresh his memory as to the laws 
 governing corporations of the State in which the company is 
 incorporated, or in which it has its principal office, and ascertain 
 whether or not the directors have automatically made them- 
 selves responsible for any part of the indebtedness. This is 
 especially important if an examination is being made for cred- 
 itors. 
 
 SECRET RESERVES 
 
 After all recorded assets have been dealt with, and after due 
 consideration has been given to any assets which have been 
 inadvertently or fraudulently omitted from the records, it may 
 be necessary to investigate the authority under which assets 
 have been intentionally omitted from the books or the balance 
 sheet, or both. 
 
 It may be perfectly obvious to everyone connected with the 
 concern under audit that certain assets exist and are known to 
 be the sole property of the enterprise, yet acting under instruc- 
 
142 AUDITING 
 
 tions from an executive source, these assets are never men- 
 tioned in the published reports of the concern's financial stand- 
 ing. Or there may be obvious undervaluations which, after 
 being so carried for a number of y6ars, are suddenly written up 
 to their actual value. 
 
 As a matter of fact, the auditor will not find a great many 
 instances of secret reserves, but wherever he represents stock- 
 holders or others who are interested in knowing the full value 
 of the assets, he should consider the possibility of the following 
 improper treatment of accounts or assets : 
 
 (i) Systematic concealment of additions to plant or equipment by 
 charging the cost thereof to maintenance instead of to asset 
 accounts. 
 
 This practice must be clearly proven, as it is not intended to 
 unreservedly condemn the occasional charging off of plant addi- 
 tions where the obvious purpose is to be conservative, and where 
 the cost is not a material factor in the operations of the period. 
 But if it is evident that a considerable sum has been expended 
 in improvements and there is no reflection thereof in the ac- 
 counts, then the auditor should insist on restating the accounts 
 and bring out clearly the actual earnings of the period. 
 
 (2) The creation of excessive reserves for depreciation, bad 
 debts, or similar items, unless the fact that the reserves are excessive 
 is expressed on the face of the balance sheet. 
 
 This is, perhaps, the favorite method of deceiving minority 
 stockholders when the directors or other insiders wish tempo- 
 rarily to understate the earnings as well as the assets. 
 
 It is not intended to condemn at this point the practice of 
 setting aside what may appear to be excessive reserves in order 
 to keep down taxes. In many instances during recent years cor- 
 porations have provided heavy depreciation reserves in order to 
 avoid the payment of State and Federal taxes on earnings and 
 assets. Usually this is done in close corporations and each 
 stockholder is fully informed as to what is being done. In such 
 cases, where the reserves are officially created, the auditor can 
 hardly object to the statement of the accounts as they appear on 
 the books. 
 
 In the natural course of events the State and National taxes 
 will be paid because the understatement of profits is temporary 
 
BALANCE-SHEET AUDIT 143 
 
 and the profits of future years may be expected to reflect the 
 working out of the reserves. 
 
 The auditor is so accustomed to these reserves being insuffi- 
 cient that he feels reluctant to criticize liberal allowances, unless 
 there is an apparent desire to defraud innocent stockholders. 
 Otherwise, he commends the disposition to be conservative, and 
 watches with interest the final outcome of the reserves. 
 
 The taxing powers are prone to exact their pound of flesh 
 and rarely provide the means whereby an overpayment for one 
 year may be applied in reduction of subsequent assessments. 
 
 Until our systems of taxation are founded on reason and 
 some knowledge of business and accounting procedure, attempts 
 to avoid overpayments may naturally be expected, and if such 
 attempts produce underpayments the fault may fairly be charged 
 jointly to those responsible for the tax legislation and to those 
 entrusted with the enforcement of the laws. 
 
 (3) Inventories should reflect fair values, as explained in 
 Chapter VI, but there is a limit beyond which valuations cannot be 
 reduced, unless the circumstances of the reduction are stated on the 
 face of the balance sheet. 
 
 This rule is of somewhat greater importance than the pre- 
 ceding one, because reserves stand out to a certain extent and 
 grossly excessive reserves are apparent, but if an inventory is 
 undervalued, anyone unacquainted with the fact is not able to 
 detect the fraud, no . matter how carefully the balance sheet 
 might be analyzed. If there is an honest desire to be ultra-con- 
 servative and write something ofif the inventory after it has been 
 properly valued, it should be accomplished by creating a "re- 
 serve for possible loss on reaUzation of inventory" and setting 
 up this reserve on the balance sheet, with a footnote stating that 
 the inventory itself is not excessive. 
 
 If those responsible for the balance-sheet valuations wish to 
 write down the inventory, but do not want the fact reflected in 
 the balance sheet, the auditor is put on notice that an attempt is 
 being made to deceive some one. The lack of a good reason for 
 concealing the truth is prima facie evidence of dishonesty and the 
 auditor should act accordingly. 
 
 (4) The circumstances surrounding the writing down of assets 
 must he carefully looked into. 
 
144 AUDITING 
 
 So many assets are overvalued that it is usually refreshing 
 for an auditor to discover a willingness to write down overvalua- 
 tions out of profits. Instances are known, however, where such 
 adjustments have been so stated as to conceal their true import 
 and minority stockholders have lost thereby. 
 
 In all cases the full earnings of a period should be shown, 
 and if it is desirable to write off assets, such as good will, or 
 write down overvaluations, such items must appear as extraor- 
 dinary deductions and not applicable solely to the period under 
 review. If the accounts are so stated, no fault can be found 
 therewith. A stockholder who does not understand accounts 
 may look at the final figures and form an erroneous conclusion as 
 to the actual profit of the period, but if there is no attempt to 
 deceive and if the accounts are clearly set forth, the stockholder 
 is simply suffering the penalty of his ignorance. 
 
 There does not appear to be, from an accounting standpoint, 
 any justification for flagrant undervaluations under any circum- 
 stances, but as the practice has supporters among some very 
 reputable financiers, it is at least in order to examine the argu- 
 ments used in support of secret reserves. The principal argu- 
 ment is that stockholders are notoriously hungry for dividends, 
 and a surplus available (in their opinion) for dividends, but not 
 so distributed, reflects no credit whatever on the management, 
 but quite the contrary. On the other hand, if the profits of the 
 good years are all divided so that when the inevitable poor year 
 arrives the dividend must be passed, there is bitter criticism. 
 Some boards of directors think that stockholders as a class 
 must not have full information for their own good, therefore, in 
 order to avoid criticism, the profits of the good years are not 
 fully disclosed and dividends are continued through the Unprofit- 
 able periods. 
 
 Banks and trust companies assume this patriarchal attitude 
 more frequently than is the case with industrial corporations. 
 Perhaps there is some justification for this practice on the part 
 of banks whose stockholders rarely change and where dividends 
 are largely depended upon for living expenses. 
 
 With respect to the banking house and equipment, there can 
 be little, if any, objection to writing down their value to a 
 nominal amount. Except in a few localities, bank buildings and 
 
BALANCE-SHEET AUDIT 145 
 
 bank furniture are not assets which can be realized upon to pay 
 depositors. The building occupied by a failed bank is not an 
 attractive place for another bank to start business in, and such 
 buildings are rarely suitable for anything else. It may be proper, 
 therefore, for a bank to write down its property account to the 
 actual value of the land and the auction value of its furniture, 
 vaults, etc. This is a secret reserve on the basis of a going busi- 
 ness, but as banks publish frequent statements of their assets, 
 no one who owns stock and who desires to ascertain the book 
 value of the stock need be deceived. 
 
 Of course, if a bank's premises are also occupied by tenants 
 who pay remunerative rentals, this fact should be taken into con- 
 sideration in writing down the book valuations. It might be 
 fair to assume that if a sudden demand for funds were made and 
 it became necessary to sell the building, a price could be imme- 
 diately realized which would represent the capitalized valuation 
 of the property, assuming that the bank's own quarters would 
 not yield any return. 
 
 There are few, if any, other classes of enterprises where there 
 is any justification for writing down the cost or value of assets 
 in order to provide a secret reserve to be held in abeyance for 
 the purpose of continuing dividends on a constant basis. The 
 stockholders of industrial corporations do not have as good an 
 opportunity of forming an opinion upon published balance sheets 
 as the stockholders of banks. They must rely on the accuracy 
 of the amount which is reported as the net profit for the period. 
 Such stock changes hands more frequently than bank stock. 
 
 It is apparent that a stockholder who desires to sell and who 
 fixes a price upon his stock based upon the reported earnings of 
 the last period is at a great disadvantage with a prospective pur- 
 chaser of his stock, who may know that the full earnings were 
 not disclosed by the report but that a part of the profit was 
 diverted to a secret fund which it was proposed to use subse- 
 quently to bolster up an unusually unprofitable period. 
 
 It has been argued that good faith on the part of the man- 
 agement should be the sole test of whether or not such trans- 
 actions be acceptable enough to a professional auditor to warrant 
 his certifying to a balance sheet and profit and loss account in 
 which they appear. 
 
146 AUDITING 
 
 An auditor can give advice, but he cannot control the action 
 of a board of directors, nor in this country does he communicate 
 directly with the stockholders of a corporation. What should he 
 do when he is asked to certify to a statement which he believes 
 contains all of the facts and figures which the board of directors, 
 acting for the stockholders and for their interests, think they 
 should have, but which conveys a false impression in that the 
 profits are understated owing to the creation of a secret reserve? 
 
 The auditor who finds himself in such an uncomfortable 
 situation has but one course to pursue; he should send in his 
 report setting out the true facts as he has found them, and com- 
 menting upon the asset valuations of which he cannot approve. 
 The directors cannot publish the report unless the existence of 
 the secret reserve is disclosed. If they do not publish the 
 auditor's report, but put out an uncertified balance sheet, the 
 auditor can do nothing. 
 
 It might not be a bad idea to urge every stockholder propos- 
 ing to sell his stock to call for a professional auditor's report 
 upon the accounts and affairs of the corporation before the sale 
 is consummated, but, unfortunately for professional auditors, the 
 value of their certificates is not yet appreciated by the majority 
 of investors. When a man buys a horse he wants it examined by 
 an expert on horses; so he calls in a veterinarian. He knows 
 less about accounts and values than he does about horses, but 
 he does not think of calling in an expert on values or accounts 
 when he buys or sells a share of stock. He has heard about the 
 value of the services of a veterinary since his childhood, but he 
 does not know that the absence of an auditor's certificate from a 
 balance sheet may indicate that the assets shown therein are 
 improperly stated, and that if he decides to sell because the 
 business does not appear to be as prosperous as he thought it 
 would be, his action is exactly in line with the intention of the 
 insiders, who promptly buy out all those who have become dis- 
 couraged. 
 
 The fact of the matter is that an auditor is taking big chances 
 when he passes a balance sheet which conceals or understates 
 assets. Good faith may be only apparent, the real purpose of the 
 management being to buy the interests of the misinformed. 
 
 In no event, however, should an auditor certify to a balance 
 
BALANCE-SHEET AUDIT 147 
 
 sheet from which any asset has been omitted entirely. The argu- 
 ments in favor of an undervaluation are weak enough, supported 
 as they are by the general assertion that the item speaks for 
 itself in the balance sheet, but there can be no argument at all 
 to support the complete omission from the asset side of the bal- 
 ance sheet of any item of property, tangible or intangible, which 
 has or may have a market value. 
 
 The auditor who knowingly certifies to such a statement can 
 be held responsible, and money damages recovered, by any 
 stockholder parting with his stock on the basis of the balance- 
 sheet figures. Such an action would be founded on a charge of 
 deceit or fraud depending upon the circumstances of each case. 
 
 Ernest Reckitt, C. P. A., has said on this point : 
 
 The shareholders of a corporation have certainly a right to know the 
 real value of the tangible assets, the estimated value of the good will, and 
 how much "water" there' is in the stock, and any statement which does not 
 separate these items should be looked upon with suspicion. A'shareholder is 
 entitled to his pro rata share of the whole profit between regular fiscal periods 
 during the time he is a shareholder. He may not receive his profit entirely 
 in the form of dividends, but that portion of the corporation's profits which 
 is not paid out in dividends, but left in surplus, should be so presented to 
 the public that, other things being equal, the selling price of the stock will 
 correspondingly increase, and the shareholder will receive the balance of his 
 profits upon the sale of his stock. It is for these reasons that, in my opinion, 
 the public accountant should refuse to countenance the "secret reserve" or 
 any other action which makes it difficult for the layman to determine the 
 true financial condition of the company in which his funds are invested. 
 
 The shareholder has too frequently been considered as a child, from 
 whom it might be advisable to keep certain facts. I believe this condition 
 of affairs is fast disappearing, and that the best cooperation is attained by 
 the directors taking their shareholders into their confidence, and if there 
 is "water" in the stock, let them separate it from the rest of the assets, and 
 then, at the close of the year, the total additions to the plant should be 
 charged to plant account, and an entry of like amount could be made credit- 
 ing good will or franchise account and charging surplus, instead of charging 
 the additions of the year direct to surplus, and thus clouding the issue. 
 
CHAPTER XI 
 BALANCE-SHEET AUDIT— LIABILITIES 
 
 In a balance-sheet audit nothing is more important than to 
 ascertain whether or not all the liabilities of any nature whatso- 
 ever appear and are properly stated. 
 
 At the outset of this chapter it may be proper to illustrate 
 this point in order that the auditor will realize the importance 
 of placing himself in the position of the one who will read the 
 balance sheet later. 
 
 Bankers extend credit to trading concerns, not to furnish 
 additional capital, but to assist them to carry stock-in-trade, or 
 accounts receivable, at their busy season, and they expect to 
 have the borrowings repaid or materially reduced during the 
 dull season. Therefore the balance sheet of a trading concern 
 is always scanned closely by the banker to determine the propor- 
 tion of current assets to current liabilities, and he calculates the 
 time within which the stock-in-trade should be realized upon. 
 Now it may be that the concern has contracted to purchase large 
 quantities of goods which have not been received, and these con- 
 tracts may call for large cash payments within a comparatively 
 short time. Furthermore, the contracts may have been made on 
 a declining market, and the goods to arrive may cost more than 
 would have been the case if not contracted for in advance. This 
 information would not appear on the regular books of account, 
 but is it not the kind of information which the banker requires 
 to make up his mind in passing upon the desirability of the risk, 
 and is it not the kind of information which an auditor should 
 seek in order to be of substantial value to his client? 
 
 The auditor who limits himself to an examination of the 
 formal books of account in making an audit is preventing him- 
 self, in many cases, from being of constructive value, and in 
 other cases he is approaching the limits of liability in money 
 damages for negligence in not doing all that a skillful and expe- 
 rienced auditor should do. It is conceded that when an auditor 
 assumes to pass on matters which are not in the books he is 
 
 148 
 
BALANCE-SHEET AUDIT 149 
 
 opening up a wide field, and perhaps a troublesome one to cover, 
 but it may as well be admitted that the ordinary so-called check- 
 ing of books, and the subsequent balance sheet prepared there- 
 from, are about as valuable to the banker or other creditor as 
 the information which the borrower can and does furnish him- 
 self. 
 
 Accounts Payable: The ideal course by which to satisfy 
 oneself that all obligations to trade creditors appear in the books 
 at the balance sheet date would be to read all the incoming mail 
 for some days before and after such date. The period prior 
 would yield information as to the original invoices for purchases, 
 and during the subsequent days ordinary monthly statements, 
 followed later by polite requests to pay, would show practically 
 all of the class of debts mentioned. The mail would likewise 
 bring notices of maturities of promissory notes. 
 
 Unfortunately, the auditor rarely has an opportunity to open 
 the mail of his clients, although it might shed light on more 
 items than accounts and notes payable. In the absence of this 
 short cut an auditor must first see to it that all the accounts pay- 
 able shown on, or indicated by, the books are reflected in the 
 balance sheet, and, second, he must conduct a proper investiga- 
 tion to ascertain whether any accounts payable actually due by 
 the concern under audit, and not shown on the books, should be 
 included among the liabilities. 
 
 The auditor cannot foresee the use to which a balance sheet 
 may be put, so that it is always his duty to use plain terms and 
 classify the liabilities so that any pertinent question which 
 arises in the mind of an interested person may be answered with- 
 out the necessity of a special examination for each question. It 
 is not enough to state the aggregate of the debts of a firm or 
 corporation, unless it is desired that it shall be understood that 
 all consist of open accounts payable, incurred in the regular 
 course of business, not due, and for which value has been 
 received. If various classes of debts, incurred in other than the 
 regular course of business, are included in one sum, it has been 
 made impossible for anyone not familiar with the facts to express 
 a reliable opinion upon the financial position of the concern. 
 
 For instance, it might appear that a firm had assets of 
 $100,000, consisting chiefly of accounts and stock-in-trade, and 
 
J50 AUDITING 
 
 accounts payable of $25,000. If the latter were not due it would 
 be a fair inference that the accounts receivable and merchandise 
 stock would be liquidated quickly enough to pay the obligations 
 as they matured. But suppose it were shown that some of the 
 accounts payable were long overdue; that the accounts receiv- 
 able were very slow; that the merchandise stock was selling 
 poorly ; and that cash receipts were being used to pay wages and 
 similar expenses. Would this make a favorable showing in the 
 eyes of a banker who might be considering the advisability of 
 extending a line of credit? 
 
 Of course a firm in such a condition might deserve the con- 
 fidence of a banker, and there might be ample security for a rea- 
 sonable line of credit, but no auditor would be justified in merely 
 stating the bald facts as shown. If the auditor does not feel 
 warranted in adding a few words of comment to convey unequiv- 
 ocally that the assets were not readily realizable and that the 
 accounts payable were long overdue, then his point of view is too 
 far apart from the author's. The latter can be of but scant 
 service to one whose conception of an auditor's duty is that it 
 requires him to state so-called facts only. The principal reason 
 why some business men feel that professional auditors cannot 
 help them is that they have been unfortunate enough to hear the 
 words and see the figures which emanated from an auditor who 
 felt that he exceeded the limits of propriety if he ventured 
 an opinion upon any important item of the balance sheet. 
 
 It is a reasonable assumption that no balance sheet prepared 
 within, say, twenty days of a certain date, exhibits every lia- 
 bility. No exception is made for those concerns which maintain 
 an inflexible order system and :where the books are not closed 
 until every order issued is represented by a purchase invoice. 
 It is always found that some one has ignored the rules and 
 ordered something for which a liability exists, or it may be for 
 an expense which does not require an order, such as long dis- 
 tance telephone calls or lawyers' bills. Taxes of which little is 
 known may be accruing, or goods may not have been delivered 
 to a customer who has refused to accept them, and return freight 
 charges and storage may have accrued. The best the auditor 
 can do is to schedule all of the liabilities to which he can find the 
 slightest clue. 
 
BALANCE-SHEET AUDIT 151 
 
 So many balance sheets have been issued which have failed 
 to include all of the liabilities that the author feels justified in 
 discussing the matter fully, in order that the student may have 
 the benefit of accumulated experience. 
 
 Trade Creditors : This may not be the largest item of the lia- 
 bilities, but it is clearly the most important to verify. The notes 
 payable outstanding may be larger in amount, but the proceeds 
 thereof were presumably used to discharge trade debts, so that 
 the latter item loses none of its' importance becaiise the balance 
 is small. 
 
 As already stated, an auditor might ascertain the total 
 amount of the debts by examining all of the mail over a sufK- 
 ciently long period, but as this procedure is perhaps out of the 
 question, he must do the next best thing. 
 
 Statements from creditors are valuable in verifying the 
 amount due or claimed to be due, and if the time permitted 
 (which it usually does not) the auditor could do no better than 
 to request a statement from everyone with whom the concern 
 might be expected to do business. Even then some one from 
 whom a purchase had been made might be forgotten, the invoice 
 might be omitted from the books, and the fact concealed from 
 the auditor. 
 
 Most concerns keep order and receiving records of some 
 description. The auditor should compare the entries in this 
 record during the period immediately preceding the balance- 
 sheet date with the purchase journal or voucher record to ascer- 
 tain if the purchases indicated are entered. Every entry need 
 not be checked. It is necessary to test only enough of the work 
 to be satisfied that no invoices have knowingly or unknowingly 
 been suppressed. 
 
 Where an audit is not completed until more than a month 
 has elapsed after the closing date, the voucher record should be 
 scrutinized to ascertain whether invoices entered subsequently 
 belong to the prior period. 
 
 The open accounts on the ledger should be compared with 
 the schedule of accounts payable. It should be ascertained that 
 the balances represent specific and recent items only. If not, 
 why not? Where any account does not look regular in every 
 way the statement from the creditor should be asked for. If it 
 
-152 AUDITING 
 
 cannot be found, request a duplicate. If told that the creditor 
 does not send statements, demand that one be procured. The 
 latter excuse is often made, but almost invariably it follows an 
 inquiry relative to a disputed account and where the ledger 
 shows a less amount to be due than is claimed. Nearly all busi- 
 ness houses do send statements either on a fixed day each month 
 or as bills fall due. The author has never heard of a refusal to 
 furnish a duplicate, or to furnish a memorandum of the amount 
 due at any stated time. 
 
 As a test, call for certain statements in every case, even if 
 none of the accounts appear irregular. Disputes occur so fre- 
 quently over discounts, allowances, returns, etc., that it may be 
 the auditor's only chance to test the reliability of the purchase 
 records. 
 
 The inspection of the order and receiving books is also 
 important in that it may disclose receipts of goods at or before 
 inventory time the invoices of which are not entered, the reason 
 given for the omission being that as the goods were received late 
 it was not considered worth while to add them to the inventories, 
 or to pass the invoices through the books until after the closing 
 date. If this practice involves a few items of small amount only 
 it is not worth condemning, but if the quantities and amounts are 
 relatively large the auditor must add the goods to the inventory 
 and the amounts of the invoices to the accounts payable. 
 
 When examining the receiving and other records for evi- 
 dence of purchases not represented by entries in the books, it 
 should be remembered that the date of an invoice may not repre- 
 sent the date of its shipment, the practice of "dating" (i. e., dat- 
 ing an invoice forward to some future time) being not at all 
 uncommon. 
 
 It is assumed that the ledger balances represent the amounts 
 due after trade discounts have been deducted but before cash dis- 
 counts are taken into consideration. Trade discounts should not 
 appear on the books of account, being direct deductions from list 
 prices. In respect to cash discounts, however, the practice is not 
 uniform. Some concerns take advantage of every cash discount 
 and make the deduction immediately upon receipt of the invoice 
 and before it is entered. Where this has been done the auditor 
 need not hesitate to pass the accounts as they stand, but where 
 
BALANCE-SHEET AUDIT 153 
 
 the deductions have not been made the auditor should be gov- 
 erned by the size of the discounts. Where the allowance is one 
 per cent for payment within ten days, or where the rate is lower, 
 the amounts due should be taken at their face. This gives the 
 period following the balance-sheet date the benefit of the earn- 
 ing, but it is not out of proportion to the cash required and the 
 expense of salaries, postage, etc., incurred. On the other hand, 
 if the allowance is more than one per cent for prepayment, and 
 if the concern has ample funds to pay all maturing accounts, it 
 may reasonably be urged that the earning belongs to the period 
 preceding the closing of the books. For instance, an invoice for 
 $1,000 may be dated June 23rd, "thirty days net, two per cent 
 ten days." It could hardly be urged that on June 30th the lia- 
 bility would be more than $980, provided that the cash balance 
 indicated that the discount would be taken advantage of. 
 
 If the auditor desires to adjust the accounts in accordance' 
 with this suggestion, it will be necessary only to note the actual 
 deductions, per cash book, during, say, the first half month suc- 
 ceeding the balance-sheet date, allowing for any possible items 
 arising out of new transactions. This would obviate the neces- 
 sity of calculating the amount in detail. 
 
 As a matter of general practice an auditor will not care to 
 take advantage of this opportunity to reduce the liabilities, as 
 there are possible deductions from assets which usually more 
 than oflfset this amount, but in the event that the greatest exact- 
 ness is required, or if there is any evidence of a desire to under- 
 state the net worth of a concern by undervaluing the assets, it 
 may be necessary to apply the same principles to the liabilities. 
 Or again, a concern doing a very large business, such as a depart- 
 ment store, may allow no cash discounts to customers but may 
 exact them from its creditors. In such a case the adjustment 
 suggested may make a material change in the balance sheet. 
 
 Consignments: If the business under audit is one where 
 there is any possibility of goods having been received on con- 
 signment, and part or all of such goods having been sold without 
 a liability therefor having been created in the books, the auditor 
 must use all due diligence to cover the point fully. Instances 
 have been known where concerns have sold and collected for 
 consigned goods without making any record of the liability until 
 
154 AUDITING 
 
 payment is made. This may occur where there is no intention 
 to deceive, as consignment accounts are usually treated as mem- 
 oranda only. 
 
 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 
 account should show the full amount due and, if the debt is a 
 current one, the amount will appear among those due to trade 
 creditors. 
 
 If it appears that the consigned goods are partly sold and 
 partly on hand, a memorandum or "pro forma" account sale 
 should be made up for the part of each lot disposed of but not 
 yet accounted for. The net proceeds due to the consignors 
 should be entered as a liability in an account called "Accounts 
 Payable Consignors." As some time may elapse before pay- 
 ment, it is not necessary to include the aggregate among the 
 trade creditors, except as a liability accrued, but not due. When 
 the books are reopened, the entries for the uncompleted consign- 
 ments should be reversed. 
 
 Notes Payable: It is usual and desirable to divide the aggre- 
 gate of notes payable into : 
 
 (i) Notes issued for merchandise. 
 
 (2) Notes discounted by own banks. 
 
 (3) Notes sold through brokers. 
 
 (4) Demand loans. 
 
 And a further separation which is not often seen, but which is 
 most desirable, is : 
 
 (a) Notes accompanied by collateral. 
 
 (b) Notes with which no collateral is given. 
 
 There is not much to say with reference to the procedure 
 involved in verifying the existence of outstanding, unpaid prom- 
 issory notes except to warn the auditor that a great many 
 instances have been known where outstanding notes have not 
 appeared as liabilities on books of account. 
 
 It may safely be said that if deception is intended so far as 
 the concealment of liabilities is concerned, there is a greater like- 
 lihood of its existing in connection with notes payable than with 
 accounts payable. The latter are usually evidenced by invoices, 
 and any attempt to hold them out would attract suspicion on 
 
BALANCE-SHEET AUDIT 155 
 
 the part of the office staff. With notes, however, it is compar- 
 atively easy to secure discounts, secrete the proceeds, and make 
 no entry therefor on the books at all. This omission is more 
 difficult to detect in, and probably occurs more frequently in con- 
 nection with, single-entry than with double-entry books. 
 
 The point is of special importance where audits are made for 
 the benefit of prospective lenders of money. The borrower tries 
 to increase his assets and decrease his liabilities to the greatest 
 possible extent. He also may attempt to conceal the fact that he 
 has issued notes and may be carrying open accounts on the 
 books, while in reality notes have been issued therefor which 
 are falling due or which are overdue and unpaid. 
 
 In a recent bankruptcy case it was disclosed that a large 
 number of notes had been given to creditors without any record 
 thereof appearing in the books. The notes bore interest and 
 several creditors had secured judgment for nonpayment. As the 
 interest and costs amounted to a considerable sum, the liabilities 
 were increased accordingly. 
 
 A more dangerous type of concealment exists wherein notes 
 are issued in a firm or corporate name for money borrowed by 
 individuals and which pass into the hands of innocent holders, 
 who, of course, can collect if a concern is solvent. Notes of this 
 description are sometimes renewed time and time again before 
 discovery. An auditor who examines the books of account in 
 the meantime is hardly likely to find any trace thereof. 
 
 If the notes are discounted by one of the regular banks, it 
 would seem that the auditor, as well as the office staff, would be 
 put on notice. This point is usually covered by a statement to 
 the staff that the discount is a personal loan to a partner or 
 officer. The auditor might secure a clue, or at least grounds 
 for suspicion, if he would trace back to its source every credit of 
 cash to the credit of a partner or officer of a corporation. As a 
 matter of fact so many so-called loans of this nature have been 
 made that an auditor may with propriety ask the question in 
 connection with every such loan: "Where did you get it?" In 
 other words, the credits to the individual accounts of partners or 
 officers might represent items which are in fact liabilities of the 
 firm or corporation. 
 
 Mortgages: As a mortgage derives its chief value from the 
 
156 AUDITING 
 
 fact that upon registry it becomes a lien, the auditor would seem 
 to have an opportunity to verify the existence of such an obliga- 
 tion by inspecting the public records. Auditors admit the value 
 of the knowledge which such an inspection discloses, but very 
 properly urge that special training is necessary to undertake the 
 task. 
 
 It is admitted by all that a well-equipped auditor must have 
 some knowledge of law, and an important branch of such neces- 
 sary knowledge is that pertaining to negotiable and non-negoti- 
 able instruments, mortgages, deeds, contracts, etc. The author 
 suggests that a reasonably intelligent auditor or audit clerk can 
 ascertain the procedure of the public registry office in less than 
 an hour, and that a search for unsatisfied mortgages or judg- 
 ments can be made in less time than it takes to verify the foot- 
 ings of a voucher register, and is an immeasurably more impor- 
 tant thing to do. If the auditor is timid about undertaking the 
 job, it might be worth while to arrange with a local lawyer or 
 title company whereby, for a small fee, any mortgages or judg- 
 ments entered against his clients would be reported to him. 
 
 So much for a purely independent search. If the auditor 
 feels justified in accepting the book record as to the existence of 
 a mortgage, he should at least endeavor to verify the amount, 
 the rate, the due date, and the property secured thereby. All of 
 these points are of interest to those who may desire to refer to 
 the balance sheet of the mortgagor. 
 
 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 the principal has 
 been legally reduced ; if not, the fact should appear on the bal- 
 ance sheet. 
 
 Bonds: So many different classes of bonds have been 
 evolved by the fertile brains of needy financiers that no attempt 
 will be made here to differentiate except in a general way. 
 
 Bonds secured by a mortgage upon real estate are, of course, 
 the most popular with investors. At one time all bonds, when 
 they were not otherwise designated, were supposed to be secured 
 by real property, but to-day many issues of bonds are mere 
 promissory notes, differing only from the usual form of the latter 
 
BALANCE-SHEET AUDIT 157 
 
 in that they are larger, have coupons attached, are sealed, and 
 are also less valuable because they do not fall due for a consider- 
 able period. From the auditor's point of view the security is 
 important because of its bearing on other obligations and the 
 equity, if any, which may exist for a subsequent lender or 
 creditor. 
 
 Balance sheets are, as a rule, deficient in the information 
 which they impart with reference to the real estate or personal 
 property which is pledged with an issue of bonds. Sometimes a 
 bond is a first lien on certain assets and a second lien on others. 
 When considering the matter of liens it should be noted that 
 interest unpaid is a lien as well as unpaid principal. 
 
 If it is feasible to have a balance sheet disclose the position 
 which a bond bears to the assets, it is the auditor's duty so to 
 state it. In any event he should determine as nearly as possible 
 the position, if it is not so disclosed. 
 
 The corporation which issues bonds should, and in most 
 cases does, keep a copy or sample thereof. The auditor should 
 read this carefully in connection with the mortgage or deed of 
 trust, make an abstract of these documents, and note all refer- 
 ences to interest rate (or rates, as changes are sometimes made), 
 due date or dates (installments of principal are frequently pro- 
 vided for), property pledged, sinking fund or similar provisions, 
 and in, fact anything which relates to the accounts or financial 
 transactions of the maker. 
 
 Judgments: It frequently happens that a prosperous concern 
 will dispute a claim, litigate it, and have judgment entered 
 against them. If the case is appealed the judgment may be 
 allowed to stand or a bond may be given pending a final decision. 
 In rare instances are these debts entered on the books. Most 
 business men consider that the entry of an invoice is an admis- 
 sion of liability, and, of course, will not permit the entry of a 
 claim which they propose to fight. 
 
 What position must the auditor take ? If a balance sheet is 
 being constructed, the amount of the judgment should be in- 
 cluded as a liability or a reserve set up to cover the estimated 
 liability under the claim. If a balance sheet has been completed, 
 the auditor should call attention thereto in a footnote. 
 
 How is the auditor to be informed as to the existence of 
 
158 AUDITING 
 
 judgments? As mentioned under mortgages (page 155), he 
 should be able to examine the public record himself. If he is 
 not willing to do this, he should make such inquiry or investi- 
 gation as is feasible. An inspection of lawyers' bills is a good 
 waiy to secure a clue. If a concern is able to pay, but does not 
 do so on principle, the auditor will have no difficulty in learning 
 the facts. If a concern is obviously hard up, the auditor is 
 charged with constructive knowledge that judgments have been 
 obtained, and he is not safe unless he secures a report based on 
 a search. Even if the search costs a few dollars the expense will 
 be well worth while. If the audit is made for a banker, the 
 latter may have had a search made, or, if not, will do so through 
 his own attorney. , 
 
 Interest Payable: Many of the liabilities which appear on a 
 balance sheet carry interest, therefore the calculation of accrued 
 interest to the date of the balance sheet is an important matter. 
 The auditor should consider the possibility of an accrual upon 
 the accounts as well as notes payable, bonds, etc. Enough book 
 accounts bear interest to warrant an inquiry being made into its 
 possibility. 
 
 Loan accounts of partners and officers of corporations almost 
 invariably bear interest, but it is not always calculated up to the 
 date of closing the books. Judgments, overdue taxes, and other 
 liens, bear interest sometimes at an extremely high rate. , 
 
 Legally, the interest on a bond is secured by the same prop- 
 erty as the principal and in effect becomes part of the principal, 
 but the latter is a long-term obligation, while interest is payable 
 at frequent intervals and should therefore appear as a current 
 liability. 
 
 Taxes: The balance sheet of a commercial enterprise not 
 owning real estate rarely shows a liability for accrued taxes, yet 
 probably ninety-nine out of, every one hundred are liable there- 
 for. Under the Federal Corporation Tax Law a tax of one per 
 cent is imposed upon the net profits of a corporation in excess of 
 five thousand dollars. This tax must be paid even if a corpora- 
 tion is dissolved before the end of the year during which the tax 
 is imposed. As the tax is specifically based on the net profits of 
 a particular period, although payable some months thereafter, 
 the tax accrues throughout the specified period, and if a net 
 
BALANCE-SHEET AUDIT 159 
 
 profit in excess of five thousand dollars is disclosed upon the 
 closing of the books, a reserve of one per cent thereof should 
 be made. 
 
 Bond interest which accrues from July ist to December 31st, 
 and which is payable on January ist, always appears among the 
 liabilities on December 31st, assuming, of course, that a proper 
 system of accounts is in force. The Federal tax has accrued, and 
 is payable thereafter, just as surely as any other item. 
 
 The uncertainty as to the constitutionality of the law may 
 have justified the omission of this liability from balance sheets 
 prior to 191 1, but there is no longer any doubt about the neces- 
 sity for a strict compliance, and auditors cannot certify to the 
 balance sheet of a prosperous corporation which has not given 
 proper consideration to this subject. 
 
 A corporation which had made a large temporary profit was 
 dissolved in July. A balance sheet was prepared and on its 
 showing, a distribution of capital and profits was made. In the 
 following February the government demanded a report and one 
 per cent of the profit realized. One of the directors had to pay 
 the assessment. 
 
 The matter of taxes is of extreme importance in all audits of 
 public service corporations, but the auditor should consider the 
 possible liability for taxes before finally passing upon any 
 balance sheet. 
 
 Water Rates, etc.: There are certain expenses, such as gas 
 and water, the bills for which are frequently rendered at long 
 intervals. The auditor should provide for all accrued expenses 
 of this class. 
 
 Wages : The date of the balance sheet does not always coin- 
 cide with the date to which a payroll has been calculated. Un- 
 less the amount is trifling the amount accrued should be ascer- 
 tained and entered as a liability. 
 
 Where there is little fluctuation in the number of men em- 
 ployed, it will be sufficient to take the proportion of the full 
 -week's payroll; i. e., if the next succeeding payroll amounts to 
 $1,000, and three days accrue in each period, the liability can be 
 stated as $500, although each day's total might vary a few 
 dollars from the others. The difiference would not be large 
 enough to pay for the work involved in making the calculations. 
 
i6o AUDITING 
 
 Rent: Rent is usually payable in advance, but this is not 
 always the case. If any is accrued and not paid, it should be 
 shown. 
 
 Freight: Sales are frequently made on a basis of free deliv- 
 ery to destination, and current freight bills are sometimes per- 
 mitted to run, if the concern is well known. 
 
 An allowance of freight to a customer should be treated as 
 a deduction from amounts due from trade debtors. 
 
 Goods may have been shipped, refused, and returned, in 
 which case freight charges will have accrued. 
 
 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, provi- 
 sion therefor should be made. 
 
 Ample provision should be made for all commissions even- 
 tually 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 commis- 
 sions 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 clearly be 
 set up as a liability. 
 
 Legal Expenses: All concerns have more or less litigation. 
 Lawyers are usually expensive, but they have the merit, if it can 
 be so termed, of waiting for their money. Before the books are 
 closed the lawyers should be requested to send in a bill. If one 
 is not found, the auditor should ascertain the amount due, if 
 any. 
 
 Audit Fees : In line with the theory that all accrued expenses 
 must be included among the liabilities, it might be assumed that 
 the expense incurred for an audit to, say, June 30th, would be 
 a proper charge to the period prior thereto. In practice, how- 
 ever, it is not usual to include the audit fee as an outstand- 
 ing liability as of the date of the balance sheet. If the auditor 
 has not performed any work on the accounts until after the 
 closing date, it is certain that no legal liability exists at that 
 time. 
 
 Under ordinary conditions the amount of the fee is not 
 
BALANCE-SHEET AUDIT i6i 
 
 known until after the report is written and submitted, so that no 
 more than an estimate could be included. 
 
 Ordinarily the fee is not such a liability as should be pro- 
 vided for, provided that the audit commences after the closing 
 date. An exception should be made, however, in the case of a 
 partnership or a close corporation where a partner or stock- 
 holder is about to retire. The audit being partly for the benefit 
 of the retiring party, and he being entitled to a copy of the 
 report, it is proper that a suflficient reserve should be set aside, 
 prior to the closing of the books, to provide therefor. 
 
 Damages: It is customary to insure against liability for 
 damages claimed by employees or the public, but few insurance 
 policies, if any, assume an unlimited liability. Then all concerns 
 do not carry such insurance, although it is a reflection on a 
 man's business ability to omit such protection. Furthermore, 
 claims for damages may arise out of alleged breach of con- 
 tract, or failure to deliver goods, or for any one of many other 
 reasons. 
 
 The auditor should inquire as to this possible liability and 
 should also request that a letter be procured from the concern's 
 attorneys stating any pending claims or suits. 
 
 It may be that claims have arisen which have not been 
 referred to the attorney. It often happens that a salesman 
 claims commissions in excess of those paid to him, or an em- 
 ployee who has been dismissed claims salary or other compensa- 
 tion for an uncompleted term of service, or claim is made for 
 a part of profits, which has not been paid. It is true that 
 these are unusual items, but it is equally true that tens of 
 thousands of dollars have been paid out in liquidation of disputed 
 claims. 
 
 If an auditor finds any evidence which leads him to suspect 
 that there may be a possible liability of this nature, he should 
 insist on being informed as to all of the facts. He can then form 
 an opinion as to the reserve, if any, which should be made on 
 the books and balance sheet to provide therefor. 
 
 Coupons, Unused Tickets, etc.: The auditor of a railway 
 company will expect to (but may not) find a reserve account for 
 the outstanding Hability in respect to unused tickets, but the 
 point receives little or no attention in other cases. Many kinds 
 
i62 AUDITING 
 
 of enterprises sell tickets, or issue coupons at a discount for cash 
 which are a charge on the subsequent operation of the business. 
 Tickets or coupons are issued by taxicab companies, spring- 
 water dealers, restaurants, amusement parks, and shows. Tele- 
 phone companies formerly issued stamps good for long-distance 
 calls. 
 
 Not all of the unused tickets, etc., will be presented, but so 
 long as they are outstanding, provision must be made for 
 redemption. The auditor will not attempt to verify the out- 
 standing liability in detail, but he should carefully examine the 
 system followed, because if the proper principles are observed, 
 the outstanding book liability will be in excess of the actual 
 redemption which may be expected. Many tickets, coupons, etc., 
 are lost or destroyed, and it is obviously impossible to issue 
 duplicates. 
 
 Deposits: Reference is not made to the deposits received by 
 banks, bankers, and saving funds, but to the funds which are 
 deposited as a guarantee of good faith, or as part payment 
 on a purchase, or as security for an unliquidated or possible 
 debt. 
 
 If the concern is operating under a public franchise, as a gas 
 or electric company, it may have the power to require deposits, 
 and in many instances it will be charged with the payment of 
 interest thereon. Interest is not usually paid until the receipt for 
 the original deposit is surrendered, and this may be many years 
 afterward. Large numbers of the receipts are lost or destroyed 
 and demand is never made. Nevertheless, the company should 
 carry all of the deposits as a liability and reserve the interest 
 accruing thereon until a sufficient time has elapsed to warrant 
 writing off such deposits as may have been uncalled for so long 
 that the chances of payment are remote. 
 
 The custom of receiving deposits of money from employees 
 is well enough established to warrant the inclusion of the caption 
 "Deposits" as one of the liabilities to be reported by prospective 
 borrowers to banks. 
 
 The auditor should investigate the procedure followed from 
 the time a deposit is accepted to the time it is withdrawn. There 
 should be ample safeguards surrounding the handling of such 
 funds, as the deposits are frequently offered by ignorant persons 
 
BALANCE-SHEET AUDIT 163 
 
 and foreigners who are not familiar with business methods and 
 who might be induced to accept irregular receipts from clerks 
 not authorized to handle the money. It is important that the 
 books and stationery used should be specially prepared for the 
 purpose, and the utmost care should be taken in writing up the 
 records. The clerk in charge of the books should not be allowed 
 to receive or pay money. 
 
 If pass-books are furnished to depositors, the auditor should 
 call in as many as possible and compare the entries and balances 
 with the books. There are so many diflEerent methods in force 
 that the auditor must rely on his general experience in order to 
 satisfy himself that the aggregate deposits appearing on the 
 balance sheet as a liability represent the actual amount due to 
 depositors. The rate of interest paid should be verified and the 
 calculations tested. Accrued interest at the date of the balance 
 sheet not credited to depositors should be added to the total 
 deposits shown by the books. 
 
 For various methods of calculating interest see Chap. XXXI. 
 
 In clubs and similar organizations it is customary for mem- 
 bers to deposit a small sum as security against the loss of keys, 
 etc. To avoid bookkeeping in connection therewith, a very loose 
 method may be in force. Frequently the cash received is placed 
 in a drawer or box without any record being made. Subsequent 
 payments are likewise made without record. Theoretically the 
 balance on hand represents the liability for outstanding keys, 
 etc. Practically it is known that part of the cash will never be 
 called for. This permits unauthorized payments to be made 
 from the fund, or part may be fraudulently abstracted. The 
 matter is unimportant except that such laxity places temptation 
 in the way of junior clerks and may be responsible for starting 
 them on a criminal career. 
 
 The auditor should call attention to the importance of a care- 
 ful record being made of all receipts and payments, no matter 
 how small, primarily for the purpose of facilitating an audit, but 
 in reality to inculcate in every employee handling cash the 
 greatest care and accuracy in connection with the handling of 
 money. 
 
 Unclaimed Dividends : The proper way of dealing with divi- 
 dend accounts is to set aside in a separate fund or bank account 
 
i64 AUDITING 
 
 the full amount of each dividend declared, charging against it all 
 payments. 
 
 It sometimes happens that stockholders cannot be reached, 
 and dividend checks are withheld or, if issued, are not cashed 
 w^ithin a reasonable time. This may leave an outstanding lia- 
 bility which may remain undischarged indefinitely. Where such 
 a state of affairs exists, any payments out of the regular order 
 should be noted, as it may be found that unauthorized payments 
 are being charged thereto. 
 
CHAPTER XII 
 
 BALANCE-SHEET AUDIT— LIABILITIES (Continued) 
 
 CONTINGENT LIABILITIES AND CAPITAL 
 
 It is not enough that a balance sheet shows what must be 
 paid ; it should set forth with as much particularity as possible 
 what may have to be paid. More than one apparently prosper- 
 ous business house and many corporations have been wrecked 
 through the necessity of having to meet obligations which did 
 not arise out of the operation of ordinary business transactions. 
 Nevertheless, the obligations were real ones, no matter how un- 
 likely they appeared to be when contracted, and a true statement 
 of the financial affairs of such concerns, prepared at any time 
 after the obligations had been entered into, would have set them 
 out. Accountants experienced in bankruptcy affairs well know 
 that rarely, if ever, do contingent liabilities appear on the 
 books of account. 
 
 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. It is true that contin- 
 gent lia.bilities are at best difficult to locate, and almost impos- 
 sible of discovery when an attempt is made to conceal their exist- 
 ence, but a professional auditor is supposed to undertake diffi- 
 cult tasks, and if he cannot report on anything except the entries 
 which he finds in the books, he had better retire from the pro- 
 fession. 
 
 Notes Discounted: As shown under "Notes Receivable" 
 (page loi) an apparent asset may represent an actual liability. 
 For instance, a trade debtor may give a note for $i,ooo which 
 clones his account. The note is discounted, which closes the 
 Notes Receivable account. The debtor finds he cannot pay and 
 renews the note when due. This may be repeated several times, 
 but at last a renewal cannot be secured and the note must be 
 paid by the indorser. After it is known that the note will not be 
 
 165 
 
i66 AUDITING 
 
 paid at maturity by the maker, the liability of the indorser is 
 more than contingent — it is actual. 
 
 Of course, if the reserve for bad debts includes a provision 
 for the full amount of the note, it would be duplication to set up 
 a further reserve against the payment of the note. Usually the 
 bad debts reserve is not large enough to take care of the contin- 
 gent liability on notes discounted, so that the auditor should 
 investigate the status of all notes under discount, and if it 
 appears probable that any will not be met when due, the liability 
 therefor should be shown. In cases where the auditor is satis- 
 fied that notes will neither be paid nor renewed he should include 
 the amounts under current liabilities stating the date when due. 
 
 Indorsements: In addition to the contingent liability upon 
 notes discounted for the benefit of the indorser, there may exist 
 a liability based on indorsements for the benefit of others, usu- 
 ally known as accommodation indorsements. 
 
 It is not proposed to discuss this subject exhaustively, as the 
 question of ultra vires at once arises, but from a practical point 
 of view it may be assumed that every indorsement, whether by 
 an individual, firm, or corporation, may become an ultimate 
 actual liability of the indorser. Promissory notes are negotiable 
 instruments, and, in order that they may circulate freely, an 
 innocent purchaser for value, without notice of a lack of consid- 
 eration on the part of a maker or indorser, may sue and recover 
 from any or all, in turn. 
 
 The assumption that the maker will pay, or that the notes 
 will not be used, or will not find their way into the hands of out- 
 siders, has been dissipated in so many thousands of cases that 
 the auditor who fails to include accommodation indorsements as 
 liabilities because he is advised that there is no possibility of 
 payment being demanded is assuming a risk for which there is 
 no professional, legal, or moral justification. 
 
 It is possible that circumstances may exist where such in- 
 dorsements are not liabilities, as would be the case if a note were 
 overdue and the holder had notice, but the vital point to bear in 
 mind is that solvent, straightforward concerns do not as a rule 
 request nor secure indorsements unless under stress of necessity, 
 or upon the payment of a consideration. If the maker of the 
 note is "hard up," the indorser should expect to pay (as he usu- 
 
BALANCE-SHEET AUDIT 167 
 
 ally is obliged to do). If consideration has passed, the indorser 
 is still likely to have to pay, but having received compensation, 
 his statement should show the amount thereof among the liabil- 
 ities to indicate the risk which has been assumed. The full 
 amount of the note, less the compensation received, is a contin- 
 gent liability. 
 
 Naturally the auditor will not include indorsements among 
 the liabilities on the balance sheet unless he gives due consider- 
 ation to the possibility of an asset to offset. The offset will usu- 
 ally consist of a claim against the maker or prior indorser who 
 has failed to meet an obligation, which at once is prima facie 
 evidence that the asset is not in satisfactory shape. In the 
 majority of cases it is merely a question of sizing up a bad 
 debt. 
 
 The foregoing remarks apply to cases where the auditor is 
 informed or readily ascertains that indorsements are outstand- 
 ing. We have now to consider the procedure where no such 
 information is volunteered, nor apparent on the records. The 
 author was about to state that the auditor is justified in assum- 
 ing that the practice does not exist, in view of the fact that the 
 great bulk of concerns have a strict rule which forbids indorse- 
 ments or guarantees, and that there must be special cause for 
 suspicion before special inquiry need be made, but reflection 
 brings to his mind so many instances of contingent liabilities 
 of this nature that the suggestion is made that all audit programs 
 contain some reference thereto. 
 
 The financial "atmosphere" of a concern is a fairly depend- 
 able index as to possible obligations or entanglements which may 
 find expression in commitments leading to future embarrassment. 
 The most common cause is overextension of business affairs, 
 and this is more likely to occur with a prosperous man than with 
 an impecunious one. The latter has little opportunity for expan- 
 sion, while the former is fairly besieged by promoters and others 
 who know by long experience that the most likely investor in a 
 new and untried enterprise is a man who knows nothing at all 
 about it. All over the country men who have made fortunes 
 in their own businesses are squandering their capital in outside 
 ventures. 
 
 If an auditor's report went no further than his client's office 
 
i68 AUDITING 
 
 it would not be necessary for him to concern himself with the 
 relation of outside ventures to the balance sheet of the business 
 under audit, but now that banks are demanding certified 
 balance sheets, the auditor must always proceed on the assump- 
 tion that the balance sheet prepared by him will go into general 
 circulation. The auditor who is observant, therefore, will be 
 able to determine by what he sees in an office what has probably 
 taken place outside. 
 
 If a partner, or officer, has withdrawn considerable sums of 
 money for investment in outside enterprises, there will probably 
 be some reference thereto in the books. Many corporations are 
 partnerships under another form of organization, and the officers, 
 who are usually identical with the large stockholders, keep per- 
 sonal accounts in the corporation books. The charges to these 
 accounts will indicate, in some degree, the interests in outside 
 affairs. 
 
 Let us consider the usual effect on the finances of a firm or 
 corporation where its owners are connected with other enter- 
 prises. The firm or corporation may have good assets of 
 $200,000 and total liabilities of $100,000. Suppose one or more 
 of the partners or officers becomes interested in another business 
 or in a flotation of doubtful merit. It may be urged that so long 
 as the balance sheet of the firm or corporation is true and reflects 
 its actual financial condition, the action of its partners or officers 
 cannot affect it. But soon the outside venture requires more 
 cash than can be supplied, so the partner or officer gives his note 
 for $25,000, which is discounted. The auditor comes in at this 
 point, discovers the interest in the outside deal, makes inquiry, 
 and is informed as to the note. He finds further that there is not 
 the slightest prospect of the note being met by the outside busi- 
 ness. 
 
 Is it not apparent that the cash account of the firm or corpo- 
 ration will be called on to meet that note ? This has happened in 
 thousands of actual cases; is it not likely to happen every time? 
 Should the auditor state the assets as $200,000, the liabilities at 
 $100,000, and a contingent liability of $25,000? Legally, no, but 
 if he can find a way to do it, he should not hesitate. Banks, cred- 
 itors, and investors would have saved millions of dollars in the 
 past if auditors had so stated the affairs of corporations. Is it 
 
BALANCE-SHEET AUDIT 169 
 
 not possible to protect the innocent investor or creditor when 
 facts of this nature are disclosed, and where a reasonable inter- 
 pretation makes them relevant? 
 
 If there is nothing in the books to indicate any connection 
 on the part of the concern itself, a partner or an officer with out- 
 side ventures, and there is no apparent reason for suspecting any- 
 possible indorsement of another's paper, the auditor may not 
 feel it necessary to carry his inquiries further. In fact, it might 
 be impracticable even if it were desirable. Nevertheless, it must 
 always be borne in mind that the indorsement of notes for out- 
 side ventures has resulted disastrously, and in cases where it was 
 least expected, consequently it is a possibility of importance. 
 
 Guarantees: Almost all of the remarks under indorsements 
 apply with equal force to guarantees. In one case the liability is 
 fixed and definite by reason of the indorsements of negotiable 
 paper, whereas a guarantee may be less definite so far as legal 
 liability is concerned, and the amount of the obligation may be 
 uncertain. Otherwise there is the same likelihood of being 
 required to pay ultimately, and if the guarantee covers an obliga- 
 tion incurred in connection with an outside venture, there also 
 exists a strong probability that the funds necessary to discharge 
 the obligation will be withdrawn from the concern under audit. 
 
 The proprietor of a successful business reported to the mer- 
 cantile agencies a net worth of about one million dollars. His 
 statement indicated that his assets were not readily realizable, 
 but his reported liabilities w^ere small and his credit was rated 
 first class. He was induced to invest in the stock of a distillery 
 and was elected a director. The distillery needed money and he 
 was induced to indorse some of its paper and guarantee other 
 loans. 
 
 The president of the distilling company was found to be a 
 defaulter to a large extent, and the company went into bank- 
 ruptcy. The indorser and guarantor was called upon to meet 
 obligations aggregating over one hundred thousand dollars, and 
 he was unable to pay all of his debts as they became due. He 
 is still struggling and may eventually pay in full, but it has 
 meant the ruin of his own business. 
 
 If an auditor had stated the accounts of the guarantor's 
 business, it is not likely that any mention would have been made 
 
170 AUDITING 
 
 of the outside liabilities, as the business was incorporated and 
 the indorsements would have been ultra vires for the corpora- 
 tion. But when the notes came due and the guarantor started to 
 pay, the only funds available were the resources of his own 
 company, and these funds were used. Therefore his balance 
 sheet to the agencies was misleading, because there were con- 
 tingent liabilities affecting it in fact if not in law. 
 
 An auditor could have readily ascertained the existence of 
 the directorship, and inquiry no doubt would have brought to 
 light the indorsements and guarantee. If so, would he have been 
 justified in mentioning the matter on the balance sheet? The 
 author is of opinion that it would have been desirable for him 
 to do so. Whether or not it would have been his clear duty could 
 have been determined only in connection with the circumstances 
 of his employment. In a serious matter of this nature an auditor 
 should consult his attorney before disclosing damaging informa- 
 tion, as it is possible that the scope of his employment might be 
 limited and that his only course would be to withdraw from the 
 engagement. 
 
 Unfulfilled Contracts: It has been mentioned that liabilities 
 not on the books, in the form of contracts to accept 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 space 
 of time. It may be urged that on the face of this statement there 
 would be no change in the net result shown by the balance sheet, 
 as an asset would be received to offset the liability. 
 
 A banker, however, might look upon this condition in a far 
 different light. The balance sheet, for instance, might show 
 stock on hand large enough or too large for the normal require- 
 ments of the business, and any unfulfilled contracts outstanding 
 at balance-sheet time which called for the receipt of additional 
 stock, which might not be readily salable, would mean an actual 
 liability, whereas the oft"set would be an asset of doubtful value. 
 
 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 reasonable prospective demand, 
 mention thereof should be made in the balance sheet. The 
 details reported would depend on the circumstances of each par- 
 ticular case. 
 
BALANCE-SHEET AUDIT 171 
 
 The Minute Book: Experience has demonstrated to auditors 
 that the examination of the minute book is a most prolific source 
 of information relative to contingent liabilities. 
 
 Recently one of the largest corporations in this country 
 issued its annual report. Included therein was the auditor's cer- 
 tificate, which said in effect : "The balance sheet is correct, sub- 
 ject to any adjustments which might have been indicated by the 
 minute books, which we were requested not to read." What did 
 this mean? 
 
 If the minute books contained evidences of liabilities or 
 changes in assets, as might be inferred from the refusal to sub- 
 mit same to the auditors, how much dependence could the 
 directors expect to have placed upon their report by the stock- 
 holders and the public? On the other hand, if the contents of 
 the minute book were harmless, why should the auditors be 
 refused access thereto and thus give rise to unfavorable com- 
 ment. 
 
 The auditor should always insist on an inspection of the 
 minutes of a board of directors, and of the executive or any other 
 committee of the board. If permission is withheld, his certifi- 
 cate should be written along lines indicated above, except that 
 the refusal would be notice to the auditor that special care 
 should be taken in passing upon balance-sheet items which 
 might be affected by the action of a board of directors. 
 
 The following points might be involved : contracts for addi- 
 tions to or for additional plant equipment; purchase of other 
 corporations or large interests therein; contracts for future de- 
 liveries of goods and materials in unusual quantities; payments 
 of bonuses and special compensation to officers and others out 
 of past profits, but actual payment to be made at a future date ; 
 settlement of pending litigation for a sum in excess of the lia- 
 bility, if any, carried therefor in the books; possibility of litiga- 
 tion such as alleged infringement of patents, which might seri- 
 ously affect the value of assets; contracts or agreements which 
 might tend to increase the assets or reduce the liabilities. These 
 are only a few of the matters which the reading of corporate 
 minutes reveals to the auditor. 
 
 Usually the disposition is to conceal from an auditor evi- 
 dence of contingent liabilities, the thought being that he might 
 
172 AUDITING 
 
 feel it his duty to provide therefor in the balance sheet. Less fre- 
 quently good news is withheld in order that the balance sheet 
 may show up as badly as possible and thus give the directors 
 time to acquire stock below its value. 
 
 The author once insisted on reading the minute book of a 
 street railway company. The president's reluctance to produce 
 the book was explained when it was found that at a meeting 
 attended by the president he agreed to accept common stock of 
 the company at par for his services. He had, however, directed 
 the treasurer to pay it in cash. As the stock was worth only a 
 few dollars a share, his disinclination to carry out his agreement 
 was natural, perhaps, but illegal and dishonest. He was obliged 
 to adjust the matter. 
 
 RESERVES 
 
 The matter of reserve accounts is in an unsatisfactory con- 
 dition from the point of view of a professional auditor chiefly 
 because the term is indiscriminately applied to items which are 
 essentially different. For instance, an inspection of balance 
 sheets will disclose that the following accounts are called "Re- 
 serves" : provision for probable losses in respect to accounts or 
 notes receivable; accounts set up to cover depreciation of plant 
 and other assets such as patents, trade marks, etc. ; discounts 
 which it is expected will be deducted by trade debtors ; arbitrary 
 charges against surplus to provide a book account for "working 
 capital" ; sinking fund accounts to take care of depletion of 
 mines, or to retire bonds at maturity. 
 
 It will be noted that some of the so-called reserves are actual 
 deductions from assets and should be so treated, thus having the 
 effect of liabilities, while others are not liabilities at all. The 
 distinction lies in the creation of the accounts. If the debit or 
 offsetting entries are proper charges against income, then the 
 accounts should be deducted from the assets to which they relate, 
 or else they should be set up as liabilities and should never be 
 grouped with the surplus account. On the other hand, if the 
 accounts represent sums set aside after the net profit of an enter- 
 prise is determined upon a proper accounting basis, for the pur- 
 pose of conserving its financial interests by reducing the surplus 
 available for dividends, and thus in reality form part of the gen- 
 
BALANCE-SHEET AUDIT 173 
 
 eral surplus of the business, then the accounts should be stated 
 as a section of the surplus account. 
 
 This line of reasoning may be tested by setting up on one side 
 the assets at what the auditor believes to be a fair net valuation ; 
 from the total so ascertained, the liabilities actual and contin- 
 gent, should be deducted ; the balance will represent what may 
 be termed the net worth of the business. If a corporation, the 
 capital stock may now be considered, leaving the balance, if 
 any, to represent surplus. 
 
 It cannot be maintained that a sum set aside to provide addi- 
 tional working capital could be treated as a liability in any sense 
 of the word. To whom is it to be paid? A liability, from a 
 balance sheet point of view, is an obligation or a debt to the 
 public, i. e., something which must or may have to be paid be- 
 fore partners or stockholders can receive a dividend or a distri- 
 bution. 
 
 In actual practice reserves are usually shown between the 
 definite liabilities and the surplus, but wherever it is possible to 
 state actual assets and actual liabilities apart from capital, sur- 
 plus, and surplus reserves, it should be done. Some reserves 
 represent unliquidated liabilities to the public, but others, such 
 as depreciation reserves, are, strictly speaking, direct deductions 
 from assets and are not liabilities. 
 
 If a necessity seems to exist for stating the gross amount of 
 the assets on one side and the reserves against such assets on 
 the other, then the reserves must be included among the liabil- 
 ities in order that the aggregate of one side may be deducted 
 from the other in order to determine net worth. This procedure 
 must not be confused with the criticism which is applied to the 
 balance-sheet form which shows on one side or the other, items 
 which are not assets nor liabilities nor deductions from either 
 class. Any amount which directly relates to an actual asset or 
 liability may be grouped therewith without violating the rule 
 against the misuse of these two terms. 
 
 The author's test, therefore, is that a reserve account, to 
 properly appear among the liabilities on a balance sheet, must 
 represent : 
 
 (i) Estimated amounts which are believed to have accrued 
 and which, when liquidated, will be actual liabilities ; 
 
174 AUDITING 
 
 (2) Items which are deductible from assets to reduce the 
 latter to their true value; 
 
 (3) Contingent liabilities; 
 
 (4) "Reserve" of an insurance company. 
 Under these will appear: 
 
 (i) Accruals such as interest, wages, taxes, etc. ; 
 
 (2) Depreciation and obsolescence of plant, exhaustion of 
 mines, estimated loss on accounts receivable, etc. ; 
 
 (3) Provision for the contingencies discussed in these pages, 
 but the reserve should be based on evidence more tangible than 
 a mere desire to be conservative. A vague feeling that some- 
 thing might have been overlooked which would decrease the 
 assets or increase the liabilities is not the proper subject for a 
 reserve. Conservative management "reserves" part of its sur- 
 plus for such contingencies, but it appears as surplus and not as 
 a liability. 
 
 (4) The reserve of an insurance company is usually an 
 actual liability, i. e., income has been received and treated as 
 income, whereas part only has been earned, as in the case of fire 
 insurance and similar companies where premiums are paid in 
 advance, and the unearned portion should be carried as a liabil- 
 ity. Theoretically, the aggregate of this unearned income forms 
 a reserve for reinsurance, the theory being that if a company 
 desired to suspend business, it could reinsure all of its risks out 
 of the reserve and leave its capital and surplus intact. Likewise, 
 life insurance companies not only collect premiums in advance, 
 but they also collect more than is sufficient to pay for the insur- 
 ance carried. The excess is returnable to the assured under the 
 contract, and is therefore a liability rather than part of the accu- 
 mulated surplus of the company. Under some policies the 
 excess is rebated annually, under others no distribution is made 
 until the poHcy expires. From an accounting point of view a 
 mutual insurance company would have no surplus, because as it 
 agrees to insure at cost, all excess premiums received are the 
 property of the assured. Of course a life insurance company 
 should be conservative to the last degree, and it may be that it 
 would not be safe to allocate all of the estimated excess income 
 to specific policy holders. 
 
 All of the classes of reserves just enumerated have been or 
 
BALANCE-SHEET AUDIT 175 
 
 will be fully discussed under their respective heads. The so- 
 called reserves which are not charges against income, but which 
 are set aside after net profits are determined, and which there- 
 fore are in reality divisions of surplus account, will be discussed 
 under the general title of "Surplus." 
 
 CAPITAL AND SURPLUS 
 
 Having discussed the asset side of the balance sheet, and hav- 
 ing enumerated all of the obligations, certain and uncertain, 
 which should appear on the opposite side thereof, the auditor 
 should devote particular attention to the treatment of what may 
 be termed the net worth of a firm or corporation. By this is 
 meant the excess of assets over liabilities. This forces some 
 comments which the author would prefer to omit, but as the 
 form of a balance sheet is of the utmost importance, they cannot 
 be avoided. 
 
 Primarily a balance sheet is prepared for the information of 
 the proprietors whose assets and liabilities are therein set forth. 
 In practice this is true as to firms, small corporations and large 
 corporations, where there are but few stockholders. In the case 
 of corporations with numerous stockholders, however, it is well 
 known that the balance sheet is made up for the directors or 
 those who control, rather than for those who own. 
 
 If a balance sheet were always intended to reach the owners 
 of the business, whose sole interest therein is to ascertain the net 
 worth of their property, the logical form of a balance sheet 
 would be to show the net worth clearly. But this is not done 
 when assets are shown on one side, and on the other, under the 
 general heading "Liabilities," there appear in this order : capital 
 stock (not a Hability), accounts, and notes payable, etc., reserves 
 (some being liabilities, some not), then surplus, the total exactly 
 agreeing with the total of the assets. 
 
 The average investor does not understand accounts. How 
 is he to determine the net worth of the business of which he is a 
 part owner? The proper way to enUghten him is to classify the 
 balance-sheet items. The assets should be shown, then the lia- 
 bilities; the excess of assets over liabilities (if any) should 
 appear next ; finally the capital or capital stock and surplus repre- 
 senting such excess. If it is desired to set aside part of the sur- 
 
176 AUDITING 
 
 plus for other purposes, the segregation should be shown on the 
 balance sheet. 
 
 This grouping can be used where it is desired to state the 
 assets and liabilities in parallel columns with the totals of the 
 two columns in agreement (see page 220), as well as where the 
 assets are first stated; then the liabilities thereunder, followed 
 by the capital plus surplus, or capital less deficit, as the case may- 
 be. (See page 217.) In both cases it will be noticed that the 
 only variation of any consequence from the form criticized is in 
 the captions and the groupings. But these are read seriously by 
 many business men, so that care should be taken to use terms as 
 nearly descriptive of the items to which they apply as possible. 
 
 There is really very little defense for the form of balance 
 sheet which shows capital and surplus as liabilities, and deficit 
 as an asset. It is true that it enables an accountant to set down 
 two sets of figures which exactly balance, and the author freely 
 admits that the best corporations and the best firms of account- 
 ants use the form under condemnation, but in his opinion the 
 practice is merely the outgrowth of custom and expediency and 
 will be changed in time. 
 
 Capital Stock: The auditor should examine the charter or 
 certificate of incorporation of the corporation, the by-laws and 
 the board minutes for information relative to the authorized 
 capital, the method of payment, and all other provisions govern- 
 ing its issuance. He should ascertain that there has been no 
 overissue by examining the certificate books and stock ledgers, 
 and he should verify the proceeds of its sale. In most States 
 capital stock cannot be issued for a consideration less than its 
 par value. 
 
 Our lax laws, however, permit almost any kind and quantity 
 of tangible or intangible property to be solemnly valued at any 
 conceivable sum, and while an auditor is not supposed to certify 
 to anything which he knows is not true, yet we have not yet 
 reached the point where an auditor is justified in volunteering 
 an opinion that capital stock issued in payment for property 
 acquired is not full paid because in his opinion the property is 
 not worth the amount of stock at par issued therefor. Of 
 course, in a special investigation, an auditor may be asked to 
 investigate points of this kind, but in an ordinary audit where 
 
BALANCE-SHEET AUDIT 177 
 
 stock has been issued for property, and the records are in satis- 
 factory shape, the auditor is not called upon to challenge the 
 good faith of the directors. 
 
 Of late years it has become popular to adopt by-laws which 
 call for certain amounts of current assets to be maintained, for 
 certain reserves to be created, etc. The auditor will need to 
 verify all of these requirements. 
 
 If stock has been sold on the installment plan, the auditor 
 will ascertain that the calls have been promptly met and whether 
 any are in arrears. If special terms have been extended to any 
 stockholder, approval of the board is necessary. 
 
 Premiums on Capital Stock: Where stock has been sold at 
 a premium, the auditor will see that all premiums have been 
 collected. The funds so realized should be credited to Premiums 
 on Capital Stock account, which should remain open, and appear 
 on the balance sheet as a special surplus account. In no event, 
 however, should the account be transferred to general surplus 
 and thus be looked upon as available for dividends. It would 
 probably be legal to declare a dividend out of funds so raised, 
 but it would be so improper as to sustain a charge of dishonesty 
 against the director who voted therefor. 
 
 Sinking-Fund Accounts: The author contends that reserves 
 for depreciation, when calculated scientifically, should be de- 
 ducted from the assets which are affected thereby or else be 
 shown as liabilities. If it should happen that compulsory sink- 
 ing-fund requirements exactly agree with the exhaustion of 
 mines or depletion of other wasting assets, the amounts thereof 
 will likewise appear as liabilities and depreciation reserves are 
 unnecessary. As a matter of fact, however, sinking-fund require- 
 ments are usually in excess of actual depreciation or exhaustion 
 reserves, so that the point to be settled is the proper method of 
 showing that the sinking-fund requirements have been legally 
 complied with and at the same time exhibiting the assets and 
 liabilities as they actually exist. 
 
 For illustration, a mortgage covering coal lands may require 
 the payment to the trustee of a sum equal to ten cents per ton 
 mined. The exhaustion charge based on engineers' estimates 
 may be five cents per ton. The reason for the difference is obvi- 
 ous. The holder of a bond would not care to take the chance 
 
178 AUDITING 
 
 of waiting for the last ton to be removed before receiving the 
 last of his principal. 
 
 In order to sell bonds the security must be ample and a con- 
 siderable margin must be allowed for errors in estimates. No 
 doubt the mortgage will require that the sinking fund shall be a 
 charge against earnings, and this is reasonable, as it serves to 
 prevent excessive dividends until the bonds are all retired. In 
 the meantime, however, there is no reason why the stockholders 
 should be kept in ignorance as to the true earnings realized, even 
 if they are not entirely available for dividends so long as the 
 bonds remain unpaid. 
 
 Therefore, the only way to show the exact (or as nearly 
 exact as possible) earnings would be to carry a reserve-for- 
 exhaustion account among the liabilities equal to five cents per 
 ton, and a reserve-for-sinking-fund account equal to an addi- 
 tional five cents per ton as a segregated part of the surplus. 
 After all of the bonds are retired this reserve account would be 
 closed into the general surplus account. 
 
 The reserve-for-exhaustion account should be sufficient to 
 equal the book value of the property account by the time the coal 
 is practically exhausted. This rule applies irrespective of any 
 special requirements for sinking-fund installments, and irrespec- 
 tive of a trust deed provision that such installments are a charge 
 against income. All fixed or wasting assets must be kept intact, 
 either in their original form or by creating an equivalent in cash 
 or some other satisfactory asset. The amounts required to main- 
 tain this equilibrium are charges against income, but as soon as 
 the installments are in excess of such requirements, the excess 
 forms a part of the surplus of the business and should be shown 
 as such. The question as to how much, if any, of the surplus is 
 available for dividends is another matter. 
 
 Reserve for Working Capital : It has been held to be legal to 
 set aside annually or at other periods out of the earnings of a 
 company a reasonable amount as a reserve for additional work- 
 ing capital, which is therefore not distributable in the shape 
 of dividends. This reserve may be temporary or permanent, as 
 the directors may determine, and corresponds with the surplus 
 of a bank or trust company, which is never used for the purpose 
 of dividends unless some extraordinary occasion arises. The 
 
BALANCE-SHEET AUDIT 179 
 
 account is a discretionary one and is almost entirely a matter of 
 bookkeeping, or rather it is a sort of notice to stockholders that 
 the amounts so set aside will not be distributed. 
 
 To treat such an account as a liability is a fallacy, because at 
 any time the directors can transfer the entire balance to general 
 surplus and pay out all or any part of it in dividends. Therefore 
 the account should always appear on the balance sheet as a sec- 
 tion of surplus, and never among the liabilities. An auditor 
 should never set up an account of this nature in the books nor 
 show it on the balance sheet unless it has been formally author- 
 ized by the board of directors. It is a most commendable practice 
 to accumulate a substantial surplus, and if the directors believe 
 that the temptation to declare dividends will be less if the sur- 
 plus account proper is diminished and some other account with a 
 different name is increased, the auditor cannot. object. But no 
 such diversion of profits should be attempted by an officer of a 
 company on his own initiative. 
 
 Preferred Stock Accumulated Dividends: Capital stock is 
 not a liability, nor can a dividend thereon be a liability unless 
 action has been taken and the funds set aside for the purpose. 
 When this is once done the action of the directors cannot be 
 rescinded and the dividend becomes a liability. 
 
 But a situation sometimes exists with respect to unpaid divi- 
 dends on preferred stock which are entitled to accumulate in 
 favor of the preferred stock until paid or otherwise disposed of. 
 This preference, however, is a factor only as against the common 
 stock. It does not accumulate as a liability and is not deductible 
 from the surplus, if any, which exists. In other words, a corpo- 
 ration may have a book surplus more than sufficient to pay 
 accumulated preferred stock dividends, but so long as no divi- 
 dend is declared by the directors no book entry is permissible. 
 The balance sheet will not reflect the aggregate of the unpaid 
 dividends unless it is noted thereon as a memorandum. 
 
 Common stockholders usually have a keen interest in the 
 value of their shares, and it is not only permissible, but desir- 
 able, that any arrears which may exist with respect to accumu- 
 lated dividends should appear as a footnote or memorandum on 
 the balance sheet. 
 
 Surplus: This should be the last word on the balance sheet, 
 
i8o AUDITING 
 
 and it should have as specific a meaning as any item of assets or 
 liabilities. This is rarely the case, however, and auditors are as 
 much to blame for this condition as anyone else. 
 
 The "surplus" of a corporation should represent an actual 
 surplus, that is, a balance of net profits after all reserves have 
 been provided, including the reserves out of surplus, such as 
 working capital, etc., leaving an amount safely distributable as 
 dividends. 
 
 This does not mean that there must be cash on hand suffi- 
 cient to pay the whole amount of surplus in dividends, but that 
 if at any time there should be surplus funds, the directors may 
 rely on the integrity of the surplus account and not lay them- 
 selves open to an action for paying dividends out of capital, or 
 before reserves for compulsory sinking funds, etc., have been 
 created. 
 
CHAPTER XIII 
 PROFIT AND LOSS ACCOUNT 
 
 At least nine tenths of all of the enterprises with which a 
 professional auditor has to deal are conducted with the expecta- 
 tion of realizing a profit. Certainly more than half, and probably 
 three-fourths, of these enterprises have their accounts stated 
 and results shown in a form to which a professional auditor can- 
 not certify without modification or adjustment. That is to say, 
 most concerns state their profit and loss accounts incorrectly. 
 
 There are frequent differences of opinion with respect to a 
 balance sheet, but, after all, it is not usually so difficult to reach 
 an agreement as to the amount at which the assets and liabilities 
 shall be stated when they are compiled from the books and 
 adjusted to meet known conditions, including valuations of dis- 
 interested persons and the scheduling of all known liabilities. 
 Reliable appraisal companies will place valuations upon all the 
 physical property. As to other assets and liabilities, there is 
 rarely any serious question of the amounts stated by the auditor. 
 But as soon as an attempt is made to state a definite and final 
 amount which represents the net profit of any concern for a given 
 period, there arises the most difficult and unsatisfactory problem 
 which an auditor must solve. 
 
 In view of the fact that there is scarcely any likelihood that 
 two professional auditors to-day would, with respect to the 
 accounts of an undertaking of any considerable magnitude, show 
 the same net result of profit, it is not surprising that the usual 
 profit and loss account is prepared upon a basis which admits of 
 criticism. It is extremely important that an effort be made to 
 establish standards which will appeal to those responsible for 
 the stating of accounts as scientific and reasonable. The latter 
 term may seem out of place, but it must be understood that rules 
 which are purely theoretical will not be observed. 
 
 It is not difficult to write out a memorandum of the items 
 which appear on the debit and credit side of the profit and loss 
 
 i8i 
 
i82 AUDITING 
 
 account, but unfortunately in actual practice the items assume 
 so many diflferent aspects that all of the rules heretofore pub- 
 lished have failed to furnish a practical method of handling them. 
 It is the purpose of this chapter to discuss theories, both legal 
 and professional, and follow up the theories by illustrations 
 which, while they may not establish a standard upon which all 
 will agree, may nevertheless assist those who desire to study the 
 suggestions of others as a means of arriving at their own con- 
 clusions. 
 
 A balance-sheet audit is only partially completed with the 
 verification of the assets and liabilities. There will be shown 
 thereon a deficit or a surplus, and it is absolutely impossible to 
 form any intelligent conclusion as to the operations of a business 
 unless an analysis in the form of a profit and loss statement 
 accompknies the balance sheet. It is not enough to know that 
 the balance sheet shows a substantial surplus; the preceding 
 balance sheet may have shown a much larger one ! 
 
 It is not enough to know that the profit or loss for a partic- 
 ular period is a certain sum. All who are interested in the enter- 
 prise desire to know the particulars of the net result, and the 
 auditor who states the transactions in an intelligent, scientific, 
 readable way is the one who finds favor with business men. 
 
 The form of the statement and related subjects are fully dis- 
 cussed in the chapter on certificates and reports (page 207). 
 
 It is proper to mention at this point, however, that the au- 
 ditor who familiarizes himself with Jhe legal as vvell as the eco- 
 nomic aspects of income and expense accounts is best prepared to 
 analyze accounts properly and to present the results so that the 
 relation of certain figures or groups of figures will convey all 
 that they should convey. 
 
 Legal Definition of Profits: The courts in different jurisdic- 
 tions have defined profits, net profits and profits available for 
 dividends, in so many dififerent ways that an auditor or corporate 
 officer who desires authority for any position which he desires 
 to assume can usually find it in the law reports. 
 
 It has been held in judicial decisions that a dividend may be 
 declared out of the profits of one year although there is a large 
 deficit carried over from previous years, and that "past due float- 
 ing debt should be paid or funded before a dividend is declared." 
 
PROFIT AND LOSS ACCOUNT 183 
 
 Nearly every conceivable situation between these two extremes 
 has been held to be legal or illegal, depending on the judge de- 
 ciding the case. 
 
 In many of the decisions profits are defined and the ludicrous 
 definitions and comments in themselves explain why it is that 
 the courts vary to such a great extent in settling disputes which 
 involve accounts. The fact is that judges, who are trained as 
 lawyers, understand as little about accounts as the members of 
 th€ bar. The adage "A little knowledge is a dangerous thing" 
 has its exemplification in the treatment by lawyers of questions 
 of accounting. They have the temerity to settle matters of the 
 greatest importance, involving complicated accounts, without 
 any evidence that anyone who understands accounts has been 
 consulted in the settlement. Occasionally an instance is found 
 where the departure from the usual legal comment is 'Bo great 
 that it is worth placing on record. The court said in one case in 
 point : 
 
 If at the end of the first year the line of railway is still in so good a 
 state of repair that it requires nothing to be laid out on it for repairs in that 
 year, still, before you can ascertain the net profits, a sum of money ought 
 to be set aside as representing the amount in which the wear and tear of the 
 line has, I may say, so far depreciated it in value as that that sum will be 
 required for the next year or next two years. I should think no commercial 
 man would doubt that this is the right course — that he must not calculate 
 net profits until he has provided for all the ordinary repairs and wear and 
 tear occasioned by his business. That being so, it appears to me that you 
 can have no net profits unless this sum has been set aside. When you come 
 to the next year, or the third or fourth year, what happens is this : as the 
 line gets older the amount for repairs increases. If you had done what you 
 ought to have done, that is, set aside every year the sum necessary to make 
 good the wear and tear in that year, then in the following years you would 
 have a sum sufficient to meet the extra cost. 
 
 Another legal definition of net profits is the following : 
 
 Theoretically all profits are "net," but as the expression "gross profits'' 
 is sometimes used to describe the mere excess of present value over former 
 value, or of returns from sales over prime cost, the phrase "'net profits" is 
 appropriate to describe the gain which remains after the further deduction of 
 all expenses, charges, costs, allowance for depreciation, etc. 
 
 Economic Definition of Profits: In discussing the subject of 
 profits the "Encyclopedia of Accounting" states that from an 
 
i84 AUDITING 
 
 economist's point of view profit consists of the surplus remaining 
 over from the employment of capital after defraying all the 
 necessary expenses and outlays incurred in its employment, and 
 after the capital has been replaced or provision made for its 
 replacement. If there are not sufficient assets left to replace 
 the capital, the result of the venture or employment is a loss 
 and the amount by which the capital is diminished is the measure 
 of this loss. Profits are arrived at by means of balance sheets 
 showing the true financial position of the concern, supplemented, 
 where the books are properly kept, by a profit and loss account. 
 
 For example, the profit of a company for the first year would 
 be the excess of assets over liabilities (including in the latter the 
 paid up capital), while there would be exhibited in the profit and 
 loss account the sources from which the profits have arisen. 
 The profit for any period is the difference between the surplus of 
 assets over liabilities at the beginning of the year and the surplus 
 as shown at the close. 
 
 Accountant's Definition of Profits: If a public accountant 
 were asked to define the term "net profit" he would probably 
 reply : "The net profit of a business is the surplus remaining from 
 the earnings after providing for all costs, expenses, and reserves 
 for accrued or probable losses." 
 
 But there are capital profits and revenue profits, as for in- 
 stance, part of a tract of land upon which a factory has been 
 erected may be sold for an amount equal to the original cost of 
 the entire undertaking. This is a realized profit, but not one 
 which falls within the ordinary definition, therefore it is not wise 
 to rely exclusively upon any one definition. 
 
 As stated on page i8o, the author believes that the word 
 "surplus" should be used only to designate an amount available 
 for dividends. The term net profits should be used only to desig- 
 nate the amount arrived at by stating the income actually 
 accrued during a stated period, collected or collectible, less the 
 cost thereof, and after provision is made for further costs 
 accrued but not paid, such as depreciation, obsolescence, taxes, 
 and other charges apportioned against the income, such as re- 
 serves for strikes^ workmen's pensions, etc., but before any 
 reserve is created for working capital, unknown contingencies, 
 etc. If an absolutely accurate balance sheet could be prepared 
 
PROFIT AND LOSS ACCOUNT 185 
 
 at the beginning and end of a period, the difference would repre- 
 sent the net profit or net loss for the term, but the valuation and 
 revaluation of capital assets involves too much speculation to 
 permit such a practice being recognized as satisfactory. This, 
 in effect, is the method used in arriving at results in a single- 
 entry business, and its utter failure to justify itself is reason 
 enough for abandoning it. 
 
 A business man wants to know his gross earnings for the 
 year, together with all of the costs and expenses which are prop- 
 erly chargeable thereto. Naturally the net result, be it a profit 
 or a loss, will coincide with the changes in the balance sheet at 
 the beginning and the end, exclusive of capital receipts or 
 expenditures during the period. But the business man does not 
 always think that; sometimes he wants to have the gross earn- 
 ings stated and as few deductions therefrom as possible made, in 
 order that a favorable result may be shown. He may be willing 
 to create a reserve for depreciation on the books, and in the cor- 
 poration tax returns, but he does not always want it to appear in 
 the statement which he shows his banker. He does not consider 
 that the profit and loss account as he would state it, taken in con- 
 nection with his balance sheets, would be inaccurate on its face. 
 The professional auditor, however, is under a much greater re- 
 sponsibility. He cannot afford to prepare a profit and loss 
 account which omits any material item. Just what should be 
 included and what excluded will now have our attention 
 
 EARNINGS 
 
 Gross Earnings: It is customary ana desirable to show the 
 gross business transacted, whether arising from sales of goods, 
 services rendered by professional men and others, or by public 
 service corporations or similar enterprises. 
 
 Returns: Where earnings arise from the delivery of goods 
 and for any reason the goods are returned, the aggregate thereof 
 is usually deducted from the gross sales before stating same. 
 The reason for this is that if the goods are returned and credited 
 at the same price at which charged, and are available for resale, 
 then it would be improper to augment the sales by transactions 
 never consummated, and thus render less valuable, calculations 
 of gross profits, etc. This is the general rule, but if anyone for 
 
i86 AUDITING 
 
 whom a statement is being prepared desires to have the returns 
 shown as a deduction from the gross sales, there is no objection 
 to complying with the request. It may be of interest as a means 
 of showing whether the proportion of returns to the total volume 
 of business is proper or otherwise. 
 
 Ordinary Transactions Only to be Included: It should be 
 noted here that in the first division of the profit and loss account 
 the only earnings which should be shown are those which are 
 incident to the normal operation of the business. All other earn- 
 ings should be excluded at this point. The reason for this is that 
 the relation of one account to another, for immediate observa- 
 tion as well as for future comparative purposes, must be ex- 
 pressed in percentages and amounts and the inclusion of any 
 item out of the ordinary scope of the enterprise would afifect the 
 percentages and thus diminish the value of the comparisons. 
 
 Allowances and Rebates : These are the next deductions and 
 will also be direct, except that separate ledger accounts should be 
 kept therefor, unless the items are few in number and amount. 
 Wherever the aggregate is a material percentage of the gross 
 sales, and therefore subject to comment and possible criticism, it 
 should be shown on the statement. 
 
 Bad Debts: The earnings just referred to are gross and are 
 so stated whether or not realized in cash or its equivalent. The 
 question arises as to whether an allowance, or reserve, for bad 
 debts should be considered at this stage and be deducted direct 
 from the gross earnings, or be treated as an expense of adminis- 
 tration or selling and be included under one of these groups. 
 The proper place is that group which reflects the cost of collect- 
 ing the proceeds of the sales. 
 
 One concern may decide to take its chances on the acumen 
 of its salesmen and maintain no credit department. The propor- 
 tion of bad debts may be fairly large, but may not be sufficient to 
 warrant the expense of a competent credit force. Another con- 
 cern in the same line of business may have a well-equipped credit 
 department and its losses from bad debts may be very small, but 
 there will be two items of expense to be grouped if an intelligent 
 comparison with the other concern is desired. For these and 
 other reasons the provision for bad debts should not be deducted 
 directly from the earnings. 
 
PROFIT AND LOSS ACCOUNT 187 
 
 The reserve created, however, is a deduction from the item 
 of trade debtors or accounts receivable on a balance sheet. It is 
 not a liability and should never be placed among liabilities or on 
 the liability side of the balance sheet. 
 
 The inspectors sent out by the Bureau of Internal Revenue 
 to verify corporation tax returns claim that a charge to the profit 
 and loss account representing a provision for bad debts cannot 
 be accepted as a proper charge unless specific accounts are desig- 
 nated. This attitude is substantially borne out by an official rul- 
 ing of the Commissioner, viz : 
 
 Bad debts, if so charged off the company's books during the year, are 
 proper deductions. But such debts, if subsequently collected, must be treated 
 as income. 
 
 This position is on a par with other and equally absurd deci- 
 sions of the Bureau referred to elsewhere. Take, for instance, a 
 department store manager whose experience has extended over a 
 great number of years. He may have discovered that the loss 
 from bad debts is one per cent of the gross sales and, based on 
 this experience, a monthly charge is made to profit and loss and 
 a corresponding reserve is created. When debtors' accounts are 
 eventually beyond hope of recovery, they are debited to the 
 reserve. This is an expense of the business and no ruling of the 
 Treasury Department can make it anything else. For a full dis- 
 cussion of bad debts refer to page 297. 
 
 Work in Progress: So far as the books of account are con- 
 cerned a clear line must be drawn between earnings which are 
 represented by completed transactions with trade debtors and 
 those which are only partially completed. In any case no profit 
 must be taken unless a cause of action has arisen which can be 
 enforced against the debtor. In other words, where work in prog- 
 ress cannot be earmarked as for a definite customer, or where 
 it has not proceeded far enough to base an action, it must be 
 taken into the inventory at cost and no profit thereon will appear 
 in the profit and loss account. But if work is undertaken "on 
 order" and is proceeding satisfactorily, and it is apparent that 
 the estimated profit thereon will be realized, more or less, then it 
 is permissible to take credit for the proportion of profit earned to 
 the date of the account. 
 
i88 AUDITING 
 
 Ordinarily, on the theory that profits must not be antici- 
 pated,, this principle would not be considered a conservative one. 
 In trading concerns orders are frequently taken far in advance, 
 and goods in an inventory may have been sold and be simply 
 awaiting delivery. Accounting authorities agree that the profit 
 on such sales should be deferred to the period during which 
 delivery is made. 
 
 It may therefore be pertinent to inquire why it is that a profit 
 may be taken on a contract only partially completed and with 
 many contingencies to face, any one of which might delay or 
 prevent the contract being fulfilled according to its terms. Per- 
 haps the best and frankest answer to this argument is that expe- 
 diency governs one case, while the other is subject to ordinary 
 commercial practice. 
 
 Most concerns which sell ahead have a fairly constant and 
 uniform business and no statistical problem is affected by charg- 
 ing sales expenses to one period while the following period reaps 
 the benefit thereof. But a shipbuilder may have at the end of 
 one fiscal period a dozen jobs under way, while at the end of the 
 next period he may have six or eighteen. If he were to take in 
 the profit on completed jobs only his books might show a state 
 of affairs vastly different from the facts, that is, his most pros- 
 perous year might easily show up the worst. The same condi- 
 tion exists with contractors in the 'building and other trades. 
 
 It may be urged that the taking of a profit on uncompleted 
 work is an extreme case of anticipating earnings, a practice 
 which is condemned throughout this book. This is admitted. It 
 should be borne in mind, however, that in all cases where there 
 are inventories and similar assets the closing of books is neces- 
 sarily based on estimates, and many instances are known of seri- 
 ous mistakes in fixing valuations on real estate and stock-in- 
 trade. 
 
 The necessity of closing at a fixed date each year may be 
 supported by careful estimates, and it will be found over a period 
 of years that a contractor who has carefully estimated the value 
 of work in progress, and who has conservatively estimated his 
 profits thereon, will have arrived at figures quite as dependable 
 as is the case in a business where the units of production are 
 smaller and where it is not the practice to anticipate profits. 
 
PROFIT AND LOSS ACCOUNT 189 
 
 Experience in dealing with contractors' accounts soon enables 
 the auditor to verify, at least approximately, the accuracy of the 
 figures submitted in connection with work in progress. 
 
 Recently the practice of having work done at a maximum 
 profit or upon a fixed percentage has been extended to much 
 work which formerly was undertaken for a round sum. In such 
 a case the profit is determined by the extent of the work com- 
 pleted and may be taken into account in the same manner as with 
 professional earnings. 
 
 Where the units of production are smaller and the time of 
 completion is comparatively short, there is no sanction for includ- 
 ing any profit whatever in the inventory prices of unfinished 
 goods. Under a very accurate and carefully kept cost system it 
 may be possible to arrive at the cost price of work in progress. 
 The auditor should ascertain that the principles upon which the 
 costs have been calculated are correct and should also satisfy 
 himself that the quantities have been checked and certified to by 
 responsible parties. 
 
 Departmental Profits: It has been held by some accounting 
 authorities that when the product of one department of a busi- 
 ness has been completed and is turned over to another depart- 
 ment, the originating department may take credit for its produc- 
 tion at the market price, and if the market price is in excess of 
 its cost, then a profit is earned and may be taken into account 
 immediately. 
 
 In support of this view it is pointed out that in some concerns 
 there may be, say, four distinct stages between raw product and 
 finished goods. Other and competing concerns may deal only 
 with one, two, or three of these stages, so that what may be an 
 intermediary stage for one will represent raw materials for an- 
 other. 
 
 For instance, a steel plant may mine its own ore and manu- 
 facture its own pig iron. A competitor may purchase all of its 
 pig iron. The former's iron may cost $10 per ton; the latter, 
 having to buy oii the market, may not be able to secure any iron 
 under $12 per ton. 
 
 The iron may be used to manufacture identical products. At 
 what price should the former concern charge the department to 
 which the iron is delivered? If at $10 per ton, the manager will 
 
igo AUDITING 
 
 be credited with a lower cost on his production than his com- 
 petitor, although the latter may, as a matter of fact, be more 
 efficient. 
 
 So far the argument is a strong one, and the point can be con- 
 ceded if the interdepartmental profits are suspended until the 
 product is finally disposed of. Otherwise a concern manufactur- 
 ing its goods from the first stage to the last might find itself with 
 a large inventory of manufactured goods and a large apparent 
 profit and yet be wholly unable to convert the book profit into 
 cash. 
 
 For comparative purposes and in order to determine the effi- 
 ciency of different departments, it may therefore be permissible 
 to adjust costs to market prices provided that in all cases such 
 intermediate profits be held in reserve until there has been a con- 
 version into cash or its equivalent. 
 
 A complete answer to the demand for an earlier disposition 
 of these profits is that the purpose of organizing an enterprise 
 which includes various stages of manufacture may be assumed 
 to be the expectation of producing a given article in complete 
 form for market at the lowest possible price, and it is expected 
 that the larger the number of stages which are covered the lower 
 will such cost be. This would not be the case if it were planned 
 to take credit for a series of profits throughout the process of 
 manufacture, as this would obscure the actual cost of the fin- 
 ished article. 
 
 Profits of Subsidiary Companies: In recent years there has 
 been a tendency toward concentration of production, and the 
 same problem arises with respect to intercompany profits as with 
 interdepartmental profits. This subject was discussed by 
 William M. Lybrand, C. P. A., in his paper on "The Accounting 
 of Industrial Enterprises," read before the American Association 
 of Public Accountants at Atlantic City in 1908. He said inter alia: 
 
 Some of the industrial enterprises of the present day begin their owner- 
 ship with the raw materials and manufacture their output all the way from 
 the first stage to the last. Necessarily this manufactur'ng cannot, in every 
 instance, be performed in one continuous operation or by one plant, and there 
 will be constant transfers from one company to another of product finished 
 up to a certain point, but subject to further manipulation in order that it 
 may be disposed of in a different form. At the end of the fiscal year or other 
 balance-sheet period there will doubtless be a quantity of such merchandise 
 
PROFIT AND LOSS ACCOUNT 191 
 
 in the inventories of the several subsidiary companies, purchased by one 
 company from another at a price greater than the actual cost of manufactur- 
 ing. As the companies are entirely distinct from each other, it may be 
 argued that the purchasing company will be justified in including such mer- 
 chandise in its inventory at the price paid to the company from which it was 
 acquired. The purchase, however, having been made by one subsidiary com- 
 pany from another, is in effect merely a transfer from department to depart- 
 ment of virtually the same corporation and not a sale on which profit can 
 be said to have been realized. The principle that profits must not be antici- 
 pated would seem therefore to be applicable in such instances, and it would 
 follow that a reserve should be provided equal to the amount by which such 
 merchandise at intercompany prices exceeds its actual manufacturing cost. 
 
 In the annual report of the United States Steel Corporation 
 for 191 1 it is stated that these intercompany profits, which 
 formerly were segregated as part of the surplus account, but 
 included among the inventories, had been eliminated from the 
 surplus account and the inventories correspondingly reduced. 
 The report stated that : 
 
 Inventory valuations as stated are on the basis of the actual purchase or 
 production cost of the materials to the respective subsidiary companies hold- 
 ing the same, imless such cost was above the market value on December 31, 
 191 1, in which case the market price was used. But as stated in previous 
 annual reports, the valuations on the basis indicated include, in respect of such 
 commodities in stock at the close of the year as had been purchased by one 
 subsidiary company from another, an amount of profits accrued thereon to the 
 subsidiaries selling the same or furnishing service in connection therewith. 
 These profits are not, however, carried into the currently reported earnings 
 of the entire organization until converted into cash or a cash asset to it, be- 
 ing meanwhile segregated and carried in a specific surplus account which 
 is practically a guarantee fund for these profits so locked up in inventories 
 pending their realization in cash. In order to present the accounts on even 
 a more conservative basis than heretofore observed, it was decided in this 
 year's consolidated general balance sheet to state the amount of the specific 
 surplus account referred to as a reduction in the total valuation at which all 
 inventories are carried in current assets. Accordingly, in the subjoined table 
 the surplus account in question is likewise shown. This plan results in there 
 being carried in the combined assets for all of the companies the inventories 
 of those materials and products on hand which have been transferred and 
 sold from one subsidiary company to another, at net values which are sub- 
 stantially the production cost to the respective subsidiary companies furnish- 
 ing the same. The net valuation thus obtained and shown for the total in- 
 ventories of all materials and products is largely below the market value 
 of the same. 
 
 This is sound and conservative accounting and should be 
 
192 AUDITING 
 
 followed by every corporation which desires to allow the future 
 to reap the benefit, if any, of future transactions, rather than to 
 sell goods to itself at a profit. 
 
 Sales for Future Delivery: As mentioned under "Work in 
 Progress," it is customary in many lines of business to solicit 
 and accept orders for future delivery. Where the expenses of 
 taking the orders have been incurred and where the goods them- 
 selves are on hand ready for delivery, it may seem ultra-conserv- 
 ative to advocate waiting for actual shipments before taking 
 credit for the profit thereon. Nevertheless, this practice is gen- 
 erally followed by successful concerns, whereas the unsuccess- 
 ful business man, in his attempts to bolster up a tottering busi- 
 ness, usually anticipates every profit in sight and forgets the 
 accrued expenses. 
 
 Theoretically if goods have been sold and are ready for ship- 
 ment and the terms of the order permit immediate shipment, 
 it may be assumed that a cause of action has so nearly arisen 
 that no great harm could follow if the goods were entered as a 
 sale, accounts receivable were debited, and the profit and loss 
 account increased by the profit. But every business man knows 
 that up to the instant of shipment, and sometimes afterwards, 
 cancellations are received and accepted, or a fire or some other 
 unexpected occurrence may operate to prevent the consumma- 
 tion of what appeared to be a sure thing. 
 
 In the annual report of the International Harvester Com- 
 pany for 191 1 appears the following comment on this point: 
 
 Assuming a continuance of present credit methods and the same pro- 
 portion of forward sales, it is considered advisable to gradually establish a 
 contingent reserve for deferred profits on forward sales. Theoretically and 
 technically, a profit is earned when the sale is made, but when the actual 
 realization of the profit on certain sales is deferred a considerable time be- 
 yond the close of the fiscal year, it is obviously a conservative and sensible 
 policy to establish a contingent reserve to meet this condition inherent in 
 the business. This policy prevents the misleading transfer of book earnings 
 to surplus, where a long period of time elapses between the date of the sale 
 and the realization of the profit in cash. 
 
 The balance sheet of the company shows a reserve for un- 
 realized profits of $2,500,000 which has been accumulating for 
 some years. 
 
PROFIT AND LOSS ACCOUNT 193 
 
 The conservative business man does not and will not antici- 
 pate the profits on goods ordered but not shipped ; the conserv- 
 ative auditor will not certify to accounts which are prepared on 
 any such basis. For a legal discussion of this question see the 
 American Malting decision (page 595). 
 
 Participations and Underwritings : During recent years 
 bankers have extended the privilege of participating with them- 
 selves in underwritings and purchases to a considerable number 
 of investors and others. It is, therefore, not an unusual occur- 
 rence to see some reference to such participation in books of 
 account. 
 
 Perhaps a majority of underwritings yield a net profit to 
 participants, but many wind up with a loss. Interim accounts 
 are reports of progress only and may be founded on the quota- 
 tion of a supported market, so that it is most unsafe to take into 
 account any profit at all until it is realized in cash. 
 
 This rule applies with equal force where securities of a new 
 corporation are distributed as a bonus. There may be a market 
 price in efifect which would insure a handsome profit, but such 
 quotations may be nominal only. The sale of a part of the par- 
 ticipation at a profit on the purchase price should be applied 
 against the entire purchase in order to write down its book cost. 
 This is based on the same general principle, viz., that the market 
 may be a fictitious one and not to be depended upon. 
 
 Profit on Sale of Assets: It may be that a profit has been 
 realized on the sale of a portion of the fixed assets of a concern. 
 Legally this profit may be carried to surplus and distributed as a 
 dividend, but such a course is apt to create a false impression on 
 stockholders. It is much better to carry such an item to an 
 account whose caption indicates the character of the entries 
 therein, and which may be carried on a balance sheet as a sepa- 
 rate section of the surplus account. Under such circumstances 
 it will not appear to be applicable to dividend distributions and 
 can be held as a contingent reserve against possible losses on 
 other capital adjustments. 
 
 Appreciation in Value of Assets : It has been intimated else- 
 where in this book that appraisal companies are apt to certify 
 to valuations in excess of book figures. It must be said in favor 
 of these companies that they seem to carry on their appraisals 
 
194 AUDITING 
 
 in a careful and conscientious manner and it may be that the rise 
 in the prices of materials and labor during the last ten or fifteen 
 years justifies their apparent overvaluations. 
 
 Unfortunately many business men who secure an appraisal 
 which sets forth that their buildings and machinery are, on the 
 basis of a replaceable valuation less depreciation, worth more 
 than they cost originally, wish to set up on their books and state- 
 ments this diagnosis, and do not like to be told that they are 
 making trouble for themselves. They have a larger valuation to 
 wipe out by depreciation reserves, and thus, in a sense, they are 
 increasing their cost of production. After a credit to surplus 
 account is once made it is most unlikely that any part thereof 
 will be used except for dividends. 
 
 The law on the subject of profits is not well settled andwill 
 not be, so long as the majority of lawyers retain their profound 
 ignorance of accounts, but it is quite likely that no legal obstacle 
 would prevent a corporation from revaluing part of its assets and 
 applying the excess so raised to surplus available for dividends. 
 With the law in such an unsatisfactory condition it remains for 
 the professional auditor to educate the business public to the 
 principle that it is not only foolhardy but unscientific to write up 
 the value of an asset which is not for sale and which therefore 
 cannot be represented by cash or its equivalent. Funds for divi- 
 dends should be realized from the earnings, otherwise the work- 
 ing capital of the company is permanently depleted if a cash divi- 
 dend is declared out of surplus created in the manner stated. 
 
 There may be in exceptional cases an obvious rise in value of 
 an item of fixed assets, but a footnote on the balance sheet is all 
 that is required to secure the benefit of an increased credit rating, 
 and any adjustment of the account in the books by increasing 
 the asset and crediting surplus is rarely permitted by good 
 accounting practice. 
 
 Professional auditors should interest themselves in. the cor- 
 poration laws of their respective States and assist in the enact- 
 ment of statutes comprehensive enough to cover the points just 
 discussed. 
 
CHAPTER XIV 
 
 PROFIT AND LOSS ACCOUNT (Continued) 
 
 EXPENSES AND LOSSES 
 
 The several accounts which include in more or less detail 
 the charges against or deductions from the earnings of an enter- 
 prise are fully described in Chapter XIX, "The Detailed Audit 
 of Expenses." There are, however, some accounts which do not 
 arisQ out of cash transactions and others about which more can 
 be said. These accounts will now have our attention. 
 
 Reserves: We have discussed on other pages the following 
 reserve accounts : 
 
 Bad Debts, page 297. 
 
 Accrued Expenses, page 200. 
 
 Depreciation, Exhaustion, etc., Chapter XXI. 
 
 Obsolescence, page 199. 
 
 Contingencies, page 165. 
 
 Sinking-Fund Accounts, pages 135, 177. 
 The question now arises as to how and when these charges 
 should appear in a current profit and loss account. The fact is 
 that they do not as a rule appear in the current profit and loss 
 account at all. 
 
 A fair proportion of the ten per cent of the business enter- 
 prises of this country who do consult professional accountants 
 heed the advice given and include among their expenses, or de- 
 ductions from income, all of the costs of doing business, and the 
 words "net profit" are not used except after full allowance has 
 been made for keeping the capital intact. Most of the remaining 
 ninety per cent, and those who consult but who do not heed the 
 professional auditor, however, include among their earnings 
 every dollar of possible income, but from such earnings are de- 
 ducted only such costs and expenses as are apparent and easily 
 ascertained, the balance being designated as "net profit." This 
 balance is carried to surplus and is thereafter referred to as the 
 
 195 
 
196 AUDITING 
 
 profit earned during the period stated. Subsequently (but only 
 if the period has been a prosperous one) various deductions are 
 made from surplus, covering depreciation, adjustment of inven- 
 tories, writing off of accounts receivable, etc. 
 
 This practice seems hopeless to the auditor who, is familiar 
 with actual conditions and who knows that about ninety-nine 
 per cent of such deductions were direct charges against earnings 
 and that most of the items could have been included in the cur- 
 rent profit and loss statements. But business men will fool them- 
 selves, and corporation officers and directors will fool their stock- 
 holders, and attempt to fool the public. However, a slight, but 
 perceptible, progress is being made, and it is inevitable that 
 some day the words "net profit" will have the same meaning as 
 the word "sterling" on silver. Laws and custom will decree that 
 the issuing of false statements such as are now spread broad- 
 cast will be a punishable offense. 
 
 It is regrettable but true that many financial writers of abil- 
 ity who should, and perhaps do, know better, are responsible for 
 much of the present unsatisfactory state of affairs in this respect. 
 Just as surely as a corporation does issue a carefully prepared 
 balance sheet and profit and loss statement, probably one certi- 
 fied to by reputable auditors, in which proper deductions are 
 made to cover the items heretofore referred to, one or more of 
 these writers will learnedly analyze its contents for the edifica- 
 tion of the investing public. Almost invariably they will ignore 
 the deductions for depreciation, etc., and solemnly state that dur- 
 ing the period the corporation "earned" a given per cent on the 
 capital — carrying out the rate to several decimal places. They 
 may mention incidentally that from the proHts there were certain 
 deductions, thus emphasizing their own opinion that the actual 
 profit was the one used as a basis for calculating the rate earned, 
 and that the deductions were purely voluntary. 
 
 When legislative investigations are instituted, these figures 
 are also the ones used, and the fallacy has been carried so far 
 that some corporations that have not and never can earn, a divi- 
 dend on their common stocks are cited as having realized large 
 earnings. In the case of the United States Steel Corporation 
 nearly all of the financial writers, and certainly all of the states- 
 men (?), who have investigated its affairs state its net earnings 
 
PROFIT AND LOSS ACCOUNT 197 
 
 over a period of years as many millions of dollars greater than 
 the accounts of the corporation itself show. 
 
 What is the real trouble? Surely accurate accounts are de- 
 sired. Is it because the tendency to overstate profits and under- 
 state losses is so general among business men that no standard 
 exists ? 
 
 Perhaps public accountants are themselves somewhat to 
 blame for present conditions. Have they always been keen to 
 make all the deductions of which they have any knowledge from 
 earnings before designating any one sum as "net profit"? 
 
 The fact is that, because some of the reserves for deprecia- 
 tion, etc., are more or less difficult to ascertain, it has been fairly 
 general to omit them entirely, or qualify the account by stating 
 that the profits are so and so exclusive of some very large costs 
 and expenses. Is it not peculiar that this action on the part of 
 the auditor exactly fits in with the wishes of the client who 
 knowingly overstates his profits ? Candidly, is it not possible to 
 estimate more closely on an allowance for depreciation than on 
 the valuations of fixed assets or current inventories to which the 
 auditor so cheerfully certifies? 
 
 Depreciation: The question of depreciation is important 
 enough to require an entire chapter for its discussion (see 
 Chapter XXI), but at this point it is in order to consider whether 
 or not depreciation is to be included among the cost and expense 
 items in the current profit and loss account. 
 
 In the preceding section attention was called to the general 
 practice of omitting this and other items from ordinary operat- 
 ing accounts. Accountants of experience defend this practice on 
 the ground that where depreciation has not been calculated at 
 all, or where an arbitrary amount has been set aside, the task of 
 determining a fair allowance — one that can be included among 
 operating costs without detracting from the value of the entire 
 statement — is too onerous to handle, with the result that costs 
 are compiled without any allowance for depreciation. It is, of 
 course, assumed that mention is niade of the omission before any 
 final figures are certified to. 
 
 It will always be admitted that wear and tear, and perhaps 
 obsolescence, is going on all the time. If not admitted in so 
 many words, the repairs and maintenance accounts speak for 
 
198 AUDITING 
 
 themselves. The usual and time-worn argument against pro- 
 vision for deterioration is that constant attention is given to the 
 upkeep of the plant and renewals and repairs are looked after as 
 soon as, or before, occasion detnands. 
 
 Disregarding for the moment the fact that there is always a 
 considerable amount of accrued wear and tear not apparent 
 enough to necessitate immediate attention, there is to be con- 
 sidered the question whether the renewals and repairs which will 
 be imperative, and which are always included among the ex- 
 penses or costs, recur regularly enough to be charged up as 
 incurred without upsetting the equilibrium of the accounts, or 
 whether in the ordinary course of affairs the amounts fluctuate 
 so greatly that factory managers are justified in leaving the 
 items out of consideration in self-defense, as otherwise their 
 costs would vary to such an extent that comparative records 
 would be ludicrous. 
 
 In the case of fuel, for example, no such difficulty arises. 
 Purchases and consumption run along regularly and no one 
 would think of omitting the cost thereof. Now wherein lies the 
 essential difference between the cost of fuel consumed under a 
 boiler and the accruing loss on the purchase price of the boiler 
 itself? Both are consumed in the process of manufacturing. 
 The cost of both must be reimbursed from the proceeds of the 
 sale of the product manufactured, or the capital of the concern 
 will be depleted. Capital depletion is exactly what happens in 
 thousands of cases. The cost of fuel is made a part of the cost 
 of the product, but for some mysterious reason the cost of the 
 boilers is provided in some other way, or at least that is the effect 
 of the accounting system followed. 
 
 The most flagrant fallacy is found in connection with the 
 accounts of the first year's operations of a new plant. The man- 
 agement, if sane, must know that the buildings and machinery 
 will not last forever and that into every unit of production there 
 has gone some part of the entire cost of the plant. It would be 
 ridiculous to charge the total cost of buildings and machinery 
 into the operations of the first year, but is it not equally unsound 
 to make no charge whatever thereto merely because the exact 
 amount of the charge is somewhat difficult to ascertain? 
 
 Accounting difficulties are comparative only, and accurate 
 
PROFIT AND LOSS ACCOUNT 199 
 
 accounts always require careful and intelligent attention. If the 
 same thought were given to calculating the proper proportion of 
 the cost of a boiler, which forms a part of the cost of operation, 
 as is given to determining the basic costs of other elements which 
 enter into the manufacturing operations of a modern plant, the 
 amount arrived at would be quite close enough to form a depend- 
 able item of prime cost. 
 
 Professional auditors fail in their duty whenever they allow 
 an opportunity to pass which might permit them to elucidate 
 the foregoing principle. Thousands of enterprises have gone 
 into bankruptcy solely because their accounts never exhibited 
 the full cost of their product. As soon as accounting practice 
 and procedure and commercial common sense are developed to 
 the point where an allowance for depreciation is made just as 
 much a part of prime cost as labor or materials, a considerable 
 number of business failures will be prevented. 
 
 Obsolescence: The author is not prepared at this time to 
 support the contention that an allowance for obsolescence is an 
 item of prime cost as is the case with depreciation. The latter 
 is certain and cannot be avoided any more than taxes or death. 
 
 Obsolescence is never certain. It is true that most of our 
 modern machinery has superseded other machinery which was 
 not worn out, and the plant of ten years ago which counted on a 
 twenty-year life for its equipment and set up a depreciation re- 
 serve on that basis has not been able to renew that machinery 
 out of the reserve. 
 
 Take the case of a machine costing $1,000 in 1903 with an 
 estimated life of fifteen years and a scrap value of $100. There 
 would have been $900 to charge to operations and a depreciation 
 reserve based on the expected life would be conservative account- 
 ing. In 1910 it is found that the machine is obsolete and a new 
 one costing $1,500 is purchased, but the new one has twice the 
 capacity of the old. Here we find our answer to a large extent. 
 An old machine will not be superseded by a new one unless the 
 latter has greater efificiency or capacity, and this supplies author- 
 ity for capitalizing part of the cost of the new machine. 
 
 It is obvious that obsolescence cannot be foreseen, and any 
 attempt to reduce the contingency to a definite allowance to 
 form part of current operating costs would defeat its own pur- 
 
200 AUDITING 
 
 pose. In view of the rapid strides in all of the mechanical 
 sciences, obsolescence is likely to continue to be a serious factor 
 in the ultimate cost of producing manufactured goods. There- 
 fore, wherever possible, a reserve should be created to meet the 
 possibility, but the reserve should be provided for out of profits 
 before stating the surplus applicable to dividends and never as 
 an item of prime cost. 
 
 Accrued Expenses, etc. : It is perhaps superfluous to mention 
 that the items of expenses in a profit and loss account embrace 
 those which have accrued during the period, whether paid for or 
 not. At the closing date all accrued expenses, rents, taxes, inter- 
 est, and similar items should be ascertained and entered as liabil- 
 ities on one side and charged to their respective expense ac- 
 counts on the other. 
 
 As many of these expenses are more or less unusual in their 
 nature, it seems unavoidable that some are omitted. The ques- 
 tion then arises in subsequent audits as to whether the items 
 applying to prior periods should be charged to surplus or in- 
 cluded among the current expenses of the period in which paid. 
 There are two reasons in favor of the latter practice and no good 
 reason in favor of the former. In the first place, where charges 
 are made against an old book surplus it simply means that so far 
 as published accounts go they are never in evidence. That is, 
 the items were not known at the time and were therefore omitted 
 from the period in which they belonged, and being eliminated 
 from the period in which paid they practically disappear. 
 
 The most valuable records compiled are comparative sched- 
 ules of earnings and expenses, and where these are carried along 
 from year to year it is practically impossible to adjust reports 
 which are perhaps a year old and of which frequent use has been 
 made. Therefore proper accounting practice permits the inclu- 
 sion of such items in the current profit and loss account, without 
 calling special attention to the matter, unless the items are large 
 enough to alter materially the results. Where the items are 
 comparatively small it may be assumed that corresponding items 
 are omitted from the current accounts and will have to be taken 
 care of in the subsequent period. 
 
 This must not be construed as an excuse for closing accounts 
 before every known liability is taken into consideration. The 
 
PROFIT AND LOSS ACCOUNT 201 
 
 auditor who does not satisfy himself that all known liabilities and 
 those which should be known are included in a balance sheet is 
 guilty of negligence and deserves any consequence which may ensue. 
 
 Cash Discounts: Where it is customary to permit trade 
 debtors to deduct a discount for cash within a limited period 
 these deductions are entered in a separate column of the cash 
 book. The discount allowed up to the date of the closing will, 
 of course, appear in the books, preferably in a separate ledger 
 account. 
 
 The aggregate of such allowances should be entered among 
 the expenses of the business and not as a direct deduction from 
 gross earnings. The theory is that the discount allowed repre- 
 sents a premium paid for prompt attention and for the use of the 
 money at an earlier date than it would be received if no induce- 
 ment were made for prepayment. Where the items are strictly 
 cash discounts, and are not permitted if the debtor does not pay 
 within the limit, then the total allowance is clearly an expense 
 and should not be charged against sales as if it represented an 
 abatement of the purchase price of the goods. 
 
 Trade Discounts: The author, in common with most practi- 
 tioners, has always stated that trade discounts were direct de- 
 ductions from invoices and should not appear in the books of 
 account of the seller or the purchaser. 
 
 It is true, however, that in some trades considerable impor- 
 tance is placed upon the variations in trade discounts, and it 
 would seem to be in order that the accountancy student should 
 be given an opportunity to decide for himself whether trade dis- 
 counts have any place in books of account. This point assumes 
 importance in auditing because the auditor cannot very well 
 report the amount of trade discounts given or received unless the 
 items have been separated throughout the period covered by the 
 profit and loss account. 
 
 At the request of the author the "case" for trade discounts 
 was stated by John R. Wildman, C. P. A., as follows : 
 
 The general practice is to deduct trade discounts from the face of the 
 purchase and sales invoices. It is claimed, however, that in large organiza- 
 tions, where the fixing of prices is delegated by the administrative ofiScers to 
 the respective heads of purchasing and sales departments, the recording of 
 the data in question facilitates the compilation of statistics which will show 
 
202 AUDITING 
 
 the average discounts and thus serve somewhat as an index to the efficiency 
 of the heads of the respective departments as well as to serve as a guide to 
 the administrative officers in reaching conclusions and formulating policies 
 concerning these phases of the business. 
 
 Theoretically, it appears to have some scientific foundation. Practically, 
 it is questionable whether the amount of work involved is warranted by the 
 purpose for which the data are used. 
 
 Accounting instruction, in my opinion, should be as broad as possible. 
 Every phase of a subject should be discussed. All the facts should be pre- 
 sented. The relative advantages and disadvantages of various methods should 
 be explained. After discussion the instructor should state the preference 
 dictated by the general practice so far as it can be ascertained. Further, the 
 relation of trade discounts to cash discounts, and the relation of both to the 
 purchase and sales prices, seem worthy of discussion. 
 
 Disposition of Profit after Being Determined: When an 
 auditor has determined the amount which he is willing to certify 
 represents "net profit," the difficult part of his task is completed. 
 Probably he will not be asked whether the amount shown should 
 be paid out in dividends or transferred to surplus, and as a 
 matter of principle he is not concerned. It may be, however, that 
 his opinion will be asked, in which event he may be able to sug- 
 gest such a disposition of the profit as will conserve the best 
 interests of the concern. 
 
 Whether to declare a cash or a stock dividend is a question 
 which may very properly be referred to the auditor. There 
 should be no transfer of profits to general surplus account unless 
 the entire amount is applicable to dividends when and if declared. 
 The net profit for the period is first shown, then any transfers 
 which have been authorized by the board -are deducted, the 
 balance being carried to surplus. This practice has been fol- 
 lowed by some of our best-managed corporations for a number 
 of years, and has the sanction of law in that the courts have 
 repeatedly held that the directors of a corporation need not de- 
 clare dividends unless they so desire, provided they can show 
 that the funds which would be required for dividend disburse- 
 ments can be used to better advantage in the business. 
 
 It is carrying this discretion to an extreme which stock- 
 holders never contemplate when they purchase stock, for the 
 directors to invest the surplus in securities the control of which 
 is not a necessary incident to the carrying on of the business for 
 which the corporation was organized. 
 
PROFIT AND LOSS ACCOUNT 203 
 
 In England the law is as follows: 
 
 English Companies (Consolidation) Act 1908. Table A. Section 99. 
 The directors may, before recommending any dividend, set aside out of the 
 profits of the company such sums as they think proper as a reserve or re- 
 serves which shall, at the discretion of the directors, be applicable for meet- 
 ing contingencies, or for equalizing dividends, or for any other purpose to 
 which the profits of the company may be properly applied, and, pending such 
 application, may, at the like discretion, either be employed in the business of 
 the company or be invested in such investments (other than shares of the 
 company) as the directors may from time to time think fit. 
 
 An auditor will recommend the setting aside of reserves for 
 contingencies or for the equalization of dividends or other rea- 
 sonable purposes so long as the financial condition of a corpora- 
 tion demands conservative financing, but when it finds itself so 
 well ofif that it can not only pay all of its debts, but has cash 
 enough to purchase investment securities, then the auditor had 
 better allow the board itself to take all the responsibility. The 
 practice savors too much of paternalism. Stockholders are said 
 to forget dividends quickly, and it is therefore not thought safe 
 to pay out big dividends in good years and small or no dividends 
 in poor years. But some stockholders are quite as well qualified 
 as the directors to invest their earnings and prefer some varia- 
 tion in the dividend rate to an attempt to build up a big surplus 
 and indefinitely postpone the distribution of the earnings of a 
 particularly prosperous period. 
 
 PRINCIPAL AND INCOME 
 
 It has been pointed out in other chapters of this book that 
 the distinction between principal and income (or capital and 
 revenue) must ever be in the auditor's mind. It afifects the 
 balance sheet as well as the profit and loss account and is a fact 
 to be faced rather than a theory to be played with. 
 
 As the matter is discussed fully under various headings, it 
 is not necessary here to review the attitude of the auditor with 
 respect to determining whether a given item belongs to principal 
 or to income, because by reason of his training and experience 
 he will decide each question according to its merits, with sound 
 accounting principles to guide him. It is at present doubtful, 
 however, whether the courts can be depended upon to decide as 
 equitably. 
 
204 AUDITING 
 
 Dividends Must Not Be Paid from Capital : While questions 
 with respect to capital and revenue arise in every branch of 
 accounts, many of them are not met squarely, but are passed over 
 undecided. Issue is not usually joined until the question of a 
 dividend arises. Directors and managers who will not admit 
 that depreciation is an operating expense will nevertheless hesi- 
 tate before voting for or advocating the payment of a dividend 
 before there have been set aside sufficient reserves to maintain 
 the capital intact. 
 
 Section 23 of the New York Stock Corporation Law pro- 
 vides : 
 
 The directors of a stock corporation shall not make dividends, except 
 from the surplus profits arising from the business of such corporation; nor 
 divide, withdraw, or in any way pay to the stockholders, or any of them, 
 any part of the capital of such corporation, or reduce its capital stock, except 
 as authorized by law. In case of any violation of the provisions of this sec- 
 tion, the directors under whose administration the same may have happened, 
 except those who may have caused their dissent therefrom to be entered at 
 large upon the minutes of such directors at the time, or were not present 
 when the same happened, shall jointly and severally be liable to such cor- 
 poration and to the creditors thereof to the full amount of the capital of such 
 corporation so divided, withdrawn, paid out, or reduced. 
 
 The English Companies (Consolidation) Act, 1908, contains 
 the following provisions relative to dividends : 
 
 Table A. Section 95. The company in general meeting may declare 
 dividends, but no dividend shall exceed the amount recommended by the 
 directors. 
 
 Section 96. The directors may from time to time pay to the members 
 such interim dividends as appear to the directors to be justified by the profits 
 of the company. . 
 
 Section 97. No dividend shall be paid otherwise than out of profits. 
 
 There is no practical diflference between this law and that 
 of New York State. In neither jurisdiction is it permissible to 
 pay a dividend unless the capital is unimpaired. Where the 
 assets have depreciated in value and the depreciation is not 
 provided for out of earnings, the capital is impaired. 
 
 There are undoubtedly many corporations in existence to- 
 day whose dividends are being or have been paid out of capital. 
 If stockholders appreciated their rights, many directors would be 
 called to account for this. 
 
PROFIT AND LOSS ACCOUNT 205 
 
 The most notable case in the United States wherein it was 
 shown that dividends were paid out of capital instead of net 
 profits or surplus is the American Malting case, which is fully 
 reported on page 595- If an auditor finds himself in disagree- 
 ment with a board of directors over the allocation of items to 
 capital or revenue he may find it salutary to request them to read 
 extracts from this case. 
 
 Decedents' Estates: The distinction between principal and 
 income assumes more importance in some trust estates than in 
 ordinary commercial practice, because while with the latter the 
 result of a misapplication of an item may afifect the ultimate solv- 
 ency of an enterprise, in respect to an estate the decision of a 
 court as to a dividend being principal or income may actually 
 deprive a dependent of the necessities of life. 
 
 Wasting Assets: It is permissible for a mining company to 
 pay out in dividends all reaHzations from its operations, but its 
 stockholders are on notice that the capital of the company is 
 being dissipated. On the other hand, if a steel company owns 
 ore lands it must not treat the entire net income from ore sales as 
 profit, but is obliged to allocate the realizations into principal 
 and income. The principal must be kept intact in order that the 
 capital may not be depleted. The income may be distributed in 
 dividends. 
 
 In an estate the practice (in the absence of testamentary or 
 statutory provisions to the contrary) is similar to that of mining 
 companies, that is, the tenant for life may work a mine or a 
 quarry or cut down timber and is not required to make good the 
 depletion. In the case of buildings, etc., the rule is different; 
 they must be maintained, ordinary wear and tear excepted. 
 
 Interest: Interest and similar income is said to accrue from 
 day to day so that the full amount accrued to the date of the 
 decedent's death becomes principal. 
 
 It has been held in at least one State that where the interest 
 is represented by a coupon the amount thereof is not apportion- 
 able, but represents a separate contract to pay a definite amount 
 at a certain time. The distinction between such a contract and 
 a registered bond, where the interest is paid by check and is not 
 represented by coupons, is a fine one, rather beyond the compre- 
 hension of a layman. 
 
2o6 AUDITING 
 
 Dividends: The date of the declaration of a dividend fixes 
 its standing as principal or income; if declared before the dece- 
 dent's death it is principal, even though it is payable after the 
 date of death. It accrues wholly on the date of declaration, i. e., 
 there is no apportionment based on the period it covers. 
 
 Stock, and Extraordinary Cash Dividends: The foregoing rule 
 does not always apply to dividends which are declared out of 
 the regular order. It is rather popular for corporations and 
 banks to accumulate their excess earnings for a long period of 
 years and then make an extraordinary distribution at one time, 
 in cash or in stock. In most cases, and in all cases where full 
 and correct accounts have been published periodically, these 
 hoarded earnings become identified with the capital of the under- 
 taking, and furthermore are reflected in the market price of the 
 stock. 
 
 From an accountant's point of view it seems absurd that a 
 life tenant, to whom there is devised the income for life on, say, 
 ten shares of stock, should receive as income, say, ninety shares 
 of the same stock, thus vitally depreciating the estate left for the 
 remainderman. But the courts have so held in spite of the in- 
 justice of the result. In some jurisdictions, however, the deci- 
 sions have been to the effect that extraordinary dividends are 
 distributions of principal. 
 
 Space does not permit a lengthy discussion of this subject. 
 Any one interested and seeking further particulars is referred 
 to a very able and interesting paper on the subject by William 
 F. Weiss, C. P. A., of New York. 
 
CHAPTER XV 
 CERTIFICATES AND REPORTS 
 
 What shall it benefit an auditor if he perform the highest 
 grade of professional work and be unable to present his results in 
 a form acceptable to and understandable by his client ? Yet this 
 happens every day, chiefly because some auditors apparently 
 prepare reports for themselves rather than for those they are 
 supposed to enlighten. An engineer builds a bridge for others to 
 use. It is useless unless it is safe and convenient. The man who 
 rides across it does not care how many difficult problems were 
 encountered in the building, nor how they were solved; he is 
 content to judge the engineer by results. So with a banker or 
 a business man. He employs an auditor because he wants re- 
 sults, and he wants results which he can use without' having to 
 follow in the auditor's footsteps and traverse the same jungles 
 of figures and grapple with the same problems through which 
 the results were accomplished. 
 
 As pointed out in Chapter VI, the auditor should prepare for 
 the termination before he starts, and as the consummation of an 
 audit must include a report on his work, this fact must be kept 
 in view during the progress of the work. 
 
 If feasible, the auditor should picture himself in his client's 
 position and reason out what he would want if the other man 
 were doing the work. The examination may have started under 
 most favorable auspices ; it may have been executed in an unex- 
 celled manner, but if it is not delivered properly the first two 
 factors go for naught. 
 
 It hardly seems necessary to state that reports should be 
 typewritten and an office copy preserved, yet auditors are fre- 
 quently induced to submit manuscripts of which no copy has 
 been retained. Subsequent embarrassment has followed this 
 unwise practice, through loss of the original, unauthorized alter- 
 ations therein, etc. It is better. to keep a cHent waiting than to 
 run such a risk. Promises to return for rewriting are not kept, 
 
 207 
 
2o8 AUDITING 
 
 as a rule, and the auditor who relies on these and similar prom- 
 ises ignores a precaution which experience has demonstrated to 
 be valuable. 
 
 Something More Than Figures are Wanted in a Report: A 
 prominent banker recently said to the author that most of the 
 reports submitted to him were lacking in information which the 
 auditor was peculiarly able to furnish. He said that auditors 
 who are retained to investigate earnings, expenses, assets, and 
 liabilities, frequently going back over a long series of years, have 
 an unusually good opportunity, for instance, to size up the per- 
 sonnel of an organization, particularly the office staff, but also 
 to a certain extent the other departments. 
 
 A banker is obliged to vouch for an enterprise as a whole 
 when he ofifers its securities to his customers. He wants the 
 assets and liabilities and net profits stated in proper form for 
 publication, and requires a certificate attached which reads well, 
 but he wants a supplemental report for his own use expressing 
 the auditor's opinions on just as many points as the latter can 
 comment on intelligently. He does not want trial balances and 
 lists of debtors and creditors and memoranda of errors in post- 
 ings and similar bookkeeping data. He will read only what is 
 of interest to him and these things are not. 
 
 The same principle applies to the client whose own accounts 
 are being reported upon by an auditor. The auditor secures 
 access to records which the usual executive does not see, and has 
 a chance to observe the staff under conditions which do not exist 
 when the boss is around. This does not contemplate that the 
 auditor will report trivial matters which will make the staff 
 hostile without being of any real benefit to the client. 
 
 Elsewhere in this book it has been pointed out that the suc- 
 cessful auditor must secure and retain the hearty cooperation of 
 the office staff, and this fact is here reiterated as a reminder that 
 a report should be a constructive document and helpful to the 
 client's staff as well as to the client. Occasions may arise where 
 the auditor cannot prevent his report from arousing hostility 
 on the part of the staff. If this must be, let it be because vital 
 defects are criticized and not trivial ones. 
 
 Terminology: It is most important that an auditor express 
 his findings and opinions in good simple English. His aim must 
 
CERTIFICATES AND REPORTS 209 
 
 be to write so clearly that his report cannot possibly be mis- 
 understood. He will not err if he follows the simple language of 
 the Bible or of Lincoln rather than the involved style of Henry 
 James. 
 
 It has been said that accounts are the language in which 
 business transactions are written. It is incumbent on the auditor 
 to exemplify the fact that this language is a simple one, and 
 readily understood. Classics may be read in dead languages, but 
 commonplace business history is better understood if written in 
 a live tongue. 
 
 Figures in themselves are of no value, but correctly arranged 
 and properly interpreted, the accounts of a business organiza- 
 tion furnish a basis for knowledge which is indispensable in the 
 successful conduct of any enterprise. 
 
 The truth may exist in a report poorly written, but if it is 
 not evident to any interested party, then th'e language used is not 
 well chosen. 
 
 Scope of Report: Certificates and reports, if true, must be 
 founded on the work which has been done. A report should be a 
 narrative of facts. It may include a short history of the enter- 
 prise under audit, particularly where it is intended for the pe- 
 rusal of those whose information on this point is limited. 
 
 A certificate should be brief and to the point and embody 
 conclusions based solely on the auditor's investigations. 
 
 A report is for the edification of others, and it is the duty of 
 the auditor to make it interesting. The most successful auditors 
 pay much attention to this aspect of their work, so that clients 
 are glad to get their reports and read them. 
 
 How much space should be given to the detailed work done 
 by the auditor? The average client does not care how the 
 auditor arrived at his results — all he wants is information. He 
 asks: "Are the accounts correct, or, if not correct, wherein are 
 they inaccurate, and how shall they be improved?" 
 
 Some auditors who have not verified every item on the books 
 think that they escape responsibility by detailing all of the 
 ground covered. If work is omitted which should have been per- 
 formed, a carefully worded report pointing out that other work 
 was done and omitting any mention of the work in question can- 
 not be used to escape liability. 
 
2IO AUDITING 
 
 Reports must be founded on facts discovered, verified, or 
 compiled by the auditor, but it is neither desirable nor necessary 
 to comment on immaterial matters and furnish superfluous 
 schedules. 
 
 The purpose for which the report is to be used must in every 
 case be carefully considered before it is written. For instance, 
 a prospective borrower does not want an auditor to submit a 
 balance sheet which is accompanied by comments on the system 
 of accounts, nor does he want long schedules of clerical errors. 
 On the other hand, it is quite in order to submit a balance sheet 
 accompanied by qualifying comments, provided the changes 
 which the auditor thinks should be made in the balance sheet 
 figures are not permissible in the books, or where balance-sheet 
 items are not sufficiently self-explanatory. 
 
 Where balance sheets are not designed for publication the 
 most satisfactory report consists of the following: 
 
 Certificate of Audit. 
 
 Comments on Audit and on Balance Sheet. 
 
 Balance Sheet, supported by detailed schedules wherever 
 they are necessary or deemed to be of practical use. 
 
 Profit and Loss statement, divided into sections or groups 
 and supported by schedules if required. 
 
 Special Schedules. 
 
 Certificate of Audit: The certificate should be as short and 
 concise as possible. Attempts to qualify a certificate are not 
 looked on wi^h favor, and unless an auditor has been greatly 
 restricted in the scope of the audit, it is his duty to conform as 
 nearly as possible to the "audited and found correct" style. Of 
 course, where qualifications are necessary they must go in with- 
 out fear or favor, but the point the author has in mind is the evi- 
 dent fear of many accountants that their certificates will be taken 
 seriously and acted upon, and in this fear they hedge them about 
 with all sorts of ambiguous qualifications. Sometimes they 
 sound like arguments, i. e., the certificate will read in efifect that 
 if so and so were done, so and so would be the result. Most 
 business men will listen to sound arguments before the report 
 is written, and the changes recommended might as well be made 
 in the balance sheet and thus permit the giving of an unqualified 
 certificate, which is always the most desirable. 
 
CERTIFICATES AND REPORTS 211 
 
 A form, variations of which are used by leading auditors, is 
 as follows : 
 
 The Board of Directors, 
 ABC Company. 
 
 We have audited the accounts of the ABC Company for the year ended 
 December 31, 1912. 
 
 We verified the Cash, the Inventories of Raw Materials and Supplies, 
 Work in Progress, and Finished Product, and the other current assets as 
 of December 31, 1912. 
 
 The Raw Materials and Supplies on hand and in process of manufacture 
 were priced at cost, except that where market values at December 31, 1912, 
 were less than cost, the inventories were reduced to market values. Sufficient 
 reserves have been made for probable losses on notes and accounts receivable. 
 
 We examined the charges to capital accounts and find them to represent 
 actual additions to the Company's property. Ample allowances have been 
 made for depreciation of plants. All known liabilities have been included 
 in the accounts. 
 
 We Hereby Certify that in our opinion the accompanying balance sheet 
 and profit and loss statement correctly presents the financial condition of the 
 Company as of December 31, 1912, and its operations for the year ended 
 with that date. 
 
 (Signed) X Y Z, 
 
 Certified Public Accountants. 
 
 If qualifications are necessary, the above form can be used as 
 a basis and the qualifications mentioned in their proper place. 
 
 Where a shorter form is wanted for a certificate which is to 
 be appended to the condensed balance sheet used by note brokers 
 and others, the following is acceptable : 
 
 We have audited the accounts of the D E F Company for the year ended 
 November 30, 1912, and 
 
 We Certify that the above balance sheet is in our opinion a correct state- 
 ment of the financial condition of the Company as of November 30, 1912, and 
 that the accompanying profit and loss statement is correct. 
 (Signed) R S T, 
 
 Certified Public Accountants. 
 
 The question sometimes arises as to how to submit a balance 
 sheet and report thereon when the audit is made so long after the 
 balance sheet date that adjustments cannot be made as of that 
 date, and the auditor cannot certify that the balance sheet "agrees 
 with the books and is correct." The best way is to have the 
 
212 AUDITING 
 
 entries journalized before the report is written, and no matter 
 how long after the date, the entries should read "as of" the date 
 of the balance sheet, and when posted to the ledger the items 
 should be connected with the closing date by a star, or asterisk. 
 Subsequent trial balances and any subsequent references will 
 then find the accounts in order, and there can be no difficulty if 
 the necessity arises for their being reconciled with the balance 
 sheet. 
 
 Wherever the auditor's recommendations as to adjustments 
 of asset or liability items are not or cannot be adopted and 
 recorded "as of" the date of the balance sheet, the most satis- 
 factory form of report thereon is to submit the balance sheet as 
 shown by the books and precede this with comments which will 
 be bound with and permanently attached to the balance sheet, so 
 that improper use cannot be made of the balance sheet by remov- 
 ing the quahfying comments. 
 
 Clients do not always appreciate the position of an auditor 
 with respect to the use of balance sheets. Experience has shown 
 that they frequently hope for a more favorable statement than 
 they receive, and as the audit may be for the purpose of securing 
 credit, an unfavorable statement places the client in an embar- 
 rassing position. Auditors must always be on their guard, there- 
 fore, that balance sheets made up by them and subject to quali- 
 fication are not submitted in such form as will admit of their 
 being separated from the qualifications. 
 
 Based on long experience of his own and other firms, the 
 author believes that the only safe method of reporting is to use 
 paper bearing one's own watermark. This is not very expensive 
 when a considerable quantity of paper is used. 
 
 Where an auditor is able to construct his own balance sheet 
 and can certify thereon that it is correct, it does not make any 
 difference whether or not it is separated from the comments. 
 In fact, it is usually preferable to submit such a balance sheet 
 complete in itself. 
 
 Form of Balance Sheet: Many tiresome pages have been 
 written explaining, or trying to explain, why it is that universal 
 American custom decrees that assets shall be placed on the left 
 hand side of the balance sheet and liabilities on the right hand 
 side. The explanation is no more satisfactory than the reasons 
 
CERTIFICATES AND REPORTS 213 
 
 advanced by English authorities to support their custom of plac- 
 ing the liabilities on the left and the assets on the right. 
 
 The author ventures the following : 
 
 The English practice is purely the outcome of custom. A 
 long time ago some one started that way and every one since 
 has followed, until now the form has the sanction of law. (See 
 forms prescribed under the English Companies Act.) 
 
 The only sound reason the author can think of for the custom 
 is that a conservative Englishman looks for his Habilities first 
 and then looks to see if he has enough assets to discharge 
 them. 
 
 In the United States, accountancy has developed more scien- 
 tifically than in England. If a short cut is logical we take it. 
 When it was found that loose leaves were far more convenient 
 and economical to handle than leaves bound permanently to- 
 gether, we adopted them. So with balance sheets. It was ob- 
 served by accountants that the average American looks for his 
 assets first and subsequently glances at his liabilities in order 
 to assure himself that his excess of assets is as much as he be- 
 lieves it to be. 
 
 Furthermore, it is common sense for a man who decides to 
 record his financial condition to place his possessions first. Fre- 
 quently a man has few or no liabilities, so that the practice of 
 stating the assets first, then the liabilities, if any, as a deduction 
 therefrom, thus arriving at the surplus, is the logical presentation 
 applicable to the great majority of business enterprises in the 
 United States. 
 
 What may be styled the account form of balance sheet is one 
 with the assets on the left and the liabilities and net worth on 
 the right, this permitting an agreement between the totals of the 
 two sides. Sometimes a deficit exists and the bookkeeper's pas- 
 sion for making things balance is so strong that the deficit is 
 included among the assets ! The almost incredible result is that 
 practically all published balance sheets consist of a confusion of 
 figures on both sides which exactly agree in total. The reader 
 thereof who is not trained in accounts does not comprehend the 
 details, but he is reassured in some mysterious way when he 
 finally discovers that the liabilities at least do not exceed the 
 assets. 
 
214 AUDITING 
 
 The author's conception of an ideal balance sheet is one 
 which will set forth : 
 
 (i) The assets, properly valued and grouped, and arranged in 
 the order of their availability. 
 
 English law and custom may be against this form, but never- 
 theless it is the most readable and the most understandable to 
 the average business man. Furthermore, it has the sanction of 
 the bankers and credit men of this country, who use balance 
 sheets oftener than any other class. (See official forms, pages 
 217-223.) 
 
 (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 any- 
 one interested the net worth, or capital and surplus, of the enter- 
 prise. 
 
 (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 therefrom if there is a deficiency. 
 
 ASSETS 
 
 Current Assets: 
 
 Cash jSo. t 
 
 Notes and Accounts Receivable o. 
 
 Inventories O. o. 
 
 Deferred Charges to Operation: 
 
 Prepaid Insurance, etc o. 
 
 Plant Assets: 
 
 Real Estate o. 
 
 Machinery, Fixtures, etc o. o. 
 
 Good Will, Patents, etc o. 
 
 LIABILITIES 
 
 Notes Payable $0. 
 
 Accounts Payable o. 
 
 Accrued Wages o. o. 
 
 Bonded Debt " o. 
 
 Reserves o. o. 
 
 EXCESS OF ASSETS 
 
 (OR MET WORTH) 
 
 Represented by: 
 
 Capital Stock o. 
 
 Surplus (or Deficit) ... ... o, o 
 
CERTIFICATES AND REPORTS 
 
 215 
 
 The most popular form among large industrial corporations 
 which publish their balance sheet is as follows : 
 
 ASSETS 
 Plant Assets: 
 
 Including Real Estate, 
 Machinery, Patents, Good 
 Will, etc. 
 
 Deferred Charges to Operations: 
 Insurance, Interest, etc., 
 prepaid . . . . o. 
 Current Assets: 
 
 Inventories . . . o. 
 
 Accounts and Notes Re- 
 ceivable . . . . o. 
 Cash o. 
 
 LIABILITIES 
 
 Capital Stock 
 
 Bonded Debt 
 
 Current Liabilities: 
 Notes Payable 
 Accounts Payable 
 Accrued Wages, etc. 
 
 Reserves 
 Surplus . 
 
 00 . 00 . 
 
 But the above arrangement is not easy reading for one unac- 
 customed to accounts, and it presupposes that the reader can dis- 
 criminate between actual liabilities and surplus. So long as it 
 is unnecessary, it is unfortunate that the surplus must be in- 
 cluded under a caption which is misleading. 
 
 The following form is preferable : 
 
 ASSETS 
 Current Assets: 
 
 Cash .... 
 Notes and Accounts 
 Receivable . 
 
 o. 
 
 LIABILITIES AND CAPITAL 
 
 Current Liabilities: 
 
 Notes and Accounts Payable $o. 
 Bonded Debt . . . . o. 
 Reserves o. 
 
 Inventories 
 Deferred Charges to Opera- 
 tion 
 
 Plant Assets: 
 
 Real Estate, etc. 
 
 Good Wm, etc. 
 Total Assets 
 
 Total Liabilities . 
 
 Excess of Assets made up as 
 follows: 
 Capital Stock . . o. 
 Surplus (or deficit) o. 
 
 Total Liabilities 
 and Capital . 
 
 It is asserted that there is a demand for the form of balance 
 sheet at top of this page from those whose chief desire is to see 
 the relation of the fixed assets to the capital stock. But this 
 information could be more readily secured from the second form, 
 because where fixed items appear first it is usual to place the 
 
2i6 AUDITING 
 
 capital stock first among the liabilities and the surplus last. 
 As the surplus may be as large as or larger than the capital, it is 
 very necessary to have these figures nearer together, as provided 
 in the second form. 
 
 It is, of course, impossible to mention by name the assets and 
 liabilities which are found in different enterprises, therefore these 
 outline forms must be suggestive only. It is hoped that other 
 chapters of this book in which is pointed out the importance of 
 the auditor's placing himself as far as possible in the position of 
 the one who is to use the accounts will be more helpful in fram- 
 ing a balance sheet than a set form, which might apply in a few 
 cases, but which would be restrictive and therefore of little value 
 in others. 
 
 One general principle which should be observed in all balance 
 sheets is that the matter of the arrangement of the groups is 
 not of so much importance as the relation of one to the other. That 
 is, it does not greatly matter whether the fixed assets are first or 
 last, but it is important that the balance sheet shall indicate, if 
 at all possible, the relation of the fixed assets to the other assets 
 and to the liabilities. For instance, a concern owning a million 
 dollars of fixed assets should have a capital and surplus, or 
 funded debt, of at least as much, otherwise the current liabilities 
 would be excessive. 
 
 Statement Required by Banks : For some years bankers have 
 required borrowers to furnish statements of their assets and lia- 
 bilities. At first a uniform statement was not insisted on, but 
 it was found that some borrowers were disinclined to submit full 
 reports and others did not know what details the banker wanted. 
 Individual banks thereupon compiled their own forms and fur- 
 nished blanks to their customers. These blanks were by no means 
 uniform, and as many borrowers used more than one bank, the 
 diversity became a nuisance to both banks and borrowers. The 
 former, in exchanging credit information with other banks, found 
 comparisons difficult, and the latter were put to unnecessary 
 trouble in arranging and rearranging their statements. 
 
 Finally an attempt was made through the various bankers' 
 associations to formulate a uniform or standard blank which 
 would embody the information most useful to banks. This plan 
 was entirely successful and resulted in the present standard form 
 
CERTIFICATES AND REPORTS 
 
 217 
 
 of borrowers' statement. The form which is reproduced here- 
 with is that officially adopted by the New York State Bankers' , 
 Association : 
 
 STANDARD FORM OF BORROWERS' STATEMENT 
 TO THE BANK: 
 
 For the purpose of procuring credit from time to time with you for our 
 negotiable paper or otherwise, we furnish the following as a true and accurate 
 statement of our financial condition on ... . 191 . . . , which we may hereafter 
 be considered as representing to be a true statement of our financial condition 
 unless notice of change is given you. 
 
 ASSETS 
 
 Cash on hand and in bank ...... 
 
 Notes Receivable of customers (not transferred) 
 Accounts Receivable of customers (not transferred) 
 Notes and Accounts Receivable of officers (not 
 
 transferred) 
 
 Merchandise finished (how valued ) . 
 
 " unfinished (how valued ) . 
 
 " . raw material (how valued ) 
 
 Land owned by corporation, used for this business 
 Buildings owned by corporation, used for this busi- 
 ness 
 
 Machinery owned by corporation, used for this busi- 
 ness 
 
 total' 
 
 LIABILITIES 
 
 Notes Payable given for merchandise . 
 Notes Payable negotiated to own banks 
 Notes Payable otherwise disposed of . . . 
 
 Accounts Payable 
 
 Deposits of Money with Us 
 
 Bonded Debt (when due) 
 
 Mortgage Debt 
 
 Chattel Mortgages ... . . 
 
 Total Liabilities 
 
 Capital . 
 
 Surplus including Undivided Profits . 
 
 TOTAL 
 
2i8 AUDITING 
 
 STANDARD FORM OF BORROWERS' STATEMENT— Continued 
 CONTINGENT LIABILITY: Notes Receivable of customers Discounted 
 
 or Sold and not included in assets enumerated above $ 
 
 Other contingent liability $ 
 
 We Have Not Pledged or Assigned any of the above Accounts Receivable; 
 
 our Assigned Accounts Receivable amount to $ 
 
 Other assets used as collateral 
 
 INSURANCE: on merchandise $ buildings $ 
 
 machinery $ Total Insurance 
 
 BUSINESS and RESULTS: Annual Sales for the year ended 191 . . 
 
 or from ; . .191. .to 191 . . 
 
 Gross Profits on Sales for the same period $ 
 
 Expense of Conducting Business " " " " 
 
 Net Profit " " " " 
 
 Other Income including investments " " " " 
 
 Combined Profit " " " " 
 
 DIVIDENDS PAID for the period 191. .to 191..$ 
 
 BAD DEBTS for the period 191 . .to 191 . .$ 
 
 CAPITAL: Authorized $ Issued jS 
 
 Par Value $ per share 
 
 BANK ACCOUNTS: where kept 
 
 MORTGAGES and BONDS on what assets a lien 
 
 Average TERMS on which we SELL 
 
 Average TERMS on which we BUY 
 
 TIME OP YEAR when NOTES and ACCOUNTS RECEIVABLE of CUS- 
 TOMERS, Uncollected, are generally maximum 
 
 minimum 
 
 TIME OP YEAR when STOCKS of MERCHANDISE on hand are generally 
 maximum minimum 
 
 TIME OF YEAR when LIABILITIES are maximum 
 
 minimum 
 
 STATEMENT: is it based on actual inventory? 
 
 if so. Date 
 
 VERIFICATION: have the books been audited by a Certified Public Ac- 
 countant? if so, Name and Date of Audit 
 
 (Sign corporation name) 
 
 Date Signed 191 . . 
 
CERTIFICATES AND REPORTS 219 
 
 This form is more explicit and desirable than that officially 
 recommended by the American Bankers' Association. In the 
 New York State form the matter of hypothecations is brought 
 prominently to the attention of the prospective borrower. In the 
 light of many unfortunate experiences where liens on accounts 
 and stock-in-trade have been concealed, the importance of this 
 possibility is unquestioned. 
 
 Furthermore, in the American Bankers' form there is danger 
 in the arrangement of the Assets and Liabilities in that Re- 
 serves are not deducted from the former nor included among 
 the latter, thus permitting the inference that by deducting the 
 liabilities as shown from the assets as shown the net worth of the 
 corporation may be ascertained. 
 
 It is true that reserves are not liabilities, but where they are 
 created in order to provide for depreciation, bad debts, etc., the 
 aggregate thereof is a direct deduction from the assets, and 
 borrowers should not be encouraged in the belief that a banker 
 considers that the "total" assets and the "total" liabilities may be 
 stated before consideration is given to items which are in fact 
 directly related thereto. 
 
220 
 
 AUDITING 
 
 The following is the "short form" recommended by the 
 American Bankers' Association : 
 
 ASSETS 
 
 
 
 
 
 LlABILlTlEb 
 
 
 
 
 
 
 
 
 
 
 Notes Payable 
 Accounts Payablb 
 Deposits 
 Bonded Debt 
 Mohtgagbb 
 Accrued Liabilities 
 
 TOTAL 
 Capital 
 
 Surplus— pROFiTfl 
 Reserves 
 
 TOTAL 
 
 
 
 
 
 Bills Rbcbivablb fNKT) 
 AccouKTS Receivable (nbt) 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Buildings 
 
 
 
 
 
 M ACBIN BRY— FlXTDBES 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 ■ "i 
 
 
 
 TOTAL 
 
 1 1 
 
 1 1 ■ 
 
 CONTINGENT LIABILITIES. On bills receivable discounted Other. . 
 
 CASH. On hand and In bank, $ Names of banks 
 
 BILLS RECEIVABLE . Any overdue or doubtful I Any from officera, directors, aub-companies, or similar Bources! 
 
 ACCOUNTS RECEIVABLE. State amount doubtful, not from cnatomera or in any way not realizable within Immediate future. . 
 
 MERCHANDISE. Finished ITnfinished Raw Valued at cost or market ? Is all salable J 
 
 LAND. Describe briefly Aseesaed value Market value 
 
 BUILDINGS. Cost ^ Age Depreciation 
 
 MACHINERY AND FIXTURES . Cost $ Depreciation Condition., 
 
 OTHER ASSETS . 
 
 Are any of assets unavailable for paying debts t Losses.. 
 
 INSURANCE. State what kind and amount. . 
 
 NOTES PAYABLE. To own hanks Through brokers Otherwise . 
 
 ACCOUNTS PAYABLE. Terms of purchase ? Do you discount and anticipate J 
 
 DEPOSITS. Thne or demand ! From whom ! Interest 
 
 BONDED DEBT AND MORTGAGES. Due? Rate On what assets a lient.. 
 
 ACCRUED LIABILITIES. Itemize 
 
 CAPITAL. Preferred Authorized $ Issued ^ Dividends Common Authorized ^ Issued^ Dividends |.. 
 
 RESERVES. Itemize 
 
 -NET SALES. 
 
 Last fiscal year ■•... 
 
 Cost of sales h 
 
 Grosi profit 
 
 Interest^ taxes, depreciation, etc 
 
 Dividends paid _ 
 
 Surplus for year „ 
 
 Have the books been audited by a Certified Public Accountant!.... If so, give name of firm and date of audit.. 
 
 CORPORATE NAME.. 
 
 By.. 
 Data signed 
 
 Office address Nature of Busineia... 
 
 Location of plants and branch offices , 
 
 (State officer's title) 
 
CERTIFICATES AND REPORTS 221 
 
 To a professional auditor the question, "Have the books been 
 audited by a Certified Public Accountant?" is of particular inter- 
 est. This question was suggested by James G. Cannon, Presi- 
 dent of the Fourth National Bank of New York City, one of the 
 foremost bankers of the country, who has for many years advised 
 bankers to use professional auditors more generally. 
 
 Unfortunately for both bankers and auditors, the former have 
 not had the nerve to take this advice except to a limited extent. 
 There have, however, been some "horrible examples" where the 
 calling in of auditors previous to making loans would have saved 
 the banks millions of dollars. 
 
 It will be noticed that the bankers wish to read the state- 
 ments just reproduced along the lines advocated on page 214 
 hereof; that is, they want to know about the assets in the order 
 of their availability, and want to ascertain the liabilities in the 
 order they must be discharged. 
 
 In order that there may here be a full presentation of the 
 forms in general use throughout the United States, we will next 
 consider the ones issued by the mercantile agencies. These 
 forms are supplied to practically every business concern in exist- 
 ence, and are therefore more familiar to the average business man 
 than any other. The arrangement is not ideal by any means and 
 the information which may be gathered from it falls far short of 
 that supplied by the bankers' and credit men's associations. It 
 is possible that the agencies do not feel at liberty to request as 
 full a statement as the others, but it is obvious that their forms 
 might be improved without seriously aiifecting their chances of 
 securing information. The corporation forms in use by the two 
 large agencies are as follows : 
 
222 
 
 AUDITING 
 
 FIRST FORM 
 STATEMENT OF FINANCIAL CONDITION 
 
 Name 
 
 Engaged in the business of 
 
 Located at 
 
 From Inventory of 19 . . 
 
 Dated 19 . 
 
 .per cent. 
 
 Under what State laws incorporated? When? 
 
 Authorized Capital? Subscribed Capital? . . , 
 
 Preferred Stock? Common Stock? 
 
 Bonded Debt Bearing interest at . . 
 
 ASSETS 
 
 Stock on hand, raw and finished $ 
 
 Amount of book accounts considered good .... 
 
 Amount of notes considered good 
 
 Cash in Bank . . . . . . . 
 
 Cash on hand 
 
 Machinery and fix ures 
 
 Any other assets, exclusive of patent rights . . . 
 
 REAL ESTATE, consisting of. 
 
 Total Assets 
 
 LIABILITIES 
 
 For merchandise . . . . $ 
 
 For machinery and fixtures 
 
 For borrowed money . . , 
 
 For mortgage on real estate . 
 
 For all other liabilities . . . 
 
 Total Liabilities $. . . 
 
 Total Assets over Liabilities $ . . . 
 
 Is the surplus at the risk of the business? 
 
 Do you keep books of account of the business? 
 
 If so, what books? 
 
 Do you borrow on accounts receivable? 
 
 Date last dividend declared How much . 
 
 INSURANCE ON STOCK, $ ON BUILDINGS, 
 
 Annual rent, $ Annual business, $ 
 
CERTIFICATES AND REPORTS 
 
 223 
 
 .19 
 
 SECOND FORM 
 
 ASSETS .... 
 
 Cash in banks 
 
 Cash on hand ..... 
 Notes receivable, actual value 
 Accounts receivable, actual value 
 Merchandise (finished and unfinished) 
 Raw material ... 
 Machinery and fixtures . 
 
 Real Estate . 
 
 Other investments (not including patents, trade-marks, 
 
 patterns, etc.) 
 
 Total Assets 
 How much, if any, of above Accounts Receivable have 
 
 been assigned or pledged for loans . 
 
 LIABILITIES. 
 
 Capital stock paid in 
 Surplus and undivided profits 
 Bills payable .... 
 Accounts payable 
 Bonded debt .... 
 Mortgage on real estate (not included as Bonded debt) 
 Chattel mortgage on all kinds of property . 
 Borrowed money from banks (not included above) . 
 " " " individuals (not included above) 
 
 All other liabilities 
 
 Total Liabilities 
 
 How much, i£ any, of the above indebt- 
 edness is past due . . . $ 
 
 ■19 
 
 CAPITAL 
 
 Authorized Subscribed 
 
 Common Stock . $ j5 
 
 Preferred Stock . $ $ 
 
 How PAID in: 
 
 In cash $ 
 
 Patents, trade-marks, patterns, etc. $ 
 
 In .other property . . . . $ 
 
 Give particulars and the value of each kind of property. 
 
 Paid in 
 
 Amount of annual business 
 
 Amount of annual expense 
 
 Annual dividend ^ 
 
 Surplus (not including undivided profits) 
 
 Indebtedness of company to stockholders included in liabilities . 
 
 Amount of insurance on merchandise 
 
 Amount of insurance on buildings and plant .... 
 
 Ever had a fire; if so, give particulars 
 
 Other interests of principal directors 
 
CHAPTER XVI 
 CERTIFICATES AND REPORTS (Continued) 
 
 Statements Requested by Credit Managers: The scientific 
 granting of credit requires a high degree of ability, and this is 
 possessed by the modern credit manager, or he would not occupy 
 the important position which he fills to-day. Nevertheless, he 
 does not depend solely on the data he can secure from the mer- 
 cantile agencies and similar sources, and many concerns have 
 adopted their own system of credit reports from customers and 
 prospective customers. 
 
 The form recommended and indorsed by the National Asso- 
 ciation of Credit Men does not differ materially from that used 
 by bankers, but it is believed that the exact form will be of inter- 
 est to those who are anxious to ascertain the point of view of 
 men to whom reports are frequently addressed. As stated else- 
 where, the auditor who prepares his reports in a form easily read 
 and easily understood by those for whom they are intended will 
 be the most successful. 
 
 Preceding the form is the following pertinent observation: 
 
 Large assets are not always necessary to the creation of credit. What 
 is most desirable is, that credit be in relative proportion to the actual assets. 
 The giver of credit is a contributor of capital, and becomes, in a certain 
 sense, a partner of the debtor, and, as such, has a perfect right to complete 
 information of the debtor's condition at all times. 
 
 Those accountants who call a deficit an asset and classify 
 capital stock and surplus as liabilities will be shocked to see the 
 informality of the following form. It brings out in strong relief, 
 almost brutally, the "total active business assets," and the "total 
 business liabilities"; and it is evident from the spaces provided 
 that the difference between the two must be the "net worth." 
 
 It is a corporation blank, but the intelligent mind that de- 
 vised the form was not hampered by the fetish of trying to make 
 the two sides balance, but went straight to the point and asked 
 for the information which a credit manager, or a business man, or 
 a banker wants. Too much emphasis cannot be placed upon this. 
 Clients assume that their own bookkeepers can prepare trial bal- 
 
 224 
 
CERTIFICATES AND REPORTS 225 
 
 ances ; that is, if they think about the matter of balancing at all. 
 Professional auditors must get away from the delusion that every 
 item in a trial balance must be transferred to a balance sheet. 
 
 The author does not advocate a change in the present system 
 merely because it has been demonstrated time and time again 
 that bankers and business men want some other form of state- 
 ment than that which has been thrust upon them by accountants 
 who are still only bookkeepers, but because the scientific manner, 
 of presentation is that which reduces figures to readable form 
 and which discloses facts rather than book balances. 
 
 This form of statement may be considered crude by the tech- 
 nical auditor, but the author ventures the opinion that if it is pre- 
 sented to one hundred business men, side by side with the usual 
 debit and credit form of balance sheet, ninety-nine will express an 
 immediate and emphatic preference for the one now shown : 
 
 CREDIT STATEMENT RECOMMENDED BY NATIONAL 
 ASSOCIATION OP CREDIT MEN 
 
 To 
 
 For the purpose of obtaining credit now and hereafter for goods purchased, 
 we herewith submit to you the following statement of our resources and liabili- 
 ties, and will immediately notify you of any material change in our financial 
 condition. 
 
 In consideration of your granting credit to the undersigned, we agree that 
 in case of our failure or insolvency, or in case we shall make any assignment 
 for the benefit of creditors, bill of sale, mortgage, or other transfer of our 
 property, or shall have our stock or plant attached, receiver appointed, or 
 should any judgment be entered against us, then all and every of the claims 
 which you have against us shall at your option become immediately due and 
 payable, even though the term of credit has not expired. All goods hereafter 
 purchased from you shall be taken to be purchased subject to the foregoing 
 conditions as a part of the terms of sale. 
 
226 
 
 AUDITING 
 
 Active Business Assets 
 
 Value of merchandise on hand at cost 
 
 If manufacturing, raw material, $ 
 
 finished, | unfinished, $ . . 
 
 Notes and accounts, cash value 
 
 Cash in hand 
 
 Cash in bank 
 
 Bills or accounts receivable, due from officers . 
 
 Patents and patterns 
 
 •Fixtures and machinery 
 
 Total real estate, cash value $ 
 
 Total encumbrances on real estate, | 
 
 Equity . 
 
 Total Active Business Assets . 
 
 Dollars 
 
 Cents 
 
 Business Liabilities 
 
 Owe for merchandise, open acct., 
 
 of which $ is past due 
 
 Owe for notes for merchandise . . 
 
 Owe banks 
 
 Owe for bills for paper sold 
 
 Owe others for borrowed money 
 
 Owe taxes and rent 
 
 Mortgages on fixtures & mach'y 
 
 Total Business Liabilities . . . 
 
 Net Worth in Business .... 
 Name in Full 
 
 President 
 
 Vice-President 
 
 Secretary 
 
 Treasurer 
 
 Dollars 
 
 Cents 
 
 OFFICERS 
 
 Address 
 
 DIRECTORS 
 
 The above statement, both printed and written, has been carefully read by 
 the undersigned, and is a full and correct statement of our financial condition 
 
 as of 191. . . 
 
 Dated 191 . . Corporation Signature 
 
 Town State By 
 
 Accommodation Indorsements 
 
 Indorsed Bills Receivable and Outstanding 
 
 Contingent 
 Liability 
 
 Authorized Capital . 
 
 Subscribed Paid in 
 
 How paid in: Cash, jS 
 
 Other property 
 
 Incorporated in what State and under what General Laws or Special Act?. 
 
CERTIFICATES AND REPORTS • 227 
 
 Nature of business? 
 
 Date of charter? 
 
 Suits pending, and of what nature? . 
 
 Are any merchandise creditors secured in any way? 
 
 Amount of annual business 
 
 Annual expenses Annual dividends 
 
 When was last dividend declared? 
 
 Rate Insurance carried on merchandise. . . . 
 
 On fixtures and machinery On real estate. 
 
 Regular time of taking inventory 
 
 Keep bank account with 
 
 Keep the following books of account . 
 
 If you have pledged or transferred outstanding accounts or property remaining 
 
 under your control, state amount thereof and amount received, or to be 
 
 received, on account of such pledge or transfer 
 
 Remarks 
 
 Liens and Hypothecations: Instances have been known where 
 certified balance sheets have gone out wherein accounts receiv- 
 able and merchandise inventories, included among the assets 
 without any qualification, have, as a matter of fact, been pledged 
 as security for loans, and thus were not assets in the sense which 
 anyone making use of the balance sheets had a right to assume. 
 
 A concern might have accounts receivable of $10,000 and 
 stock-in-trade of $10,000, with accounts and bills payable of 
 $15,000. If the latter were entirely unsecured, a prospective 
 creditor might extend further credit if the concern's standing 
 were good, on the theory that in the event of bankruptcy there 
 could be a shrinkage in the assets of twenty-five per cent before 
 a creditor would lose anything. 
 
 But suppose it were found that all of the accounts receivable 
 had been assigned to, and a chattel mortgage on the stock taken 
 by, a creditor for $10,000. This would mean that in bankruptcy 
 the unsecured creditors would probably receive nothing. 
 
 The professional auditor must never certify to a balance sheet 
 without fully considering the possibilities of liens upon the assets, 
 and if any are discovered, such liens must be plainly indicated on the 
 face of the balance sheet or mentioned in the certificate, otherwise he 
 is guilty of suppressing material information and can probably be 
 held responsible in damages to any one relying thereon who suffers 
 loss in consequence. 
 
228 AUDITING 
 
 If there is any difficulty in securing information of this 
 nature, the auditor may have to ask the question shown in the 
 credit men's standard form. If he fihds no trace of liens, and the 
 officers or partners state in writing that there are none, then he 
 could not be held guilty of negligence. It would not do, how- 
 ever, to rely on not finding any evidence ; there should be affirm- 
 ative proof that no liens exist. 
 
 PROFIT AND LOSS STATEMENT 
 
 A profit and loss statement is one which assembles all of the 
 income and expenses, or gains and losses, for a stated period. It 
 is synonymous with the "Revenue" statement sometimes pre- 
 sented, but as the term "Revenue" is more frequently used to 
 designate one side only of a profit and loss account, the term is 
 not properly applicable to a statement which includes expenses 
 as well as income. 
 
 The profit and loss statement may be divided into as many 
 sections as are desirable or necessary. The student of account- 
 ancy is usually taught to prepare the profit and loss statement in 
 two sections, the first being a trading or a manufacturing ac- 
 count, the second section being called the general profit and loss 
 account. This illustrates the principles of grouping and enables 
 percentages to be calculated which are extremely valuable for 
 comparative purposes. The trading or manufacturing account 
 usually shows on one side net sales, and on the other prime costs 
 of sales; i. e., materials used, labor, and other direct expenses. 
 In some cases other expenses are included, such as rent, interest, 
 taxes, etc. 
 
 In modern practice it is not customary to submit a trading or 
 a manufacturing account under these captions. The experienced 
 auditor or accountant compiles a profit and loss account suited 
 to the requirements of each enterprise upon which he is report- 
 ing, and in a form understandable to those who are to use the 
 report. 
 
 The following condensed form of Profit and Loss statement 
 was submitted to the St. Louis Congress of Accountants in 
 1904 by A. Lowes Dickinson, C. P. A. : 
 
CERTIFICATES AND REPORTS 
 
 Gross Earnings (whether sales of products, transportation 
 
 earnings, professional earnings, etc.) 
 
 Deduct — Cost of Manufacture or Operation: 
 
 (a) Manufacture (for a manufacturing concern) ■ 
 
 Labor $ 
 
 Material 
 
 General Manufacturing Expenses 
 
 (6) Cost of Operation (for concerns not manufacturing) : 
 (Under suitable headings accord- 
 ing to the nature of the busi- 
 ness) 
 
 229 
 
 Gross Profits 
 
 Other Earnings 
 
 Dedtict — 
 
 Expenses of Sale (Manufacturing busi- 
 ness only) $. . 
 
 Expenses of management (if distinct 
 from operation) 
 
 Net Profits from operations .... 
 
 Deduct — 
 
 Interest on Bonds $■ 
 
 Other fixed Charges 
 
 Surplus for the year 
 
 Extraordinary Profits (detailed) . 
 
 Surplus brought forward from preceding year 
 
 Deduct — 
 
 Extraordinary charges not applicable to 
 
 the operations of the year . . . $. 
 Interest and Dividend on Stocks . 
 
 Surplus carried forward 
 
230 AUDITING 
 
 Where further information is required the condensed state- 
 ment is supported by schedules or exhibits which go into as much 
 detail as may be necessary. 
 
 The auditor should strive so to arrange the accounts as to 
 show a comparison with previous periods; also, wherever the 
 nature of the business permits, unit costs or earnings should be 
 shown. For instance, the accounts of a taxicab company, if 
 properly set up, will show the average gross earnings of cabs per 
 day. They will also show the operating cost per mile. Perhaps 
 the simplest illustration is a blast furnace. Here it is relatively 
 easy to determine the cost of producing a ton of pig iron, but 
 the figures would be of little value unless the output were shown 
 with the average cost. The production for one week might be 10,000 
 tons and the average cost $8 per ton ; the next week if the pro- 
 duction were 15,000 tons and the cost $8 per ton, the natural 
 inquiry would be : Why is the cost not proportionately less upon 
 the greater output? If the cost per ton were reported sepa- 
 rately from the production, attention might not be called to the 
 possibility of lower costs being in order. 
 
 The relation which each class of expense bears to the total 
 value of business is always interesting. In dull times it may be 
 expected that certain so-called fixed charges will not vary, but 
 there are other classes of expenses which should fluctuate ratably 
 with the volume of business. 
 
 The auditor who states the accounts of a number of concerns 
 in the same line of business can readily acquire a knowledge of 
 income and costs which he may impart for the benefit of all at 
 the expense of none. He must not divulge to one client the 
 affairs of another, but if he ascertains that the office staff of one 
 wholesale grocer costs one per cent per annum of the sales, while 
 another costs one half of one per cent and is equally or more 
 efficient, he certainly is justified in making a special investigation 
 into the matter, and cannot be criticized for reporting that one 
 per cent is excessive. 
 
 Use of Charts : The use of charts by engineers probably dates 
 back to the early days of that profession; likewise, the use of 
 charts by accountants can be traced back many years. Their use, 
 however, is by no means general, although there are occasions 
 when a chart can portray a situation far more graphically than 
 
CERTIFICATES AND REPORTS 231 
 
 columns of figures, particularly to a man who is more used to 
 blue prints than to accounts. When accountants can visuaHze 
 figures as an architect can a building, their reports will be more 
 popular. 
 
 Sales Charts. An effective use of charts can be made in a 
 wholesale or retail trading concern where the question of com- 
 parisons is of great importance. A chart can be prepared at 
 the commencement of a fiscal year showing the comparative 
 
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232 AUDITING 
 
 sales by mionths and the cumulative totals for the preceding 
 year, e. g. : 
 
 It will be noted from the above that during the preceding 
 year the monthly sales in February were $14,000, going up to 
 $18,000 in June, down to $16,000 in September, up to $19,000 in 
 December, and down to $17,000 in January. These -figures are 
 shown by the dotted black line. The new year (solid liae) com- 
 mences with $16,000, a gain over the previous year as clearly 
 shown by the chart. In May the increase is not only maintained, 
 but the rate of gain is increased. 
 
 In other words, a chart will show a trend which columns of 
 figures fail to emphasize. The best place for a chart of this kind 
 is on the wall of an office or on a map holder. It may be kept 
 private by having a cover over it, or it may be rolled up. The 
 auditor may submit a sample chart, based on past experience, 
 which will indicate the possibilities of the plan. 
 
 Gross and Net Profit Charts: It is sometimes difficult for a 
 business man to calculate how much gross profit he must make 
 to cover his general expenses. The use of a chart will assist him 
 to solve his problem. 
 
 The chart opposite illustrates the fact that in any business 
 there is a point above which increases in sales return a net profit 
 greater proportionately than the increase in sales. In other 
 words, above a certain point any increase in sales occasions an 
 increase in direct cost, but does not necessarily increase the over- 
 head or indirect expense at all. The result is that the percentage 
 of profit is greater. 
 
 The chart shows that from January to June cost and ex- 
 penses were increasing, and that when the slump in sales came in 
 July and August, the expenses were not reduced in proportion. 
 The result was that in September the sales were just enough to 
 cover cost and expenses. Had the expenses been kept down to 
 the point at which they started in January, the reduction in 
 direct cost due to the decrease in sales would have kept the total 
 cost well below the low point reached by the sales. The lower 
 line represents the net profit realized. 
 
 It will be noticed from the chart on page 233 that whenever 
 the gross sales are above $10,000 per month, the net profit 
 increases rapidly, and below $10,000, the net profit drops at once; 
 
CERTIFICATES AND REPORTS 
 
 233 
 
 After a little experience the business man will be able to see the 
 danger mark. 
 
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 Combined Purchase and Sales Charts : If business is not good 
 purchases may represent an unnecessary risk as compared with 
 sales. A chart would show the sales and purchases month by 
 month, thus giving instant expression to an expansion of one 
 against a contraction of the other, as shown on page 234. 
 
 It will be noted that in June the sales fell off, but that the 
 purchases kept up the regular advance, and that by November 
 the sales were actually less than the purchases, indicating an 
 enormous increase in the inventory. If the chart had been kept 
 
234 
 
 AUDITING 
 
 up to date the proprietor would have noticed the trend in July 
 and purchases might have been cut down at once. 
 
 It may be objected that a good business man always keeps in 
 touch with such important matters and that while such a chart 
 might be of interest to him it would have no practical value. 
 This is true of many men, but it is not true of the many who have 
 
 
 
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 such a poor clerical staff that they cannot depend on their re- 
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 to understand the monthly "trial balances" which they receive. 
 
 Charts like the above can be kept up day by day so far as 
 sales are concerned. As to purchases, all depends on the method 
 of entering invoices. If compiled monthly only, of course the 
 chart can be posted only once a month, but if it is looked after, 
 say, by the loth of each month, it will be up-to-date enough to be 
 of substantial value. 
 
CERTIFICATES AND REPORTS 
 
 235 
 
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 This "graph" shows the foundry payroll. It is divided into three sections ; the first shows nuraher of 
 men employed ; the second, the numoer of hours worked ; and the third, the rate of wage. The dotted 
 lines in sections one and two show the actual number of men employed; the broken lines show the 
 same actual monthly results for 1910. 
 
236 
 
 AUDITING 
 
 
 
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 This "graph" shows the product in the foundry and the shipments of malleahleB— cumulative monthly 
 
 averages in each. This tells, ar. a c-' ^.-~i.-i ^--- j= j.-- -- _,___^,.- 
 
 and against producing less ^ 
 '"product," all was well, " 
 gate. 
 
CERTIFICATES AND REPORTS 237 
 
 The illustrations shown on pages 235 and 236 are taken from 
 System and are illustrative of the use of charts in relation to 
 labor and production statistics. 
 
 Value of Comparative Statistics: The head of the fidelity 
 department of one of the large surety companies states that a 
 great many irregularities and defalcations, especially through the 
 padding of pay rolls, would be uncovered in their infancy if the 
 managements of factories and commercial business houses would 
 pay more attention to their accounts and have compiled by their 
 accounting department comparative statistics of their business 
 — and then study them. He cites the case of a cashier of a man- 
 ufacturing concern who had been padding the pay roll for years. 
 It was the practice of this concern to have the pay roll approved 
 by the foreman, the superintendent, and the general manager. 
 It would then be sent to the cashier, who made alterations in the 
 total figures, drew a cheque for the raised amount, cashed it, 
 and paid off the men. The pay roll did not leave the cashier after 
 it was given to him to draw the cheques, he making the distribu- 
 tion for posting. This went on for years, the cashier each week 
 pocketing from two to nine hundred dollars, until a change of 
 executives brought in a manager who had been accustomed to 
 getting his accounts down so as to show the economic condition 
 of his business in statistical form. He had been in the same line 
 before and he knew that the price of raw material, the rates for 
 wages, and the various expenses were about the same as in his 
 former place, but the profit and loss account showed a much 
 smaller net profit. It was soon found that this was due to the 
 high charge for labor, and upon analysis of this charge the steal- 
 ings were discovered. 
 
 This is but one instance, but it is not hard to see that in show- 
 ing the results of a business in graphic form so that the relation 
 of the various elements, one to another, is easily seen, abnormal 
 conditions are at once detected. Some men will say that those 
 things are interesting and all very well if one had the time and 
 money to get them up. They do not realize the cost of not get- 
 ting them up. Statistics compiled by one of the large bonding 
 companies show that during the last three weeks of March and 
 the month of April, 191 1, shortages amounting to more than one 
 half million dollars were discovered in mercantile houses alone. 
 
238 AUDITING 
 
 What Not to Report: As heretofore stated, it is not wise to 
 report unimportant errors, etc., first, because it accomplishes no 
 useful purpose, if true. In any event criticisms of this nature 
 should never be made without confirmation from the office staff, 
 as they might be able to come back with proof that the errors or 
 omissions were apparent only. 
 
 Likewise, long schedules of trade debtors and creditors are 
 superfluous. For some years public accountants made it a rule 
 to furnish their clients with detailed schedules of accounts receiv- 
 able and payable, believing that such information was desired by 
 them and would be of value. They found, however, that in nine 
 cases out of ten these schedules were not referred to, and in the 
 one case remaining the schedules desired were the latest ones 
 rather than the ones submitted by the auditors, which were usu- 
 ally one or two months old. The practice was, therefore, quite 
 generally abandoned, and these schedules are now furnished only 
 on request. 
 
 In reports where special circumstances govern, such as 
 changes in partnership, it may be necessary to submit detailed 
 schedules. But the above remarks refer to the ordinary period- 
 ical audit. 
 
 A schedule of vouchers and paid cheques not submitted is 
 sometimes of importance, but, as a rule, it is more desirable to 
 prepare such a list before the end of the audit and hand a dupli- 
 cate to the bookkeeper, so that the missing vouchers may be 
 located. After as many as possible are located, the corrected list 
 should be handed to the proprietor with a request that he look 
 over it. If further inquiry or search is requested, it should be 
 made before the audit is completed. If no further attention is 
 required, the schedule is not important enough to put in a 
 report. 
 
 The auditor should scan the list of outstanding unpaid bank 
 cheques. A cheque is sometimes issued to close a disputed account, 
 etc., which renders it desirable from both the client's and the 
 auditor's point of view that it be used. The inspection would 
 apply only to those outstanding an unreasonable length of time. 
 If any doubt arises the matter should have attention at once, and 
 no mention need be made in the report unless some irregularity 
 is discovered. 
 
CERTIFICATES AND REPORTS 239 
 
 Restrictions on Client's Use of Reports: Mention has been 
 made of attempted unauthorized use of auditors' reports and 
 certificates. This is obviated by a judicious selection of clients, 
 but it may happen that a client who has paid for a report will feel 
 at liberty to use part of the contents without disclosing the con- 
 text. Anticipating this possibility, experienced auditors bind 
 and fasten their reports securely together, and page them in such 
 a way that a part cannot be used without revealing the fact that 
 it is not complete. 
 
 It does not seem feasible to suggest any plan whereby clients 
 or others may be prevented from quoting from a report. So long 
 as the statement is not made that the quotation represents con- 
 clusions of fact to which an auditor has certified, it may not be 
 objectionable, but it is remarkable how critical business men are 
 with respect to the connection, or alleged connection, of a pro- 
 fessional auditor with men or enterprises of a doubtful character. 
 
 In one case a well-known firm of auditors had for many years 
 audited and certified to the accounts of a small and prosperous 
 corporation. A large concern bought the small company and 
 consolidated it with a number of others. The bankers who mark- 
 eted the stock stated in their circulars that the accounts of the 
 small company had been audited by one firm and the accounts of 
 all the others, and of the holding company, had been audited by 
 an audit (stationery) company. The latter continued the audit 
 until the holding company went into hopeless bankruptcy. The 
 firm was not connected with the enterprise after its clients sold 
 out, but after the bankruptcy a large banking house intimated 
 that the mention of the firm's name on a circular relative to a 
 company with such an objectionable history might seriously 
 afifect their own attitude in employing the firm for accountancy 
 work. 
 
 This is an extreme case, but it illustrates the great impor- 
 tance to an auditor of restricting the use of his name to profes- 
 sional work which is creditable to him in every way, and in con- 
 nection with clients or promoters who are beyond suspicion. 
 
 Misleading Advertisements: Auditors are sometimes re- 
 quested to compile data or statistics, or prepare calculations for 
 use in new enterprises. Great care must be taken to restrict the 
 use of the reports submitted for such purposes. 
 
240 AUDITING 
 
 Recently an issue of preferred stock was advertised and a 
 large bonus of common stock was offered as an inducement to 
 purchase. The following statement was made inter alia: 
 
 Based on reports of A & B, certified public accountants, on 
 manufacturing costs and selling price from six months operation 
 at part capacity of plant at Blank City, EARNINGS AT FULL 
 CAPACITY ARE ESTIMATED AT OVER THIRTY-FIVE 
 PER CENT ON THE COMMON STOCK AFTER PAY- 
 MENT OF SEVEN PER CENT DIVIDENDS ON PRE- 
 FERRED STOCK 
 
 The intention of the foregoing was cleaily to deceive. It was so 
 printed that everyone gathered the impression that the auditors 
 had made a report, based on which earnings equal to thirty-five 
 per cent on the common stock could be expected. 
 
 It may become necessary for auditors to print on their sta- 
 tionery some form of notice to the effect that no public use can be 
 made of the information conveyed unless a memorandum setting 
 forth the form of the proposed use is submitted for inspection. 
 
 Compulsory Reports: Compared with our lack of legal re- 
 quirements, it is of interest to note the reports which must be 
 prepared in England. 
 
 The following is an extract from Table A of the English 
 Companies Act of 1908 : 
 
 Section 106. Once at least in every year the directors shall lay before 
 the company in general meeting a profit and loss account for the period since 
 the preceding account or (in the case of the first account) since the incor- 
 poration of the company, made up to a date not more than six months be- 
 fore such meeting. 
 
 Section 107. A balance sheet shall be made out in every year and laid 
 before the company in general meeting, made up to a date not more than 
 six months before such meeting. The balance sheet shall be accompanied 
 by a report of the directors as to the state of the company's affairs, and the 
 amount which they recommend to be paid by way of dividend, and the 
 -amount, if any, which they propose to carry to a reserve fund. 
 
 Section 108. A copy of the balance sheet and report shall, seven days 
 previously to the meeting, be sent to the persons entitled to receive notices 
 of general meetings in the manner in which notices are to be given hereunder. 
 
 Audit: Section 109. Auditors shall be appointed and their duties regu- 
 lated in accordance with sections 112 and 113 of the Companies (Consolidation) 
 Act, 1908, or any statutory modification thereof for the time being in force. 
 
CHAPTER XVII 
 THE DETAILED AUDIT 
 GENERAL PRINCIPLES 
 
 Completed Audit: It was stated in Chapter V that before 
 commencing an audit the auditor should be furnished with a cor- 
 rect trial balance as of the closing date. This applies to what is 
 known as a completed audit, which is the term usually employed 
 to designate the audit where a complete fiscal or interim period 
 has elapsed and where a final report is to be made on the work 
 accomplished. The procedure outlined in this and succeeding 
 chapters is designed to cover such a completed audit. 
 
 Continuous Audit is the term applied to the supervision by 
 an auditor who attends at intervals during a period, and makes 
 a report of progress rather than a report which embodies a bal- 
 ance sheet and a profit and loss account. In modern practice this 
 distinction receives little consideration. Up-to-date concerns de- 
 mand monthly reports of operations, and monthly balance sheets 
 follow as a matter of course. 
 
 The auditor who is retained to' audit the accounts, and pass 
 on or prepare these monthly reports may be said to make a com- 
 pleted audit, although in some cases part of the audit work is left 
 until the end of the fiscal period. 
 
 In large enterprises where a detailed audit is made the auditor 
 may arrange to perform part of the work during the term in 
 order to forestall congestion towards the end of the period. 
 Sometimes the client requests that frequent visits be made so that 
 if errors of principle or clerical errors are being made they can 
 be detected and corrected before very much damage has been 
 done. It is important, too, that if fraud is being practiced it 
 should be discovered at the earliest possible date. Furthermore, 
 frequent and unexpected visits tend to keep the client's staff 
 up-to-date in their work, and carelessness as well as actual errors 
 may be disclosed. The moral effect is also valuable. 
 
 If a large amount of detail work is to be verified, it is impor- 
 
 241 
 
242 AUDITING 
 
 tant that it be completed as soon after the closing date as possible 
 in order that the auditor's report may be submitted within the 
 shortest possible time thereafter. 
 
 Where interim audits are made and the auditor relies in 
 subsequent audits on the work of previous visits, there is a possi- 
 bility of the figures which he has passed being tampered with in 
 order to conceal fraud. The author is not, however, prepared to 
 offer suggestions for the detection of manipulation of accounts 
 after they have been audited. In the preparation of a balance 
 sheet and profit and loss account, if analyses of the accounts 
 are made, unauthorized alterations, if any, will probably be re- 
 vealed. As a matter of fact, experience has demonstrated that 
 such a contingency is a remote one and its possibility is best 
 guarded against by the intuition of the auditor rather than by his 
 attempting to follow certain set rules. 
 
 Completed audits are fast supplanting continuous audits and 
 it is deemed to be of more importance here to describe the former 
 fully. The auditor who masters all the essentials of a completed 
 audit can readily prepare a program for a continuous audit. 
 
 AUDIT NOTEBOOKS 
 
 Theoretically there is a great advantage in having available 
 a formal program or memorandum book, which maps out the 
 general procedure to be followed in a detailed audit, together 
 with such additional information as will indicate any special 
 points which are applicable to the particular audit to which the 
 notebook relates. Based on a somewhat extensive inquiry, it 
 appears that nearly all of the leading professional auditors of this 
 country have used some form of audit notebook at one time or 
 another. In most cases the books were used during the early 
 years of practice, but have been abandoned. 
 
 The reasons for discontinuing their use are not uniform. The 
 value of a more or less complete program is admitted by all, and 
 some firms have compiled a set of instructions and furnish all of 
 their assistants with printed copies. It is not believed, however, 
 that the use of printed audit notebooks is as general to-day as 
 it was a few years ago. 
 
 This is an indication of progress, because the old-style audit. 
 
THE DETAILED AUDIT 243 
 
 which comprised a verification of footings, postings, and vouch- 
 ers, has been found to be of Httle practical value, and as the 
 printed audit notebook was specially adapted for these opera- 
 tions, the change in method naturally made them obsolete. 
 
 The intelligent auditor makes a study of each engagement 
 and outlines a program the use of which will produce the results 
 which he decides beforehand are necessary. The program will 
 be reduced to writing, but it will vary to such an extent in dififer- 
 ent audits that it is not considered practicable nor desirable to 
 attempt to use the same program for more than one client, but it 
 is available for subsequent audits of the same accounts, in which 
 case memoranda and suggestions occurring during the progress 
 of one audit will be embodied "in the program for the next. 
 
 The author does not recommend the use of printed instruc- 
 tions, because it is impossible to make them comprehensive 
 enough to cover all of the work necessary in any one audit and 
 it follows that they are not adapted for general use. The student 
 who is attempting to gain a knowledge of the principles of audit- 
 ing has no use for an audit notebook, and the practitioner whose 
 experience is limited and who feels the need of a complete pro- 
 gram should seek to obtain the benefit of the knowledge of more 
 experienced practitioners (particularly the successful ones) be- 
 fore writing out a memorandum for himself or instructions for 
 an assistant. 
 
 The audit notebook had one advantage which must not be 
 overlooked, viz., spaces were always provided for a record of 
 work done and the initials or marks of the one who was respon- 
 sible therefor. This record is valuable in case of subsequent 
 questions as to errors made or work not fully covered. It is 
 important, therefore, that in the special program which the 
 auditor compiles for his engagements, spaces be provided to per- 
 mit of the fixing of responsibility for the carrying out of each 
 item of the instructions. 
 
 As much has been said and written in favor of audit note- 
 books, and in order that the student may judge for himself the 
 question of the desirability of their use, permission has been 
 secured to reprint several specimen pages from "The American 
 Audit Record," designed and published by Morgan L. Cooley, 
 C. P. A., which is the most satisfactory form in use. 
 
244 
 
 AUDITING 
 
 Q 
 < 
 O 
 
 Q 
 < 
 
THE DETAILED AUDIT 2^5 
 
 NOTES MADE IN THE FOLLOWING PAGES REGARDING 
 
 Hours 
 Conaumed 
 
 liMlali 
 
 Periods 
 
 1 General Organization and System of Internal 
 
 Check 
 
 2 Method of Taking and Pricing Inventory 
 
 3 General Condition and Usefulness of Books 
 
 4 Recommendations for Improvement 
 
 5 Sufficiency of Depreciation 
 
 6 Sufficiency of Reserve 
 
 7 Sufficiency of Working Capital as Shown by 
 
 Interest Paid, Discount Neglected, etc. 
 
 8 Each Item of Balance Sheet 
 
 9 Accruals 
 
 IP Deferred Charges 
 
 11 Contingent Assets and Liabilities 
 
 12 Allocation of Charges and Credits re Capital vs. 
 
 Operation and Maintenance 
 
 Prom 
 To 
 
 Prom 
 To 
 
 By 
 By 
 
 ^^ 
 By 
 
 By 
 By 
 
 By 
 By 
 By 
 By 
 By 
 
 By 
 
 From 
 To 
 
 From 
 To 
 
 CAPITAL STOCK, DIVIDENDS, BONDS AND INTEREST 
 
 Hours 
 Gonsiuned 
 
 1UI3I4 
 
 Periods 
 
 From 
 To 
 
 From 
 To 
 
 Capital Stock 
 
 1 Scheduled from Certificate Book by 
 
 2 Compared with Stock Ledger by 
 
 3 Compared with Private Ledgef by 
 
 4 Certified by Transfer Agent 
 
 Certificate Received by 
 
 5 Dividends Vouched by 
 
 6 Authority Verified by 
 
 Bonds 
 
 1 Certificate from Registrar Received 
 
 by 
 
 2 Interest Checked by 
 
 From 
 To 
 
 From 
 To 
 
 Remarka 
 
 PRIVATE LEDGER 
 
 HoUTB 
 
 Consumed 
 
 ll|=!|3l4l 
 
 Periods 
 
 From 
 To 
 
 From 
 To 
 
 From 
 To 
 
 From 
 To 
 
 Eemarks 
 
 1 Trial Balance at Beginning by 
 
 2 Footings Verified by 
 
 3 Examined to Note If AH Postings 
 
 Have Been Checked by 
 
 4 Trial Balance Before Closing by 
 
 5 Trial Balance After Closing by 
 
 6 Prepaid Items Checked by 
 
 7 Accruals Verified by 
 
 8 Reserves Noted by 
 
 9 Remaining Assets Verified by 
 
 10 Remaining Liabilities Verified by 
 
246 
 
 AUDITING 
 
 INVENTORIES 
 
 Hon 
 Conau 
 
 |l|2 
 
 T8 
 
 med Periods 
 
 I3I4 
 
 I 
 
 From 
 To 
 
 2 
 From 
 To 
 
 From 
 To 
 
 „ 4 
 
 From 
 
 To 
 
 Remarks 
 
 
 1 Physical Items Verified by 
 
 2 Appraisal Made by 
 
 3 Prices Checked by 
 
 4 Extensions Checked by 
 
 5 Footings Verified by 
 
 6' Compared with Ledger by 
 
 7 Reserve for Depreciation Computed by 
 
 8 Officials' Figures Accepted by 
 
 
 
 
 
 Basis 
 
 If tests are made, state exact extent in each case. 
 
 ACCOUNTS RECEIVABLE LEDGER 
 
 Hours 
 Consumed 
 
 f3l4 
 
 Periods 
 
 From 
 To 
 
 From 
 To 
 
 From 
 To 
 
 From 
 To 
 
 Eemarks 
 
 1 Footings Verified by 
 
 2 Balances Agreed with Controlling 
 
 Account by 
 
 3 Balances Verified by Construction of 
 
 Controlling Account by 
 
 4 Over-due Accounts Scheduled by 
 
 5 Reserve for Bad Debts Computed by 
 
 6 Reserve for Discounts Computed by 
 
 7 Customers Asked to Confirm Bal- 
 
 ances by 
 
 8 Personal Accounts Scheduled by 
 
 By means of 
 
 ACCOUNTS PAYABLE LEDGER 
 
 Hours 
 Consumed 
 
 |I|S!|'3|4 
 
 Period 
 
 From From 
 To To 
 
 From 
 To 
 
 From 
 To 
 
 Remarks 
 
 1 Footings Verified by 
 
 2 Balances Agreed with Controlling Account 
 by 
 
 3 Balance Verified by Construction of Con- 
 trolling Account by 
 
 4 Personal Accounts Scheduled by 
 
 5 Receiving Records Compared with Invoices 
 
 Recorded by 
 
THE DETAILED AUDIT 247 
 
 THE AUDIT OF INCOME AND EXPENSES 
 
 General Principles: There are two underlying principles 
 which govern the procedure in the detailed audit of income and 
 expenses. 
 
 (i) The auditor must ascertain whether the earnings shown 
 by the books are properly accounted for, and whether any of the 
 earnings are omitted therefrom. 
 
 (2) He must ascertain whether or not the expenses and losses 
 are properly stated and supported. 
 
 At the commencement of a detailed audit it is important for 
 an auditor to investigate thoroughly the relation of the clerical 
 staff to the work and to each other. Auditors are fond of stating 
 that a cashier should never have access to the ledgers, and that a 
 ledger clerk should have no access to the cash. 
 
 Theoretically this is an ideal condition and exists in most 
 large concerns, not because the proprietors realize that it is a 
 proper safeguard, but because there is enough of each class of 
 work to warrant the employment of an individual clerk for each 
 class. But in a small business where the cashier's dvities are not 
 extensive enough to keep him busy all the time, he is required 
 to assist with other duties, and naturally he is expected to under- 
 take the work for which he is best qualified — the postings to the 
 ledgers. So long as there are business enterprises the proprietors 
 of which consider that a bookkeeper's duties include the func- 
 tions of a cashier as well as those of a ledger clerk, it will be 
 necessary to exercise special vigilance in the audit thereof, for 
 fraud is so easily concealed that many clerks yield to temptation, 
 knowing that their defalcation will not be disclosed unless a pro- 
 fessional auditor is employed. 
 
 And in many instances where professional auditors have been 
 expected, the clerks have used most ingenious means to conceal 
 their fraud, so that an auditor should have a knowledge of as 
 many of these subterfuges as possible in order to detect irregular- 
 ities of any nature. 
 
 Prior Periods: In a detailed audit covering, say, a year, the 
 question frequently arises as to the auditor's responsibility for 
 the period prior to the commencement date. He will of course, 
 have it definitely understood that the commencing date should 
 
248 AUDITING 
 
 be definitely fixed and be supported by a balance sheet which is 
 assumed to be correct. 
 
 As a matter of fact, there is little danger in this procedure. A 
 proper audit for a year must of necessity shed a clear light on 
 the operations of the period immediately preceding, and if noth- 
 ing in the current work has given rise to suspicion, the former 
 accounts may be left undisturbed. Of course, if any special 
 reason exists, or a client insists on going back for two or more 
 years, the auditor must comply, but he should make the sugges- 
 tion that the last year should be audited and reported upon first, 
 so that there will be a chance for reflection before incurring the 
 expense incident to a long engagement. 
 
 Verifjcation of Footings and Postings: The least important 
 part of the audit is the verification of footings and postings, but 
 the subject demands attention and will then be dismissed. It will 
 have to be a very small business indeed where there can be any 
 justification for verifying every posting and every footing. In 
 past years about half of the auditing which was done consisted 
 of the laborious work of checking postings in detail and verify- 
 ing the footings of all books, including the ledgers. An analysis 
 of various defalcations which have occurred in recent years 
 demonstrates the fact that the percentage of frauds which have 
 been concealed by false postings and incorrect footings is small. 
 This small percentage may be covered just as well in what may 
 be called a "test" audit as in a so-called detailed audit. Where 
 books are out of balance there is a distinct value in checking over 
 as many postings and footings as possible, for it not only gives 
 the auditor a chance to see at first hand the sort of errors which 
 the bookkeepers have been making and thus furnishes data for 
 his report, but it helps along the current work, and if all the dif- 
 ferences are located, he will earn the good will of the bookkeeper, 
 which is also an important matter. The undertaking of this sort 
 of work is dangerous, however, unless it has been definitely 
 arranged with the client and he is convinced that part of the work 
 being done is that of an accountant and part that of an auditor. 
 
 Some auditors are fond of testing the ledger postings by 
 making up their own controlling accounts, or else reversing the 
 process and by analyzing each ledger account, extracting the 
 totals of each source of original entry. There are very excep- 
 
THE DETAILED AUDIT 249 
 
 tional cases where this plan may be followed, principally where 
 the ledger is not in balance. It is an old-fashioned scheme, how- 
 ever, and has no place under modern methods in a well-ordered 
 plan. Great advantages accrue to the auditor who knows enough 
 to be able to prove such work by tests and thus gain valuable 
 time which can be devoted to other and more important work — 
 more important because the largest number of frauds occur in 
 other places than footings and postings. Therefore, in that vast 
 number of audits where there has been no fraud, but where the 
 auditor wishes to justify his employment, all the constructive or 
 labor-saving suggestions will arise from the other portions of the 
 work. 
 
 Many cases are known of audits ocupying, say, four 
 weeks, where the verification of footings and postings has taken 
 three weeks and all the rest of the audit has taken one week. 
 There can be no hard-and-fast rule as to the time each class of 
 work should take, and it is not worth while to attempt to approx- 
 imate one, but it must be obvious that unless there is some spe- 
 cific justification for this division, it would be far better to spend 
 one week on postings and footings and three weeks on work 
 which afterward will mean something to the clients. 
 
 The question arises : Is it not possible that in thus cutting 
 down the work by two-thirds too much has been taken for 
 granted and that an auditor would not be excused who neglected 
 such a material part of the work as that of verifying the footings 
 and postings? The latter part of the question is answered by 
 the statement that no auditor can be excused who neglects any 
 part of the work. We must, however, be sure in each case which 
 is presented that we take nothing for granted until we have made 
 such intelligent and exhaustive tests as will assure us that the ac- 
 counts as a whole are, in our judgment, correct. Note the ex- 
 pression "in our judgment"; for the moment you deprive the 
 auditor of the free exercise of his judgment, you are reducing 
 him to the position of an automaton, and the title of professional 
 auditor becomes a> misnomer. What is an intelligent and exhaus- 
 tive test of postings and footings? In seeking an answer, first 
 direct your attention to the four general groups into which they 
 can be divided. These are: (i) the records of the purchase of 
 goods or materials as reflected in purchase or invoice books. 
 
2SO AUDITING 
 
 voucher registers, etc. ; (2) the records of sales as found in sales 
 books or binders or in any one of the various good and bad forms 
 used ; (3) the receipt of cash ; (4) the payment of cash. 
 
 The majority of postings and footings occur with respect to 
 the records mentioned, so that if we can agree on what consti- 
 tutes a fair test of these groups or divisions, we can safely leave 
 the remaining records to be dealt with on their merits. 
 
 The following suggestions are grounded upon the funda- 
 mental principle that no audit is complete unless the trial bal- 
 ances of all the ledgers, have been proved. There may be excep- 
 tions, as, for instance, a department store where there are one 
 hundred individual ledgers, in which case an exhaustive test 
 would be sufficient. 
 
 (i) Purchase Records: If fraud exists with respect to pur- 
 chases, it usually will be found in overcharges or fictitious ven- 
 dors, and very seldom, if ever, will there be any concealment of 
 fraud through manipulations of footings or postings. The au- 
 ditor does not seek to locate clerical errors in trial balances, but is 
 concerned with the possibility of the trial balance, which is 
 ostensibly in agreement, being forced. As this occurs not only in 
 cases where fraud exists, but also where there is a lazy or incom- 
 petent bookkeeper, the auditor should always be on the lookout 
 for evidence of forced balances. As a rule, however, where a 
 trial balance is forced there will be no alteration in the current 
 postings and footings. The usual and popular expedient is to 
 alter in the ledger the last posting during the perio'd to one of 
 the large nominal accounts, such' as sales or expenses. 
 
 These remarks as to the trial balance have a bearing on pur- 
 chase records to the extent that, no matter what other detail 
 work is omitted, the verification of the postings of the monthly or 
 periodical aggregates must not be forgotten. By this is meant 
 the debit side of the purchase accounts. Usually the checking of 
 the credit postings can be omitted. 
 
 As to the footings, in a fairly large concern, prove the foot- 
 ings of about every tenth or twelfth page in addition to the last 
 page of each month, where the audit covers a period of one year. 
 In a smaller concern, prove, say, every fifth or sixth page, includ- 
 ing always the last page of each month. It is hard to imagine, 
 and wide experience has not developed, a case where such a pef- 
 
THE DETAILED AUDIT 251 
 
 centage A^ould not have been just as effective in any given audit 
 as the verification of the footing of every page. That is, the veri- 
 fication of every page did not disclose any discrepancies (except 
 as hereafter noted), so that, naturally, the work could have been 
 cut down eleven-twelfths with equal results (except as to cost to 
 the client). The last page in every case is mentioned particu- 
 larly, because instances are known where such figures have been 
 altered. 
 
 (2) Sales Kecords: The monthly or other aggregates of the 
 sajes postings should be checked. 
 
 Controlling Account: If there is a controlling account in the 
 general ledger with customers, it will not be necessary to verify 
 in detail the postings of the customers' ledgers. If there is no 
 controlling account, the auditor should construct one, so in 
 neither case is it worth while to prove the debit postings. 
 
 The controlling account is a compilation of the aggregates 
 of the postings to the individual customers' accounts. They may 
 be classified as follows : 
 
 DEBITS CREDITS 
 
 Total of opening balances, as per last Cash. 
 
 trial balance. 
 Sales. Discounts. 
 
 Protested or retvimed cheques, notes, Returns and Allowances. 
 
 etc. 
 Interest, etc. ■ Notes. 
 
 Accounts charged oflE, etc. 
 Total of closing balances. 
 
 In some sets of books it may take as much work to construct 
 the controlling account as to verify every posting ; but even so, 
 the time spent in the preparation of the account is not lost, 
 because the data secured thereby will be useful in stating the 
 results of the business. 
 
 There is more fraud in connection with accounts receivable 
 than in any other department of a business, but the fraud does 
 not consist in a failure to post the sales which are recorded m the 
 sales books to the ledgers. The fraud is in omitting the sales from 
 the sales records entirely or in the failure to enter cash collec- 
 tions. 
 
 It is, however, important to know that all the sales appear- 
 ing in the sales record have been posted. As stated above, this 
 
252 AUDITING 
 
 can be, and should be, covered by use of a controlling account, 
 as the items are of such a nature that they are grouped in the 
 original records, and where the posting of a thousand entries in 
 one can be proved by one operation, time is saved. This method 
 assumes, of course, that there will be a verified trial balance of 
 the customers' ledgers to support the controlling account. The 
 question of accounts which have been collected, but which do not 
 show the collections, will be considered later. 
 
 As to the footings, verification is somewhat more important 
 than with purchase records. In a large concern, prove, say, every 
 eighth page, and in a small concern, say, every third or fourth 
 page, always including the last and sometimes the next to last 
 page of each month. 
 
 Cheques Received must be Deposited: In those corporations 
 where the capital stock is all, or nearly all, owned by its officers 
 or directors, the latter frequently handle the funds of the corpora- 
 tion as if no corporate responsibility existed. Usually they act 
 honestly and no harm is done, but an auditor cannot afford to 
 pass over illegal acts which come to his knowledge, although so 
 far as can be foreseen no one will be injured thereby. 
 
 The practice of an officer using cheques drawn to the order of 
 the corporation for his private use* cannot be condemned too 
 severely, and yet it is not uncommon. All cheques should be de- 
 posited, and the officer can withdraw a similar sum if the cor- 
 poration is indebted to him. 
 
 In a New York case, decided by the Court of Appeals in 1908, 
 where the president of a corporation (the stock of which was 
 all owned by himself and the secretary-treasurer) used a cheque 
 drawn to the order of the corporation and indorsed by it to pay 
 his personal debt, the creditors of the corporation upon its being 
 declared insolvent compelled the trust company that cashed the 
 cheque to refund the money. 
 
 Periodical Verification of Bank Balances : The auditor should 
 ascertain by personal investigation whether the bank balances 
 have been verified at frequent intervals throughout the period 
 covered by the audit. It frequently happens that clerks are care- 
 less about reconciling the bank balances with those shown by the 
 books. In some cases the pass books are not left for settlement 
 for many months ; in other cases the pass books are balanced by 
 
THE DETAILED AUDIT 253 
 
 the banks and delivered to the depositors, but are not verified by 
 the latter. 
 
 In the middle and far West, the banks have quite generally 
 adopted the plan of sending monthly statements to all depositors, 
 accompanied by the paid cheques. There is a growing tendency 
 on the part of the banks in the East to follow this plan. This is 
 to be commended, as it leads naturally to more frequent recon- 
 ciliations between the parties. 
 
 But the bank statements may be filed away without examina- 
 tion unless some one in authority insists on prompt attention. 
 Instances have been known where junior clerks have forged sig- 
 natures to cheques, and owing to carelessness in inspecting the 
 bank settlements, the fraud was not discovered for a long time. 
 
 The law is that the writing up of a bank pass book, with a 
 return of paid cheques, or a statement of account, is not con- 
 clusive upon the parties so as to preclude an ascertainment of the 
 true state of the accounts in a case where cheques are included 
 in the balance which are subsequently discovered to be forged. 
 But where the depositor is under a duty from the usages of busi- 
 ness or otherwise to examine the account within a reasonable 
 time and to give timely notice of any objections he may have, 
 an omission to perform this duty, leaving the bank to rely upon 
 the presumption that the account is acquiesced in, whereby it is 
 misled to its prejudice, will make the account conclusive. The 
 law is not unreasonable in holding that where bank settlements 
 lie around untouched for long periods those in control of the busi- 
 ness should know that a risk is being run for which there is no 
 excuse. 
 
 The auditor may sympathize with the clerk who is over- 
 worked and who omits the reconciliation of the bank balances 
 for what he considers more important duties, but nevertheless, 
 such neglect may be costly and should be reported. 
 
 (3) Cash Receipts: In all well-regulated concerns all cash 
 receipts are deposited in bank and all payments, therefore, must 
 be made from the bank account. This almost disposes of the 
 question of verifying the footings of the cash book. Where the 
 bank account is proved and the cash receipts and payments are 
 traced into and out of bank, it would seem logical that the foot- 
 ings of the cash book could be automatically proved at the same 
 
254 AUDITING 
 
 time. If this does not seem to be complete verification, in a large 
 business, the proving of every third or fourth page will be a 
 complete check. 
 
 In many small concerns the cashier handles the receipts, 
 writes up the cash book, and makes the deposits. He might 
 retain a portion of the receipts, force the footings of the column 
 to agree with the actual deposit, and increase the footings of the 
 discount column. The cash book would then balance across, 
 the cash balance agree with the amount shown by the pass book, 
 and as the discount column would be posted in total by the book- 
 keeper, the ledger would be in balance without any falsification 
 being made therein; If there were special columns provided for 
 cash sales or similar earnings, the footings of such columns could 
 be reduced by the amount of the shortage and thus afford addi- 
 tional facilities for covering up the amounts taken. 
 
 The postings of the nominal accounts should usually be veri- 
 fied, not because there is any great danger of fraud lurking 
 therein, but for the purpose of locating any possible posting to 
 a wrong account. For instance, it frequently happens that part 
 of a plant or old machinery may be sold. Sometimes such items 
 are posted to an earning account instead of to a capital or a 
 reserve account. These postings are, as a rule, few in number 
 and are important enough to be verified in extenso. 
 
 The postings to the credit of customers should be proved in 
 totals through the controlling accounts. If there is no control- 
 ling account and one cannot be constructed readily, a fair test 
 should be made of the individual ledger credits, working, of 
 course, from the ledger back to the cash book and not vice versa. 
 The reason for this is obvious; if a customer has been credited 
 with an amount which purports to have been posted from the 
 cash book, but which, as a matter of fact, is not entered there at 
 all, the discrepancy would not be discovered by using the cash 
 book as a basis, and it would not be safe to depend on looking 
 through the ledger subsequently to see that all items are ticked. 
 It is sometimes suggested that the chief danger in such practice 
 lies in the possibility that the ledger clerk can, where the work is 
 not finished at a sitting, supply the ledger tick marks himself. 
 There is not much basis for this fear, but it would be foolish to 
 expose one's self to it where no necessity exists. 
 
THE DETAILED AUDIT 255 
 
 If it is thought wise to verify the individual postings to the 
 customers' accounts, do not check every one unless some very 
 good ground for suspicion exists. If the audit is a periodical one, 
 say, for six months, cover about half the letters of the alphabet 
 only. Six months later cover the other half, or one-fourth only 
 at each audit, and take two years to the entire list. It is not an 
 infrequent fraud wherein ledger credits do not appear as cash 
 debits, but it is hard to imagine one case where a good test would 
 not have disclosed the fraud. Very few men would confine their 
 peculations to customers whose names commenced with X Y Z 
 only. The auditor can afford to take the chance that the defaulter 
 will inadvertently manipulate the account of an A customer, 
 in which case he would not escape the first time, and if he used 
 only one or two letters, he would still be detected in a reasonable 
 time. 
 
 (4) Cash Payments: On the payment side there is also a 
 possible opportunity for fraud being covered by erroneous foot- 
 ings. In most cash books there are columns for dififerent ex- 
 penses which are posted in total at the end of the month. If the 
 cashier were to take an unnumbered cheque from the back of the 
 book, or one of a style similar to the ones in current use, and 
 have it -drawn to his order or to some name representing himself 
 and did not enter the amount in the cash book, the footings could 
 be-falsified to that extent. The cheque could be numbered to 
 correspond \Mth those in use at the time. When the bank settle- 
 ment was received and the balance verified, the cheque could be 
 destroyed. 
 
 Instances are known where cheques were marked as void on 
 the stubs and the two halves of one cheque pasted on two stubs 
 (one of the portions, of course, being without a number), thus 
 providing a cheque which was used by the cashier to obtain 
 money fraudulently. 
 
 These manipulations are not likely to occur more than once 
 in an auditor's experience, but all of the possibilities mentioned 
 are based on actual expei ience, so that an auditor cannot afiford 
 to neglect all reasonable precautions to ascertain if such fraud 
 
 exists. 
 
 The auditor should insist, wherever feasible, on having all 
 payments represented by cheques. It reduces the possibility of 
 
2s6 AUDITING 
 
 manipulation of cash-book footings to a minimum, and for this 
 reason alone is worth all the trouble which may be occasioned 
 by the necessity of depositing all currency receipts. If the foot- 
 ings cannot be proved by the bank account, verify, say, every 
 third or fourth page. 
 
 If the cash book is properly columned and a controlling ac- 
 count is kept with accounts payable, most of the postings will 
 consist of monthly aggregates, which should be checked to see 
 that they do not get into the wrong ledger account. Here, how- 
 ever, it is important to avoid duplication. In many audits it is 
 desirable to make full analyses of the various expense and pur- 
 chase accounts for use in the reports. If feasible and convenient 
 this work should be done at the' time of the verification of the 
 postings, for it may be found that the details in the ledger 
 are not sufficient and the cash book pages must be consulted 
 again. 
 
 Postings to the individual, accounts need not be verified 
 unless some special reason appears. The payments are supposed 
 to be vouched to establish their authenticity, and it is not neces- 
 sary to trace the payments to the debits of the accounts. A con- 
 trolling account supported by a trial balance of the subsidiary 
 ledger is a good proof, but even where this is not in evidence the 
 checking of the debit postings is usually superfluous. 
 
 Summary: As against the practice — fairly common — of 
 checking all postings and footings, the above course will seem 
 radical. It is not radical, however, if it is approved after full dis- 
 cussion and thought, and if it will stand the additional test of 
 each particular audit. Where the slightest cause for suspicion 
 exists, there must be a careful study of every phase of the situa- 
 tion. 
 
 But if suspicion has been aroused and there is a probability 
 of something being wrong, the most foolish thing an auditor can 
 do is to jump in blindly and tick every entry in the books. This 
 has been done more than once, but the practice cannot be con- 
 demned too strongly. 
 
 Other Records: In many lines of business the books of 
 account bear distinctive titles, and it may be that in the forego- 
 ing pages these books have not been called by their technical 
 names. For instance, in a magazine publishing business a sales 
 
THE DETAILED AUDIT 257 
 
 'book, so called, may not be found, but a subscription record and 
 an advertising register will usually be kept. 
 
 With these books, as to footings and postings, about the 
 same procedure should be followed as with a regulation sales 
 book — as a matter of fact, that is exactly what these two records 
 represent — sales of advertising space and sales of copies of the 
 publication for a stated period (subscriptions). It is far more 
 satisfactory to have an illuminating title like this for a book than 
 to attempt to cut down the number of account books in use and 
 perhaps journalize every transaction. Aside from the saving of 
 labor to a bookkeeper through the use of books for special pur- 
 poses, is the more important function of keeping the records 
 clear to one who does not understand bookkeeping. Most busi- 
 ness men are at sea when they try to understand an ordinary 
 journal, but if a book is labeled "subscription record," or "adver- 
 tising register," anyone with ordinary intelligence knows exactly 
 what to look for within its pages. 
 
CHAPTER XVIII . 
 THE DETAILED AUDIT (Continued) 
 VERIFICATION OF INCOME 
 
 It is obvious that a dependable analysis of frauds can never 
 be compiled from accurate data, but an estimate prepared from 
 long experience supports the assertion that nearly, if not quite, 
 seventy-five per cent of defalcations and frauds are connected 
 directly with a failure to account for income or cash receipts, and 
 less than twenty-five per cent with methods of improperly divert- 
 ing cash after it has found its way into the treasury. 
 
 We will discuss as of the more importance the seventy-five 
 per cent division. This, in turn, can be divided into two groups : 
 the first embracing that class of frauds which consists in a fail- 
 ure to enter in the books, or at least in the books which form a 
 part of the double-entry system, any record whatever of the sale 
 or delivery of goods or materials ; the second class includes those 
 cases where there is a record of the original sale or delivery, but 
 where the subsequent collection is omitted entirely or where the 
 entry of collection is postponed until a later date. Obviously, 
 the former methods will be the ones most easily concealed, and 
 the auditor must, .therefore, be especially vigilant in this part 
 of the audit. 
 
 It is assumed that the auditor has secured a list of all books 
 in use. This list should include not only the books which form 
 part of the double-entry system, but also all those usually termed 
 "memorandum" books, which contain original data, and from 
 which the formal entries are compiled. 
 
 When the audit is completed the auditor should be able to 
 certify that, in his opinion, all revenue or earnings have been 
 properly accounted for. This does not mean that the cash which 
 was duly entered in the cash book and the sales which were in 
 due course entered in the sales records were assumed to be all the 
 cash receipts and all the sales without further investigation. 
 
 A careful inquiry should be made, or personal watch kept, to 
 
 258 
 
THE DETAILED AUDIT 259 
 
 see who opens the mail, and what record, if any, is made by such 
 person. 
 
 Sales: It is important to ascertain that all cash sales are 
 accounted for. In nearly every business some sales are collected 
 for at once and are not passed through the customers' ledgers. If 
 the general ledger shows few such transactions, this should not 
 influence the auditor unless he has made inquiry from some one 
 other than the cashier. One instance may be cited where the 
 auditor found that there were practically no cash sales accounted 
 for. He inquired as to this and was informed that it was not the 
 custom to make such sales. Further investigation, however, de- 
 veloped the fact that the cash sales had been quite large, but that 
 his first informant had pocketed the whole proceeds. In this case 
 a rough memorandum was discovered which enabled the auditor 
 to locate the entire shortage. It will be found the rule rather 
 than the exception that there is some sort of record which can 
 be compared with the cash book. The formal original records, 
 which are nicely written up and which agree exactly with the 
 other books, are not the ones the auditor wants. If he can find 
 the first "originals," in rough form, perhaps, and very dirty and 
 almost illegible, there is no doubt about the advisability of using 
 such records in preference to the fair copies, because the latter 
 are frequently written up by the same men who write up the final 
 cash records. Professional auditors agree that original records 
 corresponding closely to the above description have revealed to 
 them perhaps more instances of fraud than any other source. 
 The importance placed upon them cannot, therefore, be overesti- 
 mated. 
 
 The list of memorandum books required should include the 
 original records of sales and the original records of shipments. 
 Rarely are the order books or shipment or delivery books consid- 
 ered as formal books of account, and it is perhaps fortunate for 
 the auditor that this is so, because in many cases where the exain- 
 ination of these records has revealed, fraud there has been great 
 astonishment and usually indignation that an auditor should ask 
 to see "memorandum" books. In most of these cases if the de- 
 faulters had suspected that the books mentioned would be called 
 for, they could readily have been destroyed or altered before 
 examination. 
 
26o AUDITING 
 
 It is the auditor's duty to verify the income from sales as 
 evidenced by the records or papers covering the transactions 
 from the time an order is received until the goods have been de- 
 livered. Wherever possible, therefore, he secures the order books 
 and compares some of them with the ledgers to see that the 
 orders were filled. If not, why not? It may be that through 
 carelessness an order was not filled and that it was not reported. 
 Here is a good chance to be of positive value to the client. 
 
 Orders may have been filled and the proceeds collected and 
 not accounted for. This should be discovered by comparing the 
 shipping or delivery books with the sales records. Tests here 
 are all that are necessary, because any system of fraud in this 
 channel has been, in practically all known cases, continuous, 
 so that a complete comparison for a few weeks or a month 
 would cover the point quite as well as a more exhaustive com- 
 parison. 
 
 A fruitful source of inspiration in the effort to ascertain 
 whether or not all the income has been accounted for is the bal- 
 ance sheet — or the trial balance after closing, which may state 
 the various items of assets in greater detail than the balance 
 sheet. Proper thought should be devoted to each item to deter- 
 mine the possibility of the income therefrom being omitted from 
 the books. For instance, a mining company's balance sheet may 
 show that it owns workmen's houses. The auditor will then have 
 to find out if all of the rents of all the houses have been accounted 
 for. Furthermore, where there are tenants he will usually find 
 sales to them of coal or other fuel and all sorts of supplies. If he 
 does not find any record of such sales, he should inquire why 
 from some one "higher up." He should not take the cashier's 
 word for it. 
 
 These comments are merely suggestive and serve to illus- 
 trate the idea that the auditor must not use the receipt side of 
 the cash book as a basis for verifying the actual income or re- 
 ceipts. He must work from every outside source he can find to 
 the cash book, and he will then be reasonably safe. 
 
 There is not the same difficulty with the cases in which there 
 has been some record in one of the original books of account of 
 a sale, the subsequent collection of the proceeds of which has not 
 been accounted for, or in which although the sales have been 
 
THE DETAILED AUDIT 261 
 
 debited in due course to customers, the collections have not been 
 credited. 
 
 The former class will be disclosed by a good test of the foot- 
 ings of the sales records, and the proof of the postings of same 
 to the customers' ledgers. This has been fully covered. The 
 instances where credits have been arbitrarily made to customers' 
 accounts, but without corresponding entry in the cash book, have 
 also been covered. 
 
 Cash Discounts: The auditor should secure from the prin- 
 cipals an authoritative statement of cash discounts allowed to cus- 
 tomers, and with this as a basis a fairly exhaustive test should 
 be made of the discount deductions or allowances as stated in 
 the cash book. In rare cases the cash book will show net receipts 
 only, in which event discounts are credited through an allowance 
 book or journal, but as the latter method involves writing cus- 
 tomers' names twice, no up-to-date concern would permit it. 
 The discounts should appear in a column on the receipt side of 
 the cash book, and next to the column containing the gross or net 
 collections from customers. 
 
 For convenience in posting, the gross amount is sometimes 
 entered in the "Accounts Receivable" column. The total of the 
 discount column must then be deducted therefrom in order to 
 arrive at the cash balance. The better practice, however, is to 
 enter the net cash collection in one column and the amount of the 
 discount in the next. In posting, the two amounts should be 
 entered "in short" on the credit side of the customer's account 
 and the gross amount extended to the money column. 
 
 Instances are known where cashiers have systematically 
 overstated the discount allowance either by increasing the 
 amount actually deducted or by entering a discount where none 
 was claimed or allowed. This is a matter to which little atten- 
 tion is directed in an establishment where the work of cashier 
 and bookkeeper is performed by the same person, or where the 
 posting clerks are mere machines, and can be depended upon to 
 overlook fraud of this nature. In view of this probable freedom 
 from detection and the numerous frauds which have thus oc- 
 curred, the auditor must make a test thorough enough to sat- 
 isfy himself fully. It is not likely that if there is anything wrong 
 it will appear only occasionally, so that the test, while exhaustive 
 
262 AUDITING 
 
 as to the period covered, need extend over only a few days or 
 weeks, depending on the volume of collections. 
 
 Collections not Accounted for : We now come to what is be- 
 lieved to be the most prolific source of fraud practiced, viz., the 
 failure to enter in any book the collections from customers. The 
 detection of such fraud is difficult and it will pay, therefore, to 
 devote considerable time and space to the subject. 
 
 The most common irregularity can be illustrated as follows : 
 Customer A on January 2nd pays $112.53, say, by cheque; the 
 cashier fails to enter the collection in his books. If he has made 
 other collections in currency exceeding $112.53, ^^ 'wiH deposit 
 the cheque and take the equivalent in currency from the drawer, 
 thus obviating the necessity of forging the indorsement and hav- 
 ing the cheque cashed, although the latter method is more com- 
 mon than is generally supposed. In the first case the fraud might 
 be discovered by comparing the details of the cash receipts with 
 the details of the bank deposits as listed in the cheque stubs or 
 copy books, but this record is not always available and auditors 
 frequently find that where such a fraudulent practice exists the 
 record of the bank deposit has been altered or made up to corre- 
 spond with the cash book, which makes the comparison of no 
 value. 
 
 In most such cases the thief does not consider it safe to hold 
 out collections too long for fear some one in the office will dis- 
 cover that customer A has not paid and go after him. There- 
 fore, on January 31st he decides that it will not be wise to hold 
 up A's credit any longer, and accordingly credits him with 
 $112.53 ill the cash book, and the amount finds its way to the 
 ledger in due course. By this time the cashier is further in 
 trouble: the customer B having on January 31st paid $250 
 (also by cheque) the cashier fails to enter the amount and thus 
 creates a cash "over" of $137.47, which he removes from the cash 
 drawer as soon as he can accumulate that amount of currency. 
 Here again may be urged the importance of recommending to 
 clients the daily deposit of all receipts — currency and cheques. 
 There will then be far less opportunity for fraud afforded to a 
 clerk dishonestly inclined. 
 
 So it continues. The defaulter must soon credit B with 
 $250, and he therefore calls on C's account, or by this time A 
 
THE DETAILED AUDIT 263 
 
 may have paid again. In all cases it will be found that the 
 amount grows larger and larger until in many cases the discov- 
 ery is forced without the aid of an outside auditor. In more 
 cases, however, it goes on for years and unfortunately more than 
 once such a practice has been in full force during, prior, and sub- 
 sequent to, periodical audits by public accountants. 
 
 Confirmations of Outstandings : The best way to detect such 
 a defalcation is for the auditor to send out statements to all cus- 
 tomers, requesting them to confirm the accuracy of the balance 
 on a blank inclosed for the purpose, which in turn is returned 
 direct to the auditor's office. This is the practice followed by 
 many leading auditors, and where the client does not or will not 
 consefit to such a course, the responsibility for the integrity of 
 the customers' balances is squarely up to him. Every year the 
 objections to this practice grow less, and no doubt within a few 
 years the verification of customers' outstanding balances by cor- 
 respondence with the auditor will be the rule rather than the 
 exception. 
 
 The old form was substantially as follows : 
 
 Dear Sirs : 
 
 In making our periodical audit of the accounts of 
 
 we desire to verify the accounts receivable by direct correspondence with 
 each customer, and we are therefore sending you (attached below) a memo- 
 randum of your balance, which we would ask you to kindly compare with 
 your books, advising us as to its correctness or otherwise. 
 
 If the balance does not agree, please inform us fully as to the reason 
 and amount of the differences. 
 
 A stamped envelope is inclosed for use in replying. 
 
 Very truly yours. 
 
 Certified Public Accountants. 
 
 Perforations here 
 
 No 191 
 
 The balance of $ under date of 
 
 charged against my account on the books of is correct 
 
 Very truly yours, 
 
 The above form, or some variation of it, was used exten- 
 sively for several years, but it was found to be expensive and 
 not entirely satisfactory. The fact is that where balances are 
 correct there is no necessity for an acknowledgment. 
 
264 AUDITING 
 
 The most popular form at present is as follows : 
 
 PLEASE EXAMINE 
 
 this Statement carefully. If it is not 
 correct, please communicate DIRECT with 
 our Auditors, 
 LYBRAND, ROSS BROS. & MONTGOMERY, 
 
 55 LIBERTY STREET, NEW YORK. 
 giving full details of ainy differences. 
 
 It consists merely of a rubber stamp used on the regular 
 statement forms of the concern under audit and is more efiEective 
 than any other method. 
 
 The statements are of course prepared in the client's office 
 in the usual manner — not by the auditor. The latter, however, 
 should compare balances with ledger accounts before mailing 
 and the mailing should be done by the auditor. For some 
 accounts no statements are sent and a list thereof should be pre- 
 pared and approved by the proper authority. Some auditors 
 object to this procedure on the ground that customers who are 
 in the habit of visiting the client's place of business are apt to 
 disregard the request to take up differences direct with the 
 auditor and in most cases will report direct to the bookkeeper 
 any discrepancies. Even where customers are not accustomed 
 to calling at the client's office they still insist on writing direct 
 in connection with anything which concerns their accounts, as 
 they do not or will not appreciate the value of an independent 
 check. The auditor, therefore, cannot depend on having reported 
 to him all discrepancies in customers' accounts through the plan 
 suggested above. As a practical matter, however, the scheme 
 will bring to light any systematic fraud, because all customers 
 do not object to communicating direct with an auditor and if a 
 bookkeeper has been systematically manipulating customers' 
 accounts, one or more can be depended upon to so advise the 
 auditor, in which case the latter is put on notice and other 
 instances of fraud should be looked for. 
 
 It has been found that this independent check is of value not 
 
THE DETAILED AUDIT 265 
 
 only in the disclosure of fraud, but also in the insight which it 
 gives as to the condition of the accounts with respect to unad- 
 justed items, allowances, etc. It is needless to say that some 
 bookkeepers are careless and others lazy, and where this is so it 
 is important for the auditor to find it out. In all classes of busi- 
 ness various claims and errors crop out from time to time. 
 Where these aflfect customers' accounts, adjusting entries should 
 be made at once, otherwise the outstanding balances do not re- 
 flect the true state of the accounts. If a bookkeeper is lazy or 
 careless it will soon develop in the replies from customers to the 
 requests for confirmations. In several instances this inquiry has 
 demonstrated a very unsatisfactory condition where the cause 
 was carelessness and not fraud. In many instances, however, 
 carelessness leads to fraud. The very nature of a business will 
 suggest to an intelligent auditor practically every source of 
 revenue, special and ordinary. 
 
 Where the auditor can check loose methods he may really be 
 preventing fraud, and the auditor who prevents fraud is a very 
 useful person. 
 
 It is, of course, impossible in a limited space to suggest more 
 than a bare outline of the procedure to be followed in ascertain- 
 ing that all income has been accounted for. 
 
 Income from Investments : As mentioned elsewhere, it is now 
 a frequent practice for mercantile and manufacturing firms and 
 corporations to invest a part of their surplus in income-bearing 
 securities. By reason of the fact that these investments are out- 
 side the usual transactions, the income therefrom is not usually 
 subjected to internal audit. 
 
 The auditor will obtain a schedule of all securities held dur- 
 ing the period of the audit and will ascertain that all dividends 
 or interest accruing thereon is properly accounted for. If any of 
 the investments are in inactive stocks and the dividends thereon 
 are irregular and cannot be verified through the usual channels, 
 a schedule of collections should be compiled and submitted for 
 approval to some one in authority. 
 
 Where the investments are all grouped in one account, atten- 
 tion should be called to the desirability of opening a separate 
 account with each one, and noting at the top of the page full 
 particulars as to the serial numbers of the bonds or stock certi- 
 
266 AUDITING 
 
 ficates, together with interest or dividend dates and similar 
 information. If numerous, it would be best to have a subsidiary 
 ledger or record for these details. 
 
 Interest Receivable: Attention is called to remarks under 
 "Interest Payable" (page ooo) and to Chapter XVIII, where it 
 is shown that considerable carelessness exists with respect to the 
 collection and payment of interest, apd to the danger of accepting 
 bankers' figures as infallible. 
 
 Interest on mortgage investments should be verified, as 
 shown under "Income from Investments" (page ooo). 
 
 Interest on other loans where the interest rate and other con- 
 ditions are not always fixed in advance demands more attention. 
 Few businesses exist, particularly those conducted by firms and 
 individuals, where private loans or advances do not appear. 
 These may be to friends, or business associates, or to employees, 
 or to customers who request temporary accommodations. More 
 frequently they will represent investments entirely outside the 
 business and in connection with enterprises about which little is 
 known. 
 
 Any auditor who has had long experience can recall innumer- 
 able instances where men have made fortunes in their own busi- 
 ness and have squandered their entire surplus, and often most of 
 their capital, in mines, plantations, patents, and all sorts of indus- 
 trial flotations about which they had no technical knowledge 
 whatever. 
 
 Frequently these outside ventures commence with small 
 loans, and it is here that the auditor can sometimes be of real 
 service to his client. The client should be impressed with the 
 necessity of keeping his own capital intact, and should not have 
 so-called investments in loans to others while borrowing himself. 
 The auditor should point out to the client that he is not a banker, 
 but that if loans or advances are made to others, interest thereon 
 at current rates should be paid promptly and that the loans 
 should be cleaned up or materially reduced periodically — ^just as 
 is required by a banker. Considerable space is devoted to this 
 matter here because borrowers of this class are not, as a rule, 
 prompt in paying interest, so that the failure to discover such 
 collections will give an auditor a good opportunity to criticize 
 unbusinesslike practices. 
 
THE DETAILED AUDIT 267 
 
 Interest on bank deposits is not often inquired into, yet it 
 may be that credit is being given at two per cent when two and 
 one half or three per cent may have been arranged. Therefore 
 the auditor should always verify the rate actually in force. A 
 rough calculation can usually be made with respect to the 
 amount credited on balances. Cheques issued follow a well- 
 defined course, except in special cases, so that the test of a month 
 or two, based on average daily balances, will disclose whether or 
 not the amount received is approximately correct. The auditor 
 can often have one of the office staff compile these figures and 
 thus reduce his own time thereon to a minimum. 
 
 Discount for Prepa}mient : There is some difference between 
 interest received on notes receivable from customers and cash 
 discounts allowed by creditors for prompt or anticipated cash 
 payments, although theoretically they both represent a profit or 
 return upon the capital invested in the business. In one case the 
 amount collected is almost invariably calculated at the legal rate 
 of interest and is in effect an offset to the interest paid upon 
 money borrowed. This will be apparent if the possibility of dis- 
 counting the notes receivable is taken into consideration, in 
 which case the interest on the notes is added to the face of the 
 notes and the bank discount is deducted therefrom. It is not 
 customary or necessary to credit the interest to one account and 
 charge the discount to another account. 
 
 The rate of interest allowed for prepayments is purely arbi- 
 trary and fluctuates to a considerable extent. Most concerns 
 wish to know the amount realized from this source and a sepa- 
 rate ledger account should be kept for it. 
 
 Trade Discounts : Trade discounts are direct deductions from 
 the purchases on one hand and from the sales on the other. That 
 is, no ledger account should be kept for trade discounts, and the 
 term itself rarely appears in books of account. 
 
 The test of a trade discount is the rate. In some lines of 
 business a discount of seven per cent is allowed for payment 
 within thirty days. This is not a cash discount, as no business 
 house would pay the rate for money which is implied by the rate 
 of discount. Therefore, the concern which receives the discount 
 cannot credit it as an interest earning. As a matter of fact, it is 
 a common occurrence for notes to be given, in which case the 
 
268 AUDITING 
 
 seven per cent is deducted from the face of the bill and interest 
 at the rate of six per cent per annum added to the balance for the 
 term of the note. This clearly establishes the fact that the de- 
 duction represents a trade and not a cash discount. 
 
 The distinction, therefore, is based on the answer to the 
 query: Is the rate one which is obviously granted for anticipa- 
 tion of obligations not due? For instance, the strict enforce- 
 ment of the terms "two per cent ten days, net thirty days" indi- 
 cates that the two per cent is an earning and not a deduction 
 from the purchase price. As a general rule any discount in 
 excess of the terms just mentioned may be treated as a trade 
 discount. 
 
 For an argument in favor of entering trade discounts in the 
 books of account, see page ooo. 
 
 Rents Receivable: Where the item of income from rentals is 
 inconsiderable the records relating thereto are not apt to be in 
 good condition for auditing. If the item is a considerable one, 
 reference should be had to the suggestions under the audit of 
 "Real Estate Accounts" (page ooo) . 
 
 In the first place a complete list of all rentable property is 
 essential, and next in importance is a schedule of rentals which 
 should be received therefrom. With these two points covered 
 the auditor can make a satisfactory audit. The premises should 
 be inspected and note made of vacancies, if any. Vacancies 
 during the period should be listed and verification secured 
 from some source independent of the clerk in charge of the col- 
 lections. 
 
 The author had nearly completed the audit of a small railroad 
 company when this question arose. The balance sheet disclosed 
 the ownership of some rentable buildings. When asked for the 
 records relating thereto, the treasurer attempted to defer the in- 
 quiry, but after a list was secured and the possible income cal- 
 culated, he confessed that he had misappropriated most of the 
 rent collections. The amount was comparatively small — a few 
 hundred dollars out of total income of several millions — but the 
 ordinary income was controlled and checked by other depart- 
 ments and he seized the only opportunity for fraud which seemed 
 safe. 
 
 Where collections are in the hands of reputable agents, who 
 
THE DETAILED AUDIT 269 
 
 render periodical statements, it will not be necessary to check the 
 income in so much detail, but careful inquiry should be made to 
 satisfy the auditor that the agent has charge of all the property, 
 and that the statements, when received, are checked both as to 
 collections and deductions. It is obvious that the auditor will 
 trace into the cash receipts the total amount turned over by the 
 agent for the entire period, and if there is the slightest doubt as 
 to the genuineness of the statements submitted, the auditor 
 should request the agent to hand him a memorandum of pay- 
 ments for the period. 
 
 Realizations from Items Previously Charged to Profit and 
 Loss: Among the miscellaneous items of income which may be 
 found in almost any business, and to which the auditor should 
 pay particular attention (chiefly because it may not be expected), 
 are subsequent realizations from assets which had been charged 
 off to Profit and Loss as uncollectible. The procedure is not so 
 difficult as it appears at first sight, because the number of debits 
 to Profit and Loss over a period of years is not usually very 
 great, and as only a small proportion of these items can, in any 
 event, admit a subsequent realization, it will not be much of a 
 task for an auditor to analyze the "possible" items and scrutinize 
 them with the sole object in view of probable or possible collec- 
 tions. 
 
 Customers' accounts are the most prolific source of delayed 
 realization, as they are often written off after bankruptcy pro- 
 ceedings have been instituted, and before the final dividend has 
 been paid. 
 
 Some bankruptcies extend over a long period of years, so that 
 every such account written off should show beyond any doubt 
 that a final dividend has been received. Where accounts have 
 been written off without any evidence that bankruptcy proceed- 
 ings were ever started, the written authority for such action 
 should be submitted to the auditor. 
 
 Stocks, bonds, loans receivable, and similar items are some- 
 times written off before the properties or persons represented 
 thereby have finally been adjudicated bankrupt or otherwise 
 definitely declared to be hopeless. This line of inquiry does not 
 require much time, but experience has proved its worth. 
 
 Consignments and Goods Out on "Memorandum" : As care- 
 
270 AUDITING 
 
 lessness is apt to exist in connection with all transactions which 
 are out of the regular routine, the auditor should carefully inspect 
 the records relating to charging out, keeping track of and collect- 
 ing the proceeds of goods sent out on "memorandum" or "on 
 sale," both of which are trade terms for consignments. 
 
 If not charged to the regular ledger account of the consignee 
 (which may be inadvisable), the record of outstandings should 
 be kept in a substantial loose-leaf binder in form and in dignity 
 equal to the ordinary customers' ledgers. 
 
 It is necessary to create an impression of permanence about 
 the records in an office, or the data which are considered to be 
 temporary will be kept in an unsatisfactory and careless manner. 
 
 The record should be looked upon as a running account and 
 all freights, drayages, insurance, and other charges posted 
 thereto as incurred. In support of the memorandum or tem- 
 porary records which are closed, the auditor should be furnished 
 with evidence that the terms and conditions are in order. Usu- 
 ally the correspondence relating thereto will be sufficient, pro- 
 vided it carries the authority of one competent to fix such terms. 
 A careful test of the accounting for the net proceeds as shown to 
 be due by the record just described will then be made. If the 
 test proves that no loss is likely to have occurred, there is no 
 necessity for a complete verification. 
 
 Where consigned goods have not been accounted for when 
 the books are closed, the consignee should be asked for an ac- 
 count current up to the date of closing. Based on this, credit 
 may be taken for the proceeds of sales actually made. The 
 balance will be treated as stock-in-trade and valued on the basis 
 described on page ooo. Goods which have been charged out at 
 selling prices and appear as accounts receivable will likewise 
 have to be treated as stock-in-trade and the valuation adjusted to 
 the proper basis for balance-sheet purposes. 
 
 Goods Received for Sale: Where the concern under audit is 
 the consignee, the accounts will be handled dififerently. If the 
 goods received are to be sold on commission for account of the 
 consignor, then the income will consist of a commission on the 
 selling price, or perhaps the gross amount realized above a cer- 
 tain fixed price, or some one of the many other understandings 
 upon which consignments are received. 
 
THE DETAILED AUDIT 271 
 
 The auditor must have access to the exact contract between 
 the parties in order to test the accuracy of this income. In many- 
 cases the agreements are verbal or are based on correspondence 
 more or less conflicting as to definite terms. Misunderstandings 
 frequently arise betwreen the consignor and the consignee, due 
 principally to the failure of the minds to meet before the con- 
 tractual relations commence. The auditor will usually have an 
 opportunity to urge the desirability of an explicit contract being 
 entered into at the outset and the furnishing of a copy to the 
 client's office, so that the terms and conditions of each consign- 
 ment may be noted in the books. Where a consignment is only 
 partially disposed of when the books are closed, care must be 
 taken that the unsold goods are not included in the inventory. A 
 record of the quantities on hand should be made, but the values 
 should be entered "in short" and a memorandum made that the 
 items belong to the consignon 
 
 Inquiry should be made as to whether such goods are in- 
 sured, and if so, in whose name. If in the name of the consignee, 
 the policies must contain a stipulation covering the facts of title. 
 
 On lots partly disposed of, credit may be taken for the pro- 
 portionate commission or profit on goods sold and delivered, but 
 no income should be taken credit for on unsold or undelivered 
 goods. In order to satisfy himself that the accounts are in order 
 the auditor should request that pro forma account saleS be made 
 up for all open consignments. The quantities not yet disposed 
 of should be checked with the inventories and the accrued earn- 
 ings can also be verified. 
 
 The account sales should be scrutinized in order to see that 
 all legitimate charges are made to the consignor. Commissions 
 and freights are not usually forgotten, but careless clerks do not 
 always include insurance, cartage, allowances, and similar items 
 which may be permissible. Other items, such as extra charges 
 for special services, postage, etc., may not be thought of, but as 
 items of this nature are charged by some commission houses, it is 
 always pertinent to inquire whether the matter has had full con- 
 sideration. 
 
 Sales not Delivered: In closing books there seems to be a 
 temptation on the part of most concerns to anticipate all profits 
 in sight. Therefore, where sales have been made for future deliv- 
 
272 AUDITING 
 
 ery, the tendency is to charge the goods and create an account 
 receivable or make some adjustment of the profit and loss ac- 
 count to include the profit which it is expected will be realized. 
 Conservative business men do not follow this course, but expe- 
 rience proves that it is followed often enough to compel an au- 
 ditor to be constantly on his guard. 
 
 In the automobile trade, for instance, sales are effected and 
 substantial deposits or part payments received long before the 
 cars are delivered. But no profit has been realized and may 
 never be realized, so that the inclusion of this hoped-for profit in 
 a profit and loss account is absolutely wrong. 
 
 Thousands of such sales are never consummated by reason of 
 the failure of the factories to build the cars. The sales have been 
 canceled and the deposits returned, and all expenses incurred 
 thereby have not been compensated for. 
 
 In other cases the goods may be on hand or in process of 
 manufacture, so that the expectation of being able to deliver is 
 based on a sounder hypothesis, but the rule is precisely the same. 
 No profit must be taken until a delivery or a tender has been 
 made and the sale is converted into a valid claim against a sol- 
 vent debtor. 
 
 There is some merit in the contention that where sales for 
 future delivery have been made, and the goods are on hand 
 ready to ship, the goods may be inventoried at something more 
 than manufacturing cost. That is, the expenses of sale having 
 been incurred to this extent, the period in which delivery is made 
 should be forced to bear its share of the burden, and such ex- 
 penses should be carried forward as an asset under the caption 
 "Deferred Charges to Operations." These expenses may include 
 sales expenses such as commissions, traveling, salaries, advertis- 
 ing, etc., but must not include any part of fixed charges such as 
 rent, administration expenses, etc. 
 
 Where part of the sales price has been collected in advance or 
 deposits have been received, such items should be separately 
 stated on the balance sheets, as they do not constitute trade lia- 
 bilities, but on the contrary are evidences of prospective profits. 
 But as already stated, the prospective profit must not be antici- 
 pated, and if sales not delivered have been charged to customers, 
 the auditor should eliminate such items from the accounts receiv- 
 
THE DETAILED AUDIT 273 
 
 able and the sales account and add the goods to the inventory 
 at their cost. 
 
 There may be many a slip between the order and the profit- 
 able closing of the transaction, as Judge Clark said in the Amer- 
 ican Malting case (see page 595) : 
 
 These contracts were to deliver at a future time a product not yet made, 
 from raw material, not yet purchased, with the aid of labor not yet expended. 
 The price agreed to be paid at that future time had to cover all the possible 
 contingencies of the market in the meanwhile and might show a profit, and 
 ran the chance of showing a loss. 
 
 Sales of Building Lots : In the audit of a land or real estate 
 company it would at once occur to the auditor that he must 
 look carefully for receipts from sales of building lots. Now 
 the last places to look at are the receipt side of the cash book 
 and the sales book or other record of the sales, although when 
 he asks for a record of sales, that is the point to which he will be 
 directed, and at least nine out of ten times the client will expect 
 him to take these records as starting points rather than to con- 
 sider such a record as a goal toward which he is working. 
 
 There probably never has been a land company which did not 
 issue a map of its property nicely marked off into lots with a 
 number and block for every lot. What could be simpler than for 
 the auditor to take a map and one of the printed pricelists usually 
 available and proceed to account for every lot? All lots sold for 
 less than list price should pass inspection by a duly authorized 
 officer. All lots not accounted for as sold should be on the "for 
 sale" list or else specified as being set apart for particular pur- 
 poses, these purposes to be evidenced by resolutions of the board 
 of directors or other authority properly expressed. 
 
 As most lots are sold on installments, the auditor will then 
 look for collections of interest on the deferred installments and 
 will require that every such item be accounted for. 
 
 And so through the rather simple processes of most busi- 
 ness enterprises it will be possible to think out the sources of 
 revenue instead of using the books as a guide, for by so doing 
 the auditor will avoid the danger of being influenced by the 
 entries which are shown therein and thus lose sight of the fact 
 that those entries are not all which should appear. 
 
CHAPTER XIX 
 
 THE DETAILED AUDIT (Continued) 
 
 PURCHASES AND EXPENSES 
 
 Vouchers: It must be admitted that the examination of 
 vouchers is necessary and valuable, but with respect to relative 
 importance, such work will be classified down toward the end of 
 the list. If a careful comparison of vouchers with cash books 
 would disclose improper or extravagant purchases or expenses, 
 the very considerable work involved would be justified, but, 
 unfortunately, the ordinary voucher, so-called, is usually little 
 more than a receipt for a given sum of money and is usually of so 
 little practical use that many concerns never insist on vouchers 
 nor do they preserve them when they are furnished. 
 
 Of course, this is a matter which should not be discussed 
 with anyone whose accounts are being audited. Where vouchers 
 are taken, an auditor should call for vouchers covering all pay- 
 ments and require that they be arranged in order to correspond 
 with the cash-book entries. He should not allow it to be known 
 that there is any probability of his not checking any part of the 
 vouchers, or it will be difficult to secure them properly and have 
 them arranged in order. If a cheque bears on its face or back any 
 indication of its purpose, it is the best receipt for money paid 
 that can be secured. If it bears no evidence as to its purpose, 
 but can be readily identified with a particular bill or invoice, it 
 still is a better voucher than a receipted bill. The comparison 
 of vouchers with a cash book without the identification of the 
 entries in the cash book with the cheques is- worse than negli- 
 gence, for the sole purpose of vouching cash is to ascertain, as 
 nearly as possible, that the payments represent an equivalent in 
 value to the payers and that the equivalent — that is, the dis- 
 charge of a like liability — is received when the cash is paid. A 
 mere receipt for so much money, which can readily be forged, is 
 poor evidence of a legitimate payment, but a paid cheque, prop- 
 erly indorsed and otherwise identified as representing a definite 
 
 274 
 
THE DETAILED AUDIT 275 
 
 liability, is pretty fair proof that the money has reached a cred- 
 itor ; and if the auditor follows it up by a careful scrutiny of the 
 documents supporting the cheque, he is on the right track. 
 
 It must be remembered, however, that a paid cheque unsup- 
 ported by other documents is not conclusive evidence of the pro- 
 priety of a payment. This is well illustrated by the following 
 instance in the author's experience : 
 
 The accounts of a district school board which had passed out 
 of existence were to be audited. Only a small amount of funds 
 was handled, the total collection of taxes for district school pur- 
 poses being about $15,000 per annum. The records submitted to 
 the auditors were fairly complete, with the exception that no paid 
 bills were turned over to the new board. The paid cheques, how- 
 ever, were intact, the cash book had been well kept, with some 
 attempt at classification of expenditures, and the minute book 
 contained complete lists of all the bills approved for payment by 
 the board at its meetings. 
 
 Every disbursement recorded in the cash book was found to 
 be supported by a paid cheque, and all the payments had been 
 duly authorized by the board. Most of the payments were of 
 very moderate amounts, and thus far everything appeared to be 
 in order. Practically nothing had been seen to arouse the au- 
 ditor's suspicions. Several payments, each for a little less than 
 $150, had, however, been made to a wholesale drug house and a 
 pharmacist respectively. The auditors could not think what 
 articles aside from sponges would be purchased from these 
 sources, and concluded to obtain duplicate bills so as to ascertain 
 the nature of the articles purchased. The request for such bills 
 was in both cases met with the reply that no payment of the 
 amount mentioned had been received from the school board. 
 Further investigation developed the fact that the indorsements 
 on the cheques had been forged, which fact the auditor could not 
 know from an examination of the cheques themselves, as they 
 bore evidence of having passed through bank in the usual way. 
 It finally developed that the indorsements had been forged by a 
 member of the school board. . 
 
 Furthermore, even a bill certified as to receipt of the articles 
 shown thereon, approved for payment by the authorized offi- 
 cials, and evidenced as to actual payment by an indorsed cheque 
 
276 AUDITING 
 
 which has passed through bank in the regular manner, may not 
 be conclusive evidence of the honesty of a transaction. Another 
 school board (not the one mentioned in the preceding para- 
 graphs) had purchased a piano for $450. The documents sup- 
 porting the payment were all in regular order, and the piano 
 itself was in existence as proof of the fact that the article charged 
 for on the bill had actually been received. The auditors, how- 
 ever, made a personal visit to the store where the piano had been 
 purchased and without revealing their identity made inquiries as 
 to the prices of various styles of pianos. They were offered 
 exactly the same style of piano for which the school board had 
 paid $450 for $275, and this without any "haggling" over the 
 price. The piano concern later admitted that when it re- 
 ceived the school board's cheque for $450, it (the piano concern) 
 paid $200 in currency to the bearer of the cheque. Of course, 
 the "refund" never found its way back into the school board 
 treasury. 
 
 In small concerns many items of payments will be posted 
 direct to expense and other general ledger accounts. The vouch- 
 ers for such items should include complete evidence of being 
 genuine. The best vouchers for payments posted direct to per- 
 sonal accounts are the paid indorsed cheques, because the credit 
 side of the personal ledger accounts will have been compared 
 with the original invoices, so that very little evidence of the dis- 
 charge of the obligation is required. 
 
 An auditor can be of great assistance to his client by looking 
 into the various operations surrounding a payment as well as 
 passing on the question as to whether or not it is a bona Me 
 transaction. 
 
 Purchase Invoices: The bill or invoice should bear on its face 
 all the proper marks or initials to indicate that the goods or ma- 
 terials were received in proper order as to quality and quantity ; 
 that they were as ordered, which includes an approval of the 
 price, provided it was recorded at the time the order was given, 
 or an approval by a responsible and authorized ofificial where 
 the price was not fixed in advance ; that if the quotation was "de- 
 livery free," freight was not paid, or, if paid, has been charged 
 back to the vendor ; that where custom permits or any other indi- 
 cation appears of a cash discount being in order, it was deducted ; 
 
THE DETAILED AUDIT 277 
 
 that in all other respects the purchase was in order, including the 
 checking of the calculations, the notations as to the department 
 or account to be charged, etc. 
 
 Inquiry should be made as to whether the receiving clerks 
 keep an independent record of all goods received irrespective of 
 invoices to cover, and whether the subsequent comparison of 
 these records is carried out intelligently and completely. 
 
 As stated above, these invoices should be thoroughly tested 
 to ascertain the internal method of checking their accuracy, but 
 the auditor should never, as a matter of course, attempt to verify 
 the whole of the purchase vouchers unless he has a further pur- 
 pose in view than to "audit the books." In a large concern the 
 auditor does not think of examining every purchase invoice. He 
 makes copious tests and if nothing suspicious is discovered, is 
 willing to certify that the accounts are correct. An auditor 
 should not inspect every voucher even in a small establish- 
 ment unless there is some special reason for doing so. 
 
 There are many more important things to do in an audit, and 
 the time spent on vouchers must bear a proper relation to the 
 other time and to the fee, if it is to be fair to the auditor and to 
 the client. 
 
 It is true that some books and articles on auditing recom- 
 mend the examination of all vouchers, but these are not based on 
 successful experience nor upon a proper realization of the service 
 which the client is entitled to receive. 
 
 Where a system of internal check is in force, it will not be 
 necessary to inspect every invoice; a complete test should be 
 made to see that there is a strict compliance with the rule hereto- 
 fore mentioned, but this test will be complete by taking, say, 
 three or four months out of twelve and examining each item, 
 always including the last month of the period. The auditor 
 should then look over the cash book very carefully for the other 
 eight or nine months, and in connection with his analysis of the 
 ledger accounts he can note any unusual or suspicious-looking 
 item and call, for the voucher covering it. This will obviate the 
 necessity of checking over the mass of documents which he has 
 satisfied himself by his general test to represent purchases for 
 the proper and ordinary purposes of his client. The analysis of 
 the ledger accounts is important wherever charges have been 
 
278 AUDITING 
 
 made to plant accounts. These must always be supported by 
 proper vouchers. 
 
 In making the test care must be taken to ascertain that bills 
 are made out to the concern under audit and not to its officers or 
 clerks. Of course, where the disposition of the things purchased 
 is checked such an irregularity would be disclosed. 
 
 It is important to know not only that the entries purporting 
 to represent purchases made are proper, but that all invoices for 
 purchases actually made have been entered previous to closing 
 the books. This can be quite satisfactorily tested where there is 
 an adequate system of recording purchase orders issued, of keep- 
 ing record of incoming goods, and of checking invoices against 
 order and receiving records. The comparison of creditors' state- 
 ments with the accounts payable record should under ordinary 
 circumstances also enable the auditor to detect the omission of 
 purchase invoices. 
 
 In the case of Irish Woolen Mill Company, Lim. v. Tyson 
 and others, which is more fully referred to in the chapter on 
 Liabilities of Auditors, the auditor was held liable for negligence 
 in having failed to detect the intentional omission of purchase 
 invoices when the books were closed and the subsequent entry 
 of the invoices in the following fiscal period. The purpose of the 
 company's secretary was to make a better showing than its opera- 
 tions and financial condition justified. The court held that the 
 auditor, who had made monthly audits for a number of years, 
 should have had his suspicions aroused by the fact that invoices 
 were charged into each period which, according to their date, 
 belonged in a previous period, and that had he then made the 
 investigation which this suspicious circumstance called for, the 
 fraud would have been detected. 
 
 Missing Vouchers : These ar^ a source of much needless work 
 to many auditors. If an audit is being made and no evidence 
 whatever of fraud is found, and if the payments for which vouch- 
 ers are not submitted appear in every way to be regular, it is usu- 
 ally a waste of time to list them in detail and consume a lot of 
 time in having them located. In most cases they will not be 
 found, as many vouchers are never returned or are mislaid or 
 lost in the mails. 
 
 No specific rule can be formulated with respect to missing 
 
THE DETAILED AUDIT 279 
 
 vouchers, but the author wishes to go on record as opposed to the 
 contention of some auditors who regard this point as a very 
 serious one in every audit. The experience of the author has 
 been that where a cashier enters an irregular or wholly fic- 
 titious payment, he will always be sure to have a voucher to 
 cover. 
 
 Vouchers for Petty Cash Payments, Pay Roll, etc.: Where 
 payments are made covering expenses and wages, and for similar 
 purposes, and where there is no ledger account with the payee, 
 great care must be taken to ascertain that the amounts have not 
 been overstated, either by fraudulently raising the figures on the 
 bill or memorandum or by entering a larger amount in the cash 
 book than the voucher represents. 
 
 Petty Cash: Vouchers are often altered and petty cash pay- 
 ments are frequently the subject of manipulation. Junior clerks 
 see how easy it is to hand in a memorandum calling for $10 post- 
 age when $5 is all that is necessary, or, in fact, used, and they 
 gradually extend their field of operation until large sums are ab- 
 stracted. Postage or mail books are in general use in England, 
 and if more generally adopted here would save many a boy from 
 the penitentiary. It is a grave responsibility for any employer 
 to permit, or any auditor to approve, a loose or inefficient system 
 for handling petty cash, postage, etc. 
 
 A large percentage of young boys who are employed in the 
 business districts of our large cities and who have access to or 
 can draw from petty cash funds, are constantly following the 
 races through the worthless afternoon papers, through pool- 
 rooms, or in other ways. Conversations in large offices often indi- 
 cate the keenest interest in the results of the races not only near 
 New York, but throughout the country. Professional auditors 
 should take a firm stand on all questions, public or private, which 
 affect gambling. 
 
 Coming back to petty cash vouchers, in view of theinfor- 
 mahty of many of them, the auditor's best protection is to have 
 some responsible person scrutinize the payments, rather than the 
 vouchers themselves, and indicate his approval by initialing each 
 page or each month of the petty cash book. The whole question 
 of petty cash vouchers is one which calls for the exercise of good 
 judgment rather than the application of fixed rules, and the 
 
28o AUDITING 
 
 auditor should take this view of it rather than feel that it is 
 merely a matter of comparing pieces of paper with certain entries 
 on the payment side of a cash book. 
 
 There is no great objection to examining every voucher 
 where the concern is not too large, and where the auditor has 
 plenty of time, and where he does it properly, but he should 
 relegate the inspection of vouchers to its proper place and, if 
 pressed for time, he should attend first to more important 
 matters. 
 
 Where a test is considered sufficient the auditor may verify 
 all of the vouchers for a certain period, or all vouchers exceeding 
 a certain amount for the entire period. 
 
 There are numerous ways of handling pe ty cash, but unfor- 
 tunately most of them provide little or no check upon the cashier 
 and furnish afterward no evidence of the faithful discharge of his 
 trust. 
 
 The method of charging all petty expenditures in a lump sum 
 to an expense account known as "petty expenses" is a most com- 
 mon one, and one that is highly undesirable. The older method 
 of paying such expenses out of incoming cash or of cash received 
 from cash sales, and oftentimes of not making any entry what- 
 ever, is still worse. 
 
 The most satisfactory method is that known as the "imprest" 
 system. The petty cashier is provided with a fund of $ioo or 
 $500, or whatever amount is necessary to meet the average ex- 
 penses of two weeks or a month. This amount, when paid to 
 him, is charged to an account in the general ledger known as 
 "Petty Cash Fund" and stands undisturbed from month to 
 month. 
 
 The petty cashier keeps a cash book provided with a column 
 for each of the principal expense items, such as Office Supplies, 
 Factory Supplies, Postage, Stationery, and Printing, etc. He 
 continues to pay from his cash fund until the balance gets low, 
 or until the end of the month, when he rules off his book, pre- 
 sents it to the cashier together with his vouchers, and receives in 
 exchange a cheque for the exact amount of his expenses. This 
 and whatever cash balance he had left make up the original petty 
 cash fund. The general cashier in recording the cheque on his 
 records does not charge "petty cash," but he charges the various 
 
THE DETAILED AUDIT 281 
 
 expense accounts direct, posting from the footings of the columns 
 in the petty cash book. 
 
 In some instances a loose summary sheet is used to which 
 the vouchers are attached and on which they are entered in de- 
 tail. This system does away entirely with the petty cash book, 
 and the summary sheet and supporting vouchers become the 
 authority for the issuance of a refunding cheque to the petty 
 cashier. 
 
 Organization and Similar Expenses Which Affect More Than 
 One Year's Operation: If the expenses incurred in the organiza- 
 tion of the company, such as incorporation fees, legal, engineering, 
 and other expenses, engraving bonds and stock certificates, 
 transfer fees and stamps, etc., are more than can fairly be charged 
 into current expenses, it is permissible to spread the charges over 
 a term of years, preferably three, and not more than five. But it 
 should be ascertained whether or not the promoters (if the en- 
 terprise was "promoted") agreed to pay any part of these ex- 
 penses. This is a matter of increasing importance, as a number 
 of corporations are being organized where this obligation is 
 assumed by the organizers. 
 
 Other items, such as advertising and exploitation expendi- 
 tures which are intended to produce future business, may not 
 appear to be a proper charge against income which could hardly 
 have received the benefit of such payments. An auditor may 
 pass the carrying forward of any legitimate expenditure which 
 has been incurred solely for the benefit of future business, pro- 
 vided that in his judgment the setting up of the deferred charge, 
 and its consequent inclusion as an asset, is justified by its prob- 
 able value to the future business. 
 
 But it is not enough that the expenditure has been made. 
 For instance, a large number of circular letters calling attention 
 to a special sale in January may be sent out in December. If the 
 auditor commences work in February and finds that the cam- 
 paign was a total failure, it would be rather misleading for him 
 to certify to the accuracy of a balance sheet as of December 31st 
 showing the entire expenditure as an asset. 
 
 An auditor should be willing to back up his opinion by his 
 certificate. If in his opinion expenditures of this nature are actu- 
 ally deferred assets, he should so certify. It should, however, be 
 
282 AUDITING 
 
 noted that the most successful concerns carry on selling cam- 
 paigns all the time, and there must be some limit to the postpone- 
 ment of the actual charges to current operating. 
 
 In the discussion of a paper presented at the 1908 meeting of 
 the American Association of Public Accountants in which the 
 matter of deferred charges was mentioned, George O. May, 
 C. P. A., said : 
 
 A further point raised by one of the speakers was as to the carrying for- 
 ward of expenses on seasonal business. I think this is a dangerous practice, 
 especially where there is a big asset of good will. I think the more con- 
 servative view to take is that the expenses necessary to keep up the next 
 season's business are effectively an expense for preserving the good will of 
 the business. As regards the buying expenses of a department store, I do 
 not think any valid objection can be taken to these being included. In my 
 experience it has often been found, in fact generally, that department stores 
 do not take into account discounts on purchases on the one hand, or buying 
 expenses on the other, and that these about offset each other. 
 
 If the business is not successful there will be no future profits 
 to which the deferred items can be charged. Therefore, the 
 auditor should use every argument he can muster to induce his 
 client to absorb these expenses as soon as possible, and never 
 carry them forward unless it would be improper, from every 
 point of view, to include them among the current expenses. 
 
 More than one enterprise has been wrecked by the failure to 
 look preliminary or establishment expenses squarely in the face. 
 The temptation to state the current operations in such a way as 
 to show a profit has been too strong, and so they have gone along 
 from year to year, the burden increasing instead orf diminishing, 
 with an inevitable day of reckoning when it is realized that lia- 
 bilities cannot be liquidated with capitalized expenses. 
 
 The recent report of an automobile business stated that the 
 auditors had insisted on charging ofif all of the expenses of estab- 
 lishing branches which previously had been carried as an asset. 
 The monthly reports had shown big profits, which had been 
 largely paid out in dividends, with the result that the working 
 capital had been reduced to an amount below the safety line. 
 
 If auditors with the courage of their convictions had been con- 
 sulted earlier and had called attention to the overstatement of 
 profits, the company's credit would probably not have been im- 
 paired to the extent it was, 
 
THE DETAILED AUDIT 283 
 
 Extraordinary expenditures, such as repairs and renewals 
 incident to accidents or storms, are sometimes capitalized at the 
 time with the expressed intention of spreading the loss over sev- 
 eral years. The same situation arises where accident insurance 
 is not carried, a certain percentage of the gross receipts being set 
 aside to a reserve account to pay losses, and the payments being 
 in excess of the reserve. Quite frequently the debit balances 
 so created are carried forward as an asset until subsequent ac- 
 cruals wipe out the deficit. 
 
 This practice is not sound, because in the last analysis it 
 simply results in setting up on the balance sheet accounts which 
 are in no sense of the word assets. If the word "assets" means 
 anything at all, there can be no justification for the inclusion of 
 items of maintenance, expended because of necessity, and which 
 do not tend to improve the physical or financial position of the 
 enterprise. 
 
 It may be that these charges, if incorporated among the costs 
 and expenses of a current period, tend to hide the normal opera- 
 tions, but if the unusual item is clearly set forth this procedure is 
 preferable to making direct charges to surplus. It may be hard 
 to resist the temptation, but the practice is to be condemned. It 
 may not sound well or look well, but it has the advantage of por- 
 traying the actual state of affairs, which is not the case when an 
 attempt is made to designate an expense account as an asset. 
 Directors who realize their personal responsibility for dividends 
 paid out of capital will not vote for a distribution of earn- 
 ings which does not take into account expenses actually in- 
 curred. 
 
 All payments for insurance, bank discount, rent, taxes, dues, 
 subscriptions, and similar items should be scrutinized in order to 
 determine the proportion, if any, which applies to a subsequent 
 period and thus constitutes an asset when the books are closed, 
 in the form of a deferred charge to the future operations of the 
 business. In order to save the auditor's time he may request 
 one of the client's clerks or the insurance broker to calculate 
 the prepaid items, in all cases testing the accuracy of their 
 work. 
 
 Where discount on bonds is carried as a deferred charge to 
 operations, the auditor should verify the amortization calcula- 
 
284 AUDITING 
 
 tions. If this provision is not in order, an adjustment should be 
 made before the balance sheet is certified to. 
 
 Legal Expenses and "Graft": If charges to legal expenses 
 consisted merely of current bills from attorneys, no special men- 
 tion would be necessary, but the account is such an elastic one 
 that it requires special and careful attention. 
 
 In some lines of business secret commissions are paid to the 
 purchasing agents of customers. In spite of the publicity which 
 such practices have received during the last few years, "graft" 
 still exists and no doubt will flourish for years to come. Where 
 the recipients are unusually sensitive it is customary to charge 
 the amounts paid to legal expenses or some other account which 
 serves to screen the true purpose of the payments. From an 
 accounting point of view this is, of course, highly objectionable, 
 because it permits sales to go through with what are almost in- 
 variably excessive gross profits without the chance of charging 
 against such sales one of the direct expenses connected there- 
 with. Legal expense is not usually regarded as one of the iteins 
 of selling costs, and the auditor who suspects the truth can hardly 
 restate the accounts to accord with his suspicion. The vouchers 
 for such payments will be signed by some responsible officer of 
 the corporation or a member of the firm, so that the honesty of 
 the disposition of the funds can hardly be questioned. 
 
 Some years ago an auditor of high standing discovered m 
 the audit of one business that a commission had been paid to the 
 superintendent of the plant owned by another client. He in- 
 formed the latter, but was not profusely thanked for his informa- 
 tion. The other corporation learned of the fact, called it a gross 
 breach of trust, and declined to pay the auditor's bill. 
 
 If an auditor feels that the morals of his client are to be 
 judged along with the accounts, he should have the courage of 
 his convictions and so inform the client before the work is started. 
 He will not then have to charge ofif his bill to bad debts. 
 
 Repairs pnd Renewals : In the audit of a large manufacturing 
 establishment this will be the most troublesome account upon 
 which the auditor will be called to pass. 
 
 The underlying ptirpose of the audit of expenses is to ascer- 
 tain as far as possible that an equivalent was received for the 
 liability assumed, but the improper application in the books of 
 
THE DETAILED AUDIT 285 
 
 the expenditure for repairs and maintenance may upset the ac- 
 curacy of a balance sheet in spite of the fact that value was re- 
 ceived for the- liability assumed. That is, the expenditure for 
 repairs or for renewals may be charged to plant or some other 
 asset account instead of to current operating expense, thus inflat- 
 ing the assets on one hand and the profits on the other. It must 
 be kept in mind constantly that tacit conspiracy usually exists to 
 bring about this very result, and the auditor will be apt to find 
 strong forces arrayed against him as soon as an accurate account- 
 ing for maintenance items is begun. 
 
 The ordinary manager, superintendent, or foreman seems to 
 feel that it is a reflection on him individually or on his depart- 
 ment to incur any considerable expense on renewals and repairs 
 which he knows will increase his cost of operating. He knows 
 that an item charged to an asset account will not be charged 
 against him, so it is no wonder that an analysis of plant accounts 
 sometimes discloses remarkable items which are in no sense of 
 the word betterments, but current maintenance. 
 
 In order to make a complete audit of items which should be 
 charged to repairs, the charges to plant accounts must be an- 
 alyzed. 
 
 Allowances and Returns: There are two very good reasons 
 for a careful scrutiny of all credits to customers, the first being 
 that by means of unauthorized credits fraud may be concealed. 
 That is, cash collected from a customer is not accounted for, and 
 subsequently, to avoid discovery, the ledger account is closed by 
 an entry which indicates that goods have been returned or that 
 an allowance has been made. 
 
 The second reason is that in the absence of fraud there may 
 be carelessness both in the manner of granting credit for allow- 
 ances and returns and in the record thereof. For instance, some 
 automobile dealers deduct freight from credits for returned 
 defective parts ; others do not. To a dealer doing a large business 
 this makes a difference of several hundred dollars a year. 
 
 In some concerns full credit is not given where goods are 
 returned simply on account of an overstock. In others, there is 
 little or no check on the returns and full credit is allowed. 
 
 The auditor should, therefore, examine the record which has 
 been kept and see to it that so far as possible the entries are 
 
286 AUDITING 
 
 approved by some responsible official and that no abuse has been 
 made of the return privilege. In order to test the integrity of the 
 entries, it may be desirable to call for the correspondence in con- 
 nection with a certain number of items. 
 
 Goods returned are not purchases, but deductions from sales, 
 but so far as stock records are concerned they should be treated 
 as purchases and tests should be made to see that the entries in 
 the return book are posted to the stock sheets as regularly as 
 those in the purchase records. Otherwise an opportunity might 
 be afforded to a stock clerk to ship goods without accounting 
 therefor. 
 
 Separate columns should be kept in the allowance and return 
 book, as allowances may or may not be posted to a separate ledger 
 account, while returns are always deductible from sales. 
 
 The newspapers recently reported a case wherein it appeared 
 that the bookkeeper of a baking company had manipulated his 
 books by crediting customers with excessive returns. The fol- 
 lowing is the police account, in part: 
 
 He (the bookkeeper) left the firm the early part of this month, and 
 when his books were examined, the firm found a shortage of more than 
 $1,500. He admitted entering in the books to the credit of customers a 
 greater number of loaves of bread daily than were actually returned by the 
 firm's drivers. 
 
 Empties: In many lines of business shipments are made in 
 bottles, boxes, barrels, or other form of package, which have a 
 residual value, the test of the latter being the cost, durability, and 
 expense of return. When no charge is made for the package and 
 credit is allowed for returns, there is the equivalent of a purchase, 
 provided the allowance is not more than the open market price. 
 If the credit is at a higher price than the market, the excess is 
 clearly a deduction from sales. If credit is passed only upon 
 return and the allowance is not more than cost, no record need 
 be kept of those outstanding, as it makes no difference whether or 
 not they are returned. If a separate charge for packages appears 
 on the invoices, there is no difificulty in keeping track of the 
 aggregate charged for and the aggregate returned, if the informa- 
 tion is of value. 
 
 In the case of kegs, crates, syphons, etc., for which no charge 
 
THE DETAILED AUDIT 287 
 
 is made, but which must be returned, the most common, and 
 probably the most satisfactory, method of handling is to note 
 the quantities in the sales book and post the items to the cus- 
 tomers' ledger, in which a special column should be provided on 
 both debit and credit sides. If this system has not been in force, 
 a very careful test of the records should be made, as errors usually 
 exist, and they may be unnecessary as well as expensive. 
 
 The method of inspection and of passing credit should have 
 the auditor's attention. If the receiving clerk is careless or ineffi- 
 cient, the number of packages returned may not be verified and 
 damaged or broken packages may be passed as in good condition. 
 The clerk in charge of the credits should not be allowed to settle 
 the custom of the house with respect to prices to be allowed, 
 freight payments, etc. 
 
 If packages are charged to customers at a substantial increase 
 over cost, and if permission is granted for return at the same 
 price, the auditor must provide a reserve to cover outstandings 
 when the books are closed. 
 
 Where packages are furnished free with an obligation to 
 return, it must be assumed that customers treat the obligation 
 lightly and that a considerable proportion will not be accounted 
 for, in addition to the usual losses and breakages. If feasible, 
 an attempt should be made at some convenient time to secure an 
 actual inventory of packages on hand and within reach that are 
 positively known to be recoverable. A comparison of these fig- 
 ures with the book inventory would form a sound basis for a 
 depreciation or expense rate. 
 
 Salaries: In all cases a pay-roll book showing names, posi- 
 tions, and salary rates of all employees should be kept. This 
 does not include workmen and others whose compensation is re- 
 ferred to throughout this book as wages. 
 
 The book should be arranged with thirteen columns, to cover 
 three months' time. Each column should be initialed by an ex- 
 ecutive. The cashier should have written authority for each 
 change in rate and for each name added. If one cheque is drawn 
 for an entire pay roll, the auditor should verify the footings of, 
 say, every third week. 
 
 Salesmen's Commissions: Examine contracts and note provi- 
 sions as to percentage, territory, and particularly as to whether 
 
288 AUDITING 
 
 commissions are payable on delivery of goods or on collection of 
 accounts; also whether based on gross sales or on net proceeds 
 after deductions for cash discounts, freight, etc. 
 
 Traveling Expenses, Entertaining, etc.: Examine contracts 
 of salesmen, if any, to see if limit has been placed on traveling 
 and other expenses. If contracts are not required, inquire of 
 manager if any understanding of this nature is in force. 
 
 In many concerns the utmost liberality prevails in such 
 allowances, but sentiment along these lines is changing and sales- 
 men are being held to a stricter accountability than was formerly 
 the case. The auditor, therefore, should take pains to make 
 inquiries on this point at each audit. 
 
 Vouchers for traveling and similar expenses should be ap- 
 proved by some one in authority. 
 
 The auditor is interested in seeing that railroad mileage is 
 properly accounted for. Mileage may be carried as a separate 
 account on the ledger, if it is large, or it may be regarded as cash 
 and included in the cash figures. 
 
 When it is given out, the full amount in the book is charged 
 at cost against the Traveling Advance account of the one who is 
 using it. When it is returned, credit is given just as if cash were 
 received. 
 
 Wages : In the audit of a business where many employees are 
 found it will be necessary to devote some time to a consideration 
 of the system in force, with respect to time records and wages 
 payments. It is a well-known fact that receipts are worthless so 
 far as being a check on the amount paid. It may be valuable to 
 a concern to have a receipt from each man to guard against sub- 
 sequent disputes, but these receipts are of little real value to an 
 auditor who is attempting to prove to his own satisfaction that 
 the aggregate amounts of the pay-roll payments have reached the 
 hands of those entitled thereto. The auditor must think this out 
 for himself in each audit, but it is suggested that the best check 
 on wages payments is to use as many people as possible during 
 the various stages from the point where the time is recorded to 
 the final handing out of the envelopes. If the latter, for instance, 
 is done by an employee who has no access to the rolls or to the 
 cash, it makes a good check. If an auditor is on hand when the 
 men are being paid ofif, he should supervise the operation or take 
 
THE DETAILED AUDIT 289 
 
 a more active part, if feasible. Obviously, this procedure would 
 be of no value unless it was done without notice to anyone. 
 
 A few large corporations have tried the experiment of paying 
 exclusively by cheque, but it is believed that the plan has been 
 abandoned by most of them. 
 
 The auditor must direct his attention to two main points, viz., 
 the records which may be kept accurately, or inaccurately, and 
 the clerical force in charge of the records, who may be honest or 
 dishonest. 
 
 Fortunately for employers, most of the records now in gen- 
 eral use are, or should be, mechanical or automatic. The time 
 clock registers the time in apd out, and other devices stamp the 
 time actually employed on various jobs. In the office these 
 records in turn are checked and proved by mechanical means. 
 
 The audit of wages earned therefore resolves itself into a 
 critical inspection of the system in use. Before making this in- 
 spection, the auditor should acquaint himself with the particulars 
 of all the latest devices on the market. He can then evince a 
 familiarity with any system he finds and note any lack of effi- 
 ciency, and is also in a better position to make suggestions where 
 unsatisfactory methods are found. 
 
 The author feels that the scope of this book is too limited to 
 contain directions as to the best system, except to suggest that, 
 since scientific management has taken hold of the labor question 
 so seriously, and has been more or less successful, the auditor 
 who has to deal with the audit of wages paid, and who is ex- 
 pected to criticize the records relating thereto, owes to himself 
 and his profession the duty of at least reading the best-known 
 books on factory management, and glancing over the descriptive 
 circulars of some of the really wonderful mechanical appliances 
 designed especially by experts familiar with the practical side of 
 the question. So much for the system. 
 
 The personnel and extent of the clerical force are important 
 from the auditor's point of view. He should be especially vigi- 
 lant in small establishments where the office force is small and 
 where the same clerk keeps or assists with the original records, 
 makes up or assists with the envelopes, and distributes them or 
 has some connection with the distribution thereof. 
 
 Concrete instances may serve better than theory in pointing 
 
290 AUDITING 
 
 out the course the auditor should take to satisfy himself that the 
 pay rolls are correct. 
 
 The auditor should ascertain that the names of discharged 
 men are removed from the pay roll as of the proper date. In a 
 large factory the foreman handed in to a clerk in the office who 
 had access to the pay rolls, slips bearing the names of men dis- 
 charged. He destroyed the slips and recorded full time to the 
 credit of the men discharged. In paying off he secured the en- 
 velopes and retained the money. The fraud was not discovered 
 for a long time. 
 
 In a factory where time books were kept by the foreman, the 
 assistant cashier transferred the time therein to the pay-roll book. 
 In addition, he entered several fictitious names. The cashier 
 himself made up the envelopes and superintended the paying off. 
 Each week a number of envelopes were left over, as is nearly 
 always the case in a large plant, on account of sickness, etc. 
 Most of them are called for within a short time. In this case the 
 dishonest clerk always had an opportunity to secure the en- 
 velopes covering the fictitious names. The fraud was discovered 
 by the auditor calling in the time books and comparing them 
 with the pay roll. 
 
 Duties: The vouching of duties is one requiring great care, 
 because, until recently, collectors of internal revenue would not 
 accept cheques in payment, but insisted on legal tender. Where 
 such payments are few in number, they are usually made through 
 a custom-house broker, and his invoices, if properly checked and 
 approved, will be sufficient evidence of the propriety of the pay- 
 ments. 
 
 In any event, the auditor should inquire into the procedure in 
 force and satisfy himself that the matter is properly handled. In- 
 stances have been known where everything was left to clerks 
 who did not have skill enough to discover errors if they did exist. 
 
 Interest and Collection Charges: Too much confidence is 
 placed in the accuracy of bank clerks ; therefore it will usually be 
 found that interest charged on loans and credited on balances, 
 discount deducted, and collection fees charged are, in nine cases 
 out of ten, accepted as final without being checked by the client's 
 stafif. Auditors whose experience includes much bank work are 
 familiar with the numerous errors made by bank clerks in their 
 
THE DETAILED AUDIT 291 
 
 own records, and while perhaps a majority of bank officers insist 
 on these errors being located and corrected, yet it is obvious that 
 in calculations involving interest and collection charges or 
 credits, there is not the same likelihood of correction of errors as 
 exists with those items which enter into the regular double-entry 
 system of the bank. 
 
 It follows that many errors will be made and will remain 
 undetected unless the auditor tests the items. But the auditor 
 should not stop with the verification of the calculations. Banks 
 will charge as high an interest rate on loans and discounts as 
 they think the traffic will bear, and if an auditor finds that a con- 
 cern with first-class credit is being charged six per cent, when he 
 knows that other concerns of equal or inferior standing are pay- 
 ing four and one-half or five per cent, it will certainly be in order 
 to mention the matter when a good opportunity arises. The suc- 
 cessful auditor will not lose any good chance to render a service 
 which falls within the scope of a business adviser. 
 
 Insurance Premiums: Experience shows that the bills of in- 
 surance agents are rarely scrutinized unless the item of premiums 
 is a very large one and the bill is in charge of some one especially 
 designated to keep track of the insurance in force and the rates 
 charged for insurance. For this reason a careful audit of the 
 premium bills and a careful analysis of the total insurance carried 
 is a fruitful field of inquiry for the auditor, and particularly 
 advisable in audits where great care is taken with other classes 
 of expenses. 
 
 In one case an auditor noticed that a policy had been can- 
 celed and another company substituted. He looked for a credit 
 to cover the return premium on the canceled policy, but failed to 
 find it. This started a complete investigation into insurance 
 matters, and it was found that for several years back one or more 
 policies had been canceled each month, due to the undesirability 
 of the risk, but that no credit therefor had been issued by the 
 agent. The total amount recovered amounted to several hundred 
 dollars and the discovery greatly enhanced the auditor's reputa- 
 tion. 
 
 Sufficient attention is not paid to the amount of insurance 
 carried. If overinsured, a useless expense is incurred, and if 
 underinsured, an unjustifiable risk is assumed. The matter is 
 
292 AUDITING 
 
 one requiring comparatively little time, perhaps not so much as 
 to verify the footings or postings for a short period, and is of 
 very much more importance. 
 
 As stated elsewhere, the unexpired portion of premiums pre- 
 paid at the date of the balance sheet is a deferred asset. In a 
 going business it is proper to set up the full unexpired proportion 
 of the premiums paid in advance, but in a statement of affairs, 
 such as is required in the event of proposed or forced liquidation, 
 it may be necessary to base the calculations upon the "short" 
 rates which are used in the cancellation of policies. 
 
 Freight and Express: Freight is another class of expense 
 which is passed by many auditors on the assumption that the 
 amounts paid are sure to be accurate, and that it is a waste of 
 time to attempt to go into detail. As a matter of fact, transpor- 
 tation companies, and particularly express companies, are chronic 
 overchargers, and every bill must be checked most carefully. 
 
 An auditor need not go into tariff details, but he should in- 
 quire closely into the method of check in use, and if he finds that 
 the freight and express bills are not approved as to weights and 
 rates by an intelligent clerk who uses all possible sources of 
 information to secure the lowest quotations, he will probably find 
 an opportunity to make a constructive report on the situation. 
 
 Many trades have a central association with a traffic bureau, 
 which furnishes full and free information when requested to do 
 so by its members. The Interstate Commerce Commission will 
 also assist a shipper who feels aggrieved. 
 
 In one very large manufacturing company being audited for 
 the first time by the author's firm, it was found that practically 
 no attention was given to the inspection of freight bills, it being 
 assumed that the charges were always in order. A careful test 
 disclosed the fact that many purchases had been made on a basis 
 of freight being prepaid by the shipper. Now it is the custom 
 in such cases for the consignee to pay the freight and deduct 
 same from the invoices. The company under audit had paid the 
 freight in every case, but had charged it to purchases account 
 instead of to the shipper. The investigation was carried back 
 several years and many thousands of dollars were actually re- 
 covered. 
 
 Postage: Vouchers should be secured for all purchases of 
 
THE DETAILED AUDIT 293 
 
 stamps. Postmasters will always sign receipts when requested 
 to do so. 
 
 Defalcations of small sums are frequently found in connec- 
 tion with postage accounts, so that an auditor should not only 
 scrutinize such payments very carefully, but should suggest safe- 
 guards which will reduce future possibilities of loss, and more 
 important still, remove a serious source of temptation to junior 
 clerks. 
 
 There should be some relation between the total cost of post- 
 age and other expense accounts, such as stationery and printing, 
 advertising circulars, etc. 
 
 A daily mail book showing the total postage used on out- 
 going mail requires very little time to compile and is valuable for 
 several reasons. It affords an opportunity to apportion the cost 
 to various accounts and has a most excellent moral effect on 
 those who handle the stamps, as some one in authority from 
 each department should initial the charges to such department 
 at least weekly. 
 
 Inquiry should be made to ascertain if postage is paid on 
 outgoing shipments of goods in small quantities. Many con- 
 cerns add postage to such shipments, and custom permits it 
 unless quotations are made "prepaid." If not so made and a con- 
 siderable number of shipments are made by mail, it will be in 
 order for the auditor to suggest that the cost of the postage be 
 added to the invoice. 
 
 In one instance, where quotations distinctly stated that post- 
 age would be added where small lots were sent by mail, the 
 shipping department was extremely careless and few such 
 charges were made. The auditor who discovered the laxity re- 
 ceived warm commendation for his vigilance and was requested 
 to make the most comprehensive investigation into all the other 
 departments of the business. 
 
 Journal Vouchers: Vouchers should be submitted for all 
 journal entries and the auditor need not announce in advance 
 how many of them he intends to inspect. If formal vouchers 
 have not been taken, the journal should be read over carefully 
 and all entries for which authority should have been secured 
 pointed out as requiring proof. 
 
 The journal can be used fraudulently by fictitious or irregular 
 
294 AUDITING 
 
 credits to customers or other personal accounts to conceal the 
 misappropriation of cash collected therefrom. To detect this, all 
 credits to customers for allowances, returns, etc., and all accounts 
 charged off as bad should be approved by some authorized offi- 
 cial. If no such approval appears, the auditor should ask that the 
 journal entries themselves be initialed. Other credits to personal 
 accounts are made for salesmen's expenses, etc. These should be 
 verified in the same manner as cash vouchers. 
 
 Well-managed concerns now supply their salesmen with a 
 fixed fund, and payments for expenses cover the exact expend- 
 itures during a given period. This obviates the necessity for 
 paying out round sums after the first item. Subsequent pay- 
 ments can be charged direct to the proper expense account and 
 journal entries are done away with. 
 
 Transfers from one account to another may be for the pur- 
 pose of fraudulently increasing one account or decreasing an- 
 other. 
 
 The experienced auditor need not spend very much time on 
 the journal, as a careful glance over the pages will develop any 
 entries which require explanation. The inexperienced auditor 
 should examine the entries carefully and call for documentary 
 evidence to support an item which by any chance might be irreg- 
 ular. 
 
 There is a tendency on the part of bookkeepers to use a 
 printed form for journal vouchers which serves in most cases as 
 a memorandum from which the actual book entry is made, the 
 result being that every entry is duplicated. One, however, is 
 called a voucher, although it may not be approved nor have 
 attached any evidence of its authenticity. If such a form is used, 
 any papers or documents relating thereto, such as original corre- 
 spondence from attorneys stating that an account is worthless, 
 etc., should be attached. Where founded on the action of a com- 
 mittee or board of directors, reference should be made to the 
 page of the minute book where recorded. If reference is made to 
 a contract or agreement, the file or location of the original docu- 
 ment should be stated. 
 
 Purchase Returns: It is no part of the normal conduct of a 
 business to return goods which have been purchased and re- 
 ceived. For this reason, when goods are returned because they 
 
THE DETAILED AUDIT 295 
 
 are defective or unsatisfactory, or because they were not ordered, 
 etc., the record of such returns is not always a permanent or satis- 
 factory one. 
 
 In most cases dependence is placed on a memorandum on the 
 original invoice, and if made before the invoice is entered on the 
 books, it is practically sure to prevent payment. But sometimes 
 the invoice will have been entered, and if care is not taken, the 
 account will be paid in due course without making any deduc- 
 tion. 
 
 The best preventive is to have a good-sized book labeled 
 plainly "Returned Purchases," in which shall be entered a mem- 
 orandum covering every return. This book should be compared 
 with the purchase books regularly to prevent errors in payments. 
 
 Cancellation of Vouchers: Instances are known where dis- 
 honest clerks have used old vouchers to support fictitious, dupli- 
 cate payments, altering the dates thereof. It is always important 
 for an auditor to mark a voucher in such a way that there can be 
 no possibility of its being presented or used again. 
 
 The best method of cancellation is to use a rubber stamp 
 bearing the name of the auditor and the initial or number of the 
 clerk in charge of the audit. Some auditors use a conductor's 
 punch. 
 
 The book entries should be marked in some distinctive way 
 to indicate that a voucher therefor has been compared with the 
 entry, and as the voucher may be more or less incomplete, it is 
 wise to use different marks or initials to indicate the kind of 
 voucher submitted. 
 
 Each auditor should select his own marks. It is advisable to 
 change them from time to time as the client's clerks become 
 famihar with the marks, as well as the procedure of a routine 
 audit. 
 
CHAPTER XX 
 
 THE DETAILED AUDIT (Continued) 
 THE TRIAL BALANCE 
 
 One of the most important matters in any audit is the verifica- 
 tion of the trial balance. By this is not meant the routine checking of 
 the ledger footings and extraction of the balances merely to test 
 its arithmetical accuracy, but that careful examination or study 
 of it which will throw light on the entire and detailed working of 
 the whole system. Every ledger caption should mean some- 
 thing. After some experience, an auditor, by simply looking at 
 the various accounts scheduled on the trial balance, will be able 
 to discuss the whole system, and without further data suggest 
 improvements therein. Of course, no sane practitioner would 
 commit himself after such a cursory glance, but he will have 
 gained sufficient insight into the affairs of his client to suggest 
 the next and succeeding steps in the audit. He must not spend 
 too much time on trifling errors in a trial balance, but should 
 take enough time to satisfy himself that the trial balance hon- 
 estly represents the face of the ledgers and that it may be relied 
 on as a basis for a report or balance sheet. 
 
 The auditor should secure a copy of the last trial balance at 
 the earliest possible moment. Usually, if he will ask for it at the 
 commencement of an audit, it will be copied for him by an office 
 clerk. He need not ask for the customers' balances in detail, as 
 he will wish to compile these himself, as explained hereafter. As 
 to the other accounts, however, the trial balance is of great im- 
 portance. Subsequent analyses of accounts will lead up to the 
 trial balance, and any alteration of figures in the ledger would 
 probably be disclosed thereby. 
 
 If the trial balance is not correct, it is no part of an auditor's 
 duties to locate the error or errors therein. He should insist on 
 the client's staff securing an exact balance, or, if this is imprac- 
 ticable, the matter should be referred to the client and an under- 
 standing reached as to further procedure. 
 
 396 
 
THE DETAILED AUDIT 297 
 
 The best plan is for the audit to proceed as if no difference 
 exists. The various tests suggested should be made, but no 
 more, unless numerous errors are discovered, in which case per- 
 mission should be secured from the client to verify all the work 
 and secure a correct balance. Where the errors are few in num- 
 ber and the accounts are reasonably correct, the auditor should 
 not attempt to hunt for clerical errors. He would better post- 
 pone the audit until they are located, even if an additional 
 clerk is required. Any one who spends his time in such work is 
 not, and is not developing into, a professional auditor. Such ele- 
 mentary bookkeeping work should be left to clerks. 
 
 Outstanding Accounts: A schedule of accounts receivable 
 should be compiled as part of the trial balance. It is a waste 
 of time to prepare or verify a trial balance and subsequently 
 duplicate the larger part of it in the form of customers' bal- 
 ances. 
 
 The balance due from each customer should represent spe- 
 cific invoices unpaid, or else it should be clear that the debtor is 
 making partial payments. Where the credits indicate that the 
 latter is not the case, yet the balance due cannot be identified 
 with the most recent invoices, then it is apparent that a discrep- 
 ancy exists which requires explanation. In all such cases the 
 auditor should require one of the office staff to show the com- 
 position of the balance. It may develop that in order to furnish 
 this information the entire account will have to be analyzed, but 
 this, of course, is the best possible reason for insistence on the 
 part of the auditor. 
 
 Income from sales cannot be completely verified until all debits 
 to customers are ascertained to be collectible; charges known to 
 be uncollectible, but remaining open in the accounts of solvent 
 debtors, may be difficult to locate, but are none the less impor- 
 tant. 
 
 If the balances used in the final trial balances are not brought 
 down, then they should be noted on the ledger pages in ink. 
 Preferably, this should be done by the office staff, but, if neces- 
 sary, the auditor should do it himself. 
 
 Bad or Doubtful Accounts: The schedule just referred to, in 
 addition to showing that the balances due from solvent debtors 
 are composed of collectible items, should indicate each account 
 
298 AUDITING 
 
 that is overdue, stating the number of months past due, so that a 
 subsequent classification can be made to determine the amount 
 required to be reserved to bring the aggregate due from trade 
 debtors to an amount which will be realized in cash. 
 
 It is not always desirable to close a doubtful account to profit 
 and loss, nor is it desirable to carry an account long overdue 
 among the current accounts. The best practice, therefore, is to 
 transfer the account (or the sheet, if the ledger is in loose-leaf 
 form) to a doubtful accounts ledger, at the same time creating a 
 reserve therefor. The balances in this supplemental ledger will 
 not be lost sight of, as they form part of the trial balance. 
 
 As soon as an account is known to be irretrievably bad, it 
 should be written off entirely. In the meantime a record of the 
 progress of collection, such as commencement of suit, etc., should 
 be noted on the account. 
 
 Provision for bad debts in the form of a reserve should be 
 made each month, based on a percentage of the total sales. This 
 fixes in the minds of all concerned that losses may be expected 
 and stimulates the credit and collection departments to keep 
 down the losses and "make a profit on the reserve." Where this 
 course is not followed, the auditor will have to make the reserve 
 large enough to cover the losses which his experience teaches 
 will be incurred. 
 
 In this respect managers and others sometimes mislead the 
 auditor because they will not admit the full amount of bad debts. 
 After some years of experience an auditor finds that his opinion 
 on this point is better than any one else's and he will use his own 
 judgment in stating the probable losses. This applies especially 
 where the business is comparatively old and actual losses for a 
 series of years can be ascertained. 
 
 ASSET AND LIABILITY ITEMS 
 
 From the standpoint of clients' relations to their employees, 
 the audit of income and expenses is more important than the 
 audit of the balance sheet, but the accuracy or inaccuracy of the 
 balance sheet affects proprietors, whether partners or stock- 
 holders, also the public as represented by bankers, creditors, 
 prospective investors, or as a basis of transfer from one partner 
 to another. 
 
THE DETAILED AUDIT 299 
 
 The detailed audit naturally includes a verification of the 
 assets and liabilities, and in order to avoid repetition, the chapters 
 on balance-sheet audits (page 87) should be referred to as indi- 
 cating a part of the program of a detailed audit. Some balance- 
 sheet items are more fully covered in a detailed audit than in a 
 balance-sheet audit. They will be discussed at this point. 
 
 Notes Receivable: The record of notes received should be 
 examined, and if comparatively few notes have been received, 
 the disposition of each note should be followed from the account 
 to which credited until collected or returned unpaid. If a large 
 number of notes have been received, the auditor should test the 
 accuracy of the record by selecting a few months at random out 
 of the year and verifying in detail the transactions appearing in 
 those months. 
 
 Notes Receivable Protested: See that they are charged back 
 to the individual account of debtor, and that a subsequent attempt 
 is made to collect. The protested note should be submitted as a 
 voucher or otherwise accounted for in all cases where the item 
 is still open. It would be possible for a dishonest cashier to 
 charge back as unpaid, items actually collected, and subsequently 
 write off the account to bad debts; but in such a case, as no 
 voucher could be produced, the fraud would be disclosed. It is a 
 small matter, but the auditor should ascertain whether or not all 
 protest fees and accrued interest are charged. to debtors, as well 
 as the face of the notes. In many cases collection can be made 
 subsequently and the omission to charge all proper items direct 
 to debtors' accounts means a loss thereof. 
 
 Inventories : In a detailed audit this item in the balance sheet 
 should be the first to be examined if there are collateral indica- 
 tions that the business has been profitable, even though the 
 books show a loss. Inventories are frequently taken hurriedly, 
 materials in transit are often omitted, or included when the bills 
 therefor have not been entered. An inventory at the beginning 
 of a period might be overvalued, and at the end undervalued, and 
 numerous other causes might be cited to suggest errors which, if 
 not detected, result in misleading profit and loss statements. In 
 a case of this nature an auditor will find the inventories a most 
 fruitful source of error. 
 
 Here also an auditor will have to use good judgment in pass- 
 
300 AUDITING 
 
 ing values, for each increase or decrease in an inventory affects 
 the profit and loss account correspondingly. It is about as bad 
 to pass undervalues as overvalues where the result may be used 
 in an ulterior matter. The most flagrant cases, however, are 
 overvaluations, and with these an auditor must deal without fear 
 or favor. 
 
 Premiums and Discounts on Bonds to be Amortized : Where 
 bonds are sold at a premium, the amount received in excess of 
 the par value represents the equivalent of interest collected in 
 advance, and must be held in reserve and distributed over the 
 years to which it applies as a reduction in bond interest account. 
 For instance, a corporation may sell its five per cent lo-year 
 bonds at 105, indicating that its credit is rated on a basis of about 
 four and one-half per cent, that is, if a four and one-half per cent 
 bond had been issued, the corporation should have realized about 
 par. Therefore, the bond interest, when paid, is subject to a de- 
 duction of one-half of one per cent annually. The excess received 
 at the time of sale should not be applied to income or to surplus, 
 but, as stated . above, must be carried as a deferred credit and 
 reduced annually. 
 
 Likewise when bonds are sold at a discount it is because the 
 rate of interest the bonds bear is less than the effective rate at 
 which the corporation's credit is rated. For instance, if five per 
 cent lo-year bonds are sold at 90, it means that the corporation's 
 borrowing strength is rated at about six per cent, and in order 
 to reflect the actual rate each year as interest is paid, it will be 
 necessary to carry the discount as a deferred charge among 
 the assets and write off to interest account one per cent annually. 
 This, added to the amount paid in cash, will adjust the interest 
 account to the proper cost. 
 
 Premiums on Capital Stock: With respect to premiums re- 
 ceived on capital stock, the principle is different. There is no 
 liability on account thereof, and no distribution to the income of 
 future years. 
 
 The amount received is clearly a capital receipt and is not 
 available as a fund out of which to pay dividends ; that is, from 
 an accounting point of view. There may be no legal obstacle in 
 the way of crediting the premiums to surplus, and paying out 
 the entire surplus as dividends, but in effect a board of directors 
 
THE DETAILED AUDIT 301 
 
 might as well attempt to pay out the remaining portion of the 
 amount paid for stock. Let us suppose that stock is issued at 
 $110 per share, $100 being credited to capital stock, and $10 to 
 surplus. If the latter amount is distributable, why not $10 more, 
 leaving $90 to be credited to capital ? The answer would prob- 
 ably be made that the law will not permit capital stock to be issued 
 at a discount, but as property of all kinds may be turned in as 
 payment for stock, the theory of stock being issued for actual 
 value is a dead letter. 
 
 Premiums received on capital stock should be credited to an 
 account so entitled or to capital surplus, and should not be ab- 
 sorbed in the regular surplus account. 
 
 Branch Accounts: The extent of the examination of branch 
 accounts will depend on the system of accounts employed. 
 Where local collections are made, the accounts receivable will 
 require the same attention as described on page 258 ; where ship- 
 ments are reported to the head office, and collections are not 
 made locally, there will still be the necessity of testing the deliv- 
 ery records to ascertain that all have been reported, and that 
 cash sales, if any, have been duly accounted for. At the same 
 time the stock accounts will require attention, both from the 
 point of view of theft or loss and overvaluation. 
 
 Nearly all branch managers have an interest in the profits 
 derived from their own territory, and in consequence nearly all 
 branch managers place the highest possible valuation on their 
 stock-in-trade. It may seem difficult to manipulate the stock 
 record valuations where prices are fixed at the head office, but 
 opportunities usually arise in connection with shopworn or 
 obsolete stock, etc., and in some cases quantities are dehberately 
 overstated. 
 
 Local expenses and purchases are usually reported to the 
 head office in detail, so that outstanding liabilities should be com- 
 paratively easy to verify. If paid locally, the usual precautions 
 will have to be taken to ascertain that no omissions are made. 
 (See page 148.) 
 
 In some cases where time does not permit an auditor to visit 
 all branches personally, local auditors can be employed to advan- 
 tage. Uniform instructions should be sent out and adhered to 
 strictly, so that the auditor in charge will feel safe in using the 
 
302 AUDITING 
 
 figures, so verified. Where this procedure is necessary the certi- 
 ficate should be modified as follows : 
 
 "We have audited (head office accounts) . . . and have 
 compared the returns from the several branches therewith (the 
 latter having been audited locally and the certified returns sub- 
 mitted to us), and in our opinion they are correct, etc." 
 
 Capital Expenditure: Throughout the audit of expenditure 
 the distinction between capital and income must be borne in 
 mind. It is sometimes believed that so long as expenditure for 
 capital outlay, as well as for current maintenance, is charged to 
 income and not capitalized, no fault can be found with such a 
 conservative course, but that the reverse of this practice cannot 
 be justified under any circumstances. Theoretically this posi- 
 tion is wrong, the proper rule being to ascertain the correct 
 application of each payment and to charge the account to which 
 the item belongs. Practically, much can be said in support of 
 what is known as the conservative method. 
 
 The great difficulty in ascertaining the exact efifect of altera- 
 tions, betterments, and new construction, and the prevailing 
 tendency of managers and others to emphasize the propriety of 
 capitalizing the payments, inevitably educate accountants and 
 business men who do not want to deceive themselves, to the de- 
 termination to charge to maintenance every item about which 
 there is the slightest doubt. In other words, a practice which is 
 objectionable in theory becomes a virtue in practice, and a sub- 
 stantial reason therefor is that the business always gains thereby 
 and never loses. 
 
 The audit of capital expenditure is rarely satisfactory when 
 made by items, as one item may be chargeable to capital, while 
 another item of exactly the same nature may be chargeable to 
 income, the distinction depending entirely on the purpose for 
 which used. 
 
 All well-regulated concerns have a storeroom system, which 
 means that most debits to plant accounts originate in storeroom 
 charges. It is simply impossible to determine long afterward, 
 by a mere inspection of the voucher, whether it should be 
 charged to one account or another. 
 
 The most satisfactory verification is to secure a dependable 
 memorandum of the additions and improvements which have 
 
THE DETAILED AUDIT 303 
 
 been undertaken or completed in order to increase the earning 
 power or efficiency of the plant. That is, if a new building has 
 been erected or a new power plant installed, assemble all of the 
 items applicable thereto and compare the expenditure as a whole 
 with the estimated value of the improvement, or the official 
 authorization, ascertain what it replaced, if anything, and what 
 additional capacity or economies are effected thereby. 
 
 Odds and ends should not be charged to capital, so that the 
 increase in plant accounts for a given period should be reducible 
 to definite grouping as indicated above. If it is found that the 
 total capacity of the plant is not materially increased by the out- 
 lay, it may be inferred that the changes were necessary to renew 
 or replace worn-out or obsolete buildings or equipment. 
 
 Cash Discounts on Capital Payments : It is held by some that 
 the cash discounts deducted from payments on account of capital 
 outlay should be credited to interest or discount account and be 
 treated as an earning. This, however, is a fallacy, as will be 
 shown by a concrete example. Suppose a fund of $10,000 is set 
 aside to buy machinery; the invoices may aggregate exactly 
 $10,000 and are subject to a discount of two per cent if paid 
 within ten days. Advantage is taken of the discount and $9,800 
 is paid out. It cannot be contended that the cost is $10,000 and 
 an earning of $200 is realized, because such is not the fact. The 
 machinery cost $9,800 in cash, and the cash balance which re- 
 mained is simply an unexpended fund. It has not been used and 
 is now available for other purposes. This is parallel with the 
 treatment of cash discounts on merchandise purchases, the net 
 result being the same because the purchases account is ultimately 
 reduced by the amount of the discount through the profit and loss 
 account. 
 
 Real Estate: In any business other than that of real estate 
 operators there will be very few items of payment in connection 
 with the purchase of land or improved real estate. More fre- 
 quently it will be found that bonds or stocks are issued in pay- 
 ment therefor. Usually these items can be vouched from the 
 minutes of boards of directors, the contracts themselves and the 
 acknowledgments of the payees. 
 
 An instance is known of a promoter who was made the presi- 
 dent of a holding company who paid himself, as representing one 
 
304 AUDITING 
 
 of the subsidiaries, a larger number of bonds than he was en- 
 titled to. The records of the holding company were altered to 
 fit the transaction and the auditors were deceived. If the books 
 of the subsidiary company had been examined, the fraud would 
 have been discovered. 
 
 Buildings: Where a considerable amount is being expended 
 on new or old buildings, the payments should be carefully 
 vouched. Individual payments, however, will probably be sup- 
 ported by genuine-looking vouchers and will not reveal irregu- 
 larity, which may be going on, either on the part of the client's 
 staff or on the part of the contractor. Therefore, the operations 
 as a whole should be checked with the authorizations of the 
 board of directors, or executives in charge of the work, and with 
 the bids or estimates submitted before work was commenced. 
 
 Unfortunately architects' certificates as to partly com- 
 pleted work are not always reliable, on account of the connection 
 which sometimes exists between contractors and architects, and 
 in rare cases only can an auditor go behind these certificates. 
 
 It is permissible to charge all expenses and outlays in connec- 
 tion with these operations, such as permits, architects' and en- 
 gineers' fees, clerical salaries when clearly applicable to new 
 work, and similar items to the work itself. It may seem more 
 conservative to charge part of this expenditure to revenue, but in 
 all cases it is preferable to assemble all costs into one account, 
 then if it appears desirable to write of? a part of the cost, it can 
 be done at any time. The whole cost, however, having once 
 appeared in one account, will subsequently be available for any 
 desired information. 
 
 Where new buildings are erected in whole, or in part, by the 
 concern itself, it is important to ascertain that no profit is in- 
 cluded. Auditors frequently find this state of affairs and are 
 met with the argument that if the contract had been awarded to 
 an outside concern, a contractor's profit would have been added. 
 A concern not in the contracting business cannot always, how- 
 ever, erect a building, or, in fact, perform any work outside of 
 its usual operations, at the same cost as one whose sole efforts 
 are devoted to this class of work and who may be depended upon 
 to have discovered economies in purchasing, planning, and ex- 
 ecuting not possible except after long experience. If an actual 
 
THE DETAILED AUDIT 305 
 
 saving has been effected, it is not a realized profit and should not 
 be treated as such. The asset account should represent cost and 
 no more. 
 
 Machinery, etc.: The important point to keep in mind in 
 connection with purchases of machinery, tools, fixtures, etc., is 
 whether they represent actual additions to plant and equipment, 
 or whether they are renewals. This point is covered in Chapter 
 XXI, "Depreciation." 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. 
 
 Where machines, etc., are built by the concern itself, the 
 remarks found above under Buildings will also apply. 
 
 Notes Payable : All notes paid during the period under audit 
 should be submitted as vouchers. If notes are issued from a stub 
 book, or if a special form is used, all should be accounted for. 
 Spoiled notes should be pasted on their respective stubs as is 
 done with cheques. 
 
 If careful consideration is given to the notes issued during 
 the period, it will assist the auditor to determine whether all 
 notes outstanding at the date of the balance sheet appear thereon. 
 
 Partners* Withdrawals: If payments are made in currency, 
 partners should approve their accounts as they appear in the 
 ledger. 
 
 The practice, so prevalent, of drawing comparatively small 
 amounts at a time and initialing a voucher, or declining to give 
 one at all, is a direct temptation to dishonesty on the part of the 
 cashier. Auditors should criticize the practice vigorously and 
 suggest to partners that their withdrawals be by cheque only, 
 and that they pay their personal bills through their own bank 
 accounts. 
 
 Dividends: The audit of dividend payments is simple. Au- 
 thorization must always be found in the board minutes, and any 
 dividend declared, if paid, must be paid to all stockholders of 
 record at the date named. Dividends cannot be declared as of a 
 past date, but may be dated ahead as far as may be desired. 
 
 In the case of Jones v. Terre Haute & Richmond R. R. Co., 
 (57 N. Y. 196), Commissioner Reynolds said: 
 
 It is certainly true, as a general rule, that a stockholder in a corpora- 
 tion has an interest in proportion to his stock in all the corporate property 
 
3o6 AUDITING 
 
 and has a right to share in any surplus of profits arising from its use and 
 employment in the business of the company; and this legal right does not 
 depend upon the question whether he is a stockholder of long standing or of 
 recent date. The moment a person becomes stockholder in a corporation, 
 all the incidents of interest or quasi-ownership in the 'corporate property 
 attach. 
 
 in another New York case the court refused to order the 
 directors to pay additional dividends, although the corporation 
 had a very large surplus, part of which was in bank and repre- 
 sented a sum far in excess of that actually required for current 
 purposes, and part of which was invested in outside securities. 
 The court said, "The discretion of the directors in regard to de- 
 claring dividends will not be interfered with in the absence of 
 fraud or an abuse of discretion." 
 
 Stock Dividends: Dividends are supposed to be distributions 
 of earnings and accrue to the stockholder only at the time of 
 declaration. A stockholder in a corporation having a large sur- 
 plus and earning several times the amount of its dividends is no 
 more justified in taking a proportionate part of an expected 
 dividend into his accounts as income than he would be in assum- 
 ing that the entire surplus would be divided. When the dividend 
 is actually declared and becomes an obligation of the corpora- 
 tion, it becomes, in turn, income receivable to the stockholder. 
 
 In the case of a stock dividend the rule also applies, the only 
 exception being where the dividend is an extraordinary one and 
 where the distribution includes the surplus of two or more years 
 which, as a matter of fact, has been capitalized. 
 
 Not long ago the Standard Oil Company of Indiana declared 
 a stock dividend of 2,900 per cent, that is, the holder of $100 in 
 stock received additional stock amounting to $2,900. Suppose 
 the owner of one share died shortly before the declaration of the 
 dividend, leaving the income of his estate to his wife for life and 
 the principal to his children, the stock would have been appraised 
 at perhaps $2,000, based on earnings of, say, ten per cent per 
 annum on that price. If the principle that dividends are income 
 were applied, the widow would receive the $2,900 per share in 
 new stock, and at her death, if no other change took place, the 
 children would receive the original share, worth now only $100 
 and yielding perhaps seven per cent per annum. This would be 
 so inequitable and so at variance with the testator's intentions 
 
■ THE DETAILED AUDIT 307 
 
 that most of the States would permit the dividend to be treated 
 as a distribution of principal and not of income. 
 
 Precisely the same rule should apply where stocks are 
 carried on balance sheets at very high figures and are reduced in 
 price per share through the distributiori of large stock dividends. 
 Unless it is very clear that the declaration consists of the earn- 
 ings of a recent period, the whole dividend should be treated as 
 capital. If it can be apportioned, it would be proper to apply that 
 part of it representing a distribution of the earnings of the last 
 year or period to current income. Where State laws govern the 
 matter the laws must be observed. The auditor should be thor- 
 oughly informed as to the provisions of the law in this respect 
 in his own State and in any others where he practices. 
 
 Capital Stock: A trial balance should be taken of the stock 
 ledger to see that the aggregate outstanding is in agreement with 
 the general ledger account. It should be noted if there is any 
 account in the name of the company or its treasurer, which was 
 intended to represent treasury stock, but which may or may not 
 be such. 
 
 The stock certificate books should be examined and recon- 
 ciled with the stock ledger. All canceled certificates should be 
 inspected or accounted for. As stated on page 353 under 
 "Banks," fraud has been practiced by raising certificates. 
 
 Bonds: A proof should be taken of the bond ledger or reg- 
 ister to ascertain that the aggregate outstanding is correct and is 
 in agreement with the general ledger. Canceled bonds should be 
 inspected or accounted for. The bond agreement should be 
 read, and if it contains any provisions as to sinking funds, etc., 
 it should be seen that these are carried out or report made 
 thereon. 
 
 It should be determined whether or not the amount of inter- 
 est accrued has been set up in the accounts and whether the 
 amount due has been paid. 
 
 Careful methods should be in force relative to coupons. They 
 should be canceled effectively immediately upon receipt, and kept 
 on file, not destroyed. The auditor should see that the canceled 
 coupons are accounted for. 
 
 Taxes: Corporations are subject to special taxes, such as the 
 Federal Corporation Tax, State Franchise Tax, etc. The auditor 
 
3o8 AUDITING 
 
 should see that these, as well as the usual taxes on property, are 
 provided for. 
 
 In New York State there is a tax of two cents per hundred 
 dollars of par value or fraction thereof, imposed on all transfers 
 of stock. The seller of the stock, or his broker, pays this tax by 
 affixing revenue stamps to the certificate surrendered. The 
 officer of the corporation, however, who transfers the stock or 
 causes it to be transferred is liable to the penalty for failure to 
 pay the tax. 
 
 OFFICE METHODS 
 
 In nearly every audit where no previous work had been done 
 for the client the auditor was formerly asked to note any im- 
 provements or changes which might occur to him during the prog- 
 ress of the audit. It did not seem incongruous that a profes- 
 sional accountant whose whole time was spent in examining and 
 criticizing accounts should in the course of an extensive practice 
 acquire experience of great value, and that he should be able to 
 give to new clients the benefit of such experience. At the pres- 
 ent time there is somewhat of a feeling that the auditor is not a 
 specialist in system work and that in order to be up-to-date an 
 "efficiency engineer" must be employed. But suppose we com- 
 pare present conditions with those of about ten years ago. At 
 that time stationery houses, which carried an "auditing department" 
 as a side line, were making a great stir through advertising and 
 traveling solicitors, and were oilfering to produce wonderful 
 results, including daily balance sheets and profit and loss state- 
 ments, the only requirement being the installation of their 
 patented stationery. Offices were turned inside out and new 
 books and blanks were installed by the ton, but for some reason 
 the service did not measure up to the promises, and hundreds of 
 offices discarded much of the "junk" which had been thrust upon 
 them and went back to saner methods. 
 
 For a short time the auditor was back in favor. He had no 
 cut-and-dried system, nor did he know before he entered an office 
 how its system should be mapped out, but out of long experience 
 he was able to make suggestions which cut out unnecessary work 
 and proposed changes which embraced the use of all the latest 
 labor-saving devices. Then came the "efficiency engineer," who 
 
THE DETAILED AUDIT 309 
 
 again modestly affirmed that the auditor was not a specialist in 
 systems and that he could not be expected to keep his clients 
 up-to-date. The crop of over-charged and dissatisfied patrons of 
 the "efficiency engineer" is commencing to be heard from, and 
 it is believed by some who have studied the situation that before 
 long the auditor will be back in his former position as a recog- 
 nized authority on business systems. 
 
 The auditor should keep fully informed on the latest devices, 
 mechanical and other kinds, for saving labor or rendering it more 
 efficient; he should understand and be prepared to explain the 
 relation of one department of a business to another and the ad- 
 vantages of coordination; he should study cost systems and be 
 ready to install any required accounting system; he should 
 acquire and follow up a knowledge of the means of imparting in- 
 formation by means of charts and other visual methods. 
 
 It might be urged that an auditor cannot hope to cover more 
 than a small part of the field of auditing within a considerable 
 period of practice, and that to expect him to add the work of a 
 system specialist is unreasonable. The answer to this is that no 
 one can be a good auditor without picking up all of the rudiments 
 of systematizing, and that in any event system is a matter of evo- 
 lution. 
 
 Ready-made systems have been popular, but never success- 
 ful. No system will work out well unless a good man studies the 
 concern and becomes acquainted with its personnel before he 
 starts, and then "lives with the job" until its completion. The 
 auditor may not be able to handle many such engagements, but 
 he should not allow the so-called system experts to bluff him out 
 of the remunerative work. He is probably better qualified to 
 perform it than anyone else. 
 
 Styles of Books and Records : The auditor will note by actual 
 inspection whether the records are kept economically and effi- 
 ciently or otherwise. If the old-fashioned bound books are in use 
 and loose-leaf records would be an improvement, he should 
 recommend a change. On the other hand, it may be that some 
 records are being kept on cards or loose leaves which could be 
 written up more readily and referred to more easily in bound 
 books. In such a case the latter would be recommended. 
 
 In view of the elasticity and convenience of cards and loose- 
 
310 AUDITING 
 
 leaf records, these systems are becoming more and more popular. 
 In the early stages it was feared that the leaf or card might be 
 lost, destroyed, or easily altered, but after a number of years of 
 experience this fear has practically disappeared. 
 
 Filing Systems: With the unit system of records has come 
 the unit system of filing. Press copy books are becoming a 
 rarity and have been discarded by most modern offices. Docu- 
 ments, correspondence, etc., are now filed in vertical files and in 
 such a form as to be readily accessible. ' 
 
 In many modern offices the method is in force of making a 
 carbon copy of each letter, and in the mailing department a press 
 copy in a letter book. The carbon copy takes the place of a 
 "tickler" and is filed so that it will come up for further attention 
 on the day decided upon. The letter book impression is taken 
 just before the letter is put in the envelope and records the sig- 
 natures and other identifying marks. It is properly indexed, and 
 becomes a safeguard against the loss of the carbon or the unwar- 
 ranted alteration of the letter. 
 
 The essential features of a filing system are : 
 
 1. Certainty of obtaining any paper or all papers on a par- 
 ticular subject. 
 
 2. Rapidity of obtaining filed papers. 
 
 3. Rapidity of filing papers. 
 
 4. Cheapness of operation. 
 
 5. Simplicity. 
 
 6. Small space required. 
 
 7. Cross-reference, numbering, etc. 
 
 In a report on the handling and filing of correspondence, 
 President Taft's Commission on Economy and Efficiency makes 
 the following suggestions, which apply with as great force 
 to the average business corporation as to the government ser- 
 vice : 
 
 1. That all correspondence shall be filed flat in vertical files. 
 
 2. That all correspondence should be filed by subjects arranged upon 
 a self-indexing basis. 
 
 3. No book or card record of correspondence is desirable. 
 
 4. That carbon copies should supplant press copying. 
 
 5. That the employment of the dictation machine (phonograph) for 
 dictating should be extended widely. 
 
 6. That transparency or "window" envelopes should be used. 
 
THE DETAILED AUDIT 311 
 
 7. That forms that must be filled in on the typewriter should be so 
 arranged as to facilitate the work. 
 
 8. That on internal correspondence no salutation or complimentary 
 closing should be used and that the initials of the person addressed and the 
 writer should be used instead of full names. 
 
 Copying: Where large quantities of copies are desired, there 
 are the multigraph, the revolving duplicator, and the old- 
 fashioned flat duplicator. The revolving duplicator is perhaps 
 the most popular, requiring only the typewriting of a waxed- 
 paper stencil. For work requiring more than a thousand impres- 
 sions, the multigraph or one of the several makes of printing 
 machines is preferable. 
 
 Mailing Department: The handUng of mail is important and 
 has come to be a separate department. Incoming mail usually 
 contains remittances in cheques and cash, and has proven in more 
 cases than one a simple source of illegitimate wealth to enterpris- 
 ing but ill-paid clerks and cashiers. Some responsible person — 
 preferably an officer of the company — should have charge of the 
 incoming mail. As it is opened it should be distributed to 
 baskets designated for the various departments, and should be 
 delivered with as much care as is used in opening it. 
 
 Outgoing mail must be handled differently. It is desirable 
 to have the stenographers who write letters address the en- 
 velopes at the same time, and then, instead of delivering them 
 both to the executive, the letter only should be delivered, and 
 the envelope (together with any inclosures) sent to the mail- 
 ing department. When the letter has been signed it is sent to 
 the mailing department, where it is put in the envelope, with 
 the inclosures, and is sealed, stamped, and mailed. It is the duty 
 of the mailing department to keep posted on changes in closing 
 hours for the various domestic and foreign mails. 
 
 Stock on Hand : In many cases the auditor will find it prac- 
 ticable to-introduce a perpetual inventory of stock on hand. He 
 may base his suggestions on the following general recommenda- 
 tions quoted from "The Accountant's Manual," Vol. II : 
 
 (i) Debit and credit accounts should be opened, as far as possible, for 
 each description of stores used. On one side of the accounts the receipts 
 would be entered, showing the date, weight, quantity, or number, and other 
 particulars ; and, on the other side, the stores issued from time to time would 
 be entered, with such particulars as were necessary or suitable, the difference 
 
312 AUDITING 
 
 representing what ought to be in hand, or thereabouts, as, in accounts of this 
 kind, the balance shown upon the accounts can hardly be depended upon 
 exactly. 
 
 (2) It is the opinion of practical mill owners and managers that in 
 many cases a really efficient and exact check on stores is not practicable. It 
 could, no doubt, be devised, but the detailed work in connection with it, and 
 consequent labor and expense, put it out of the range of every-day business, 
 whatever theorists may say. But many useful rule, may be laid down pre- 
 ventive of fraud and waste, amongst others the following, taken from actual 
 experience : 
 
 (o) Where stores are distributed for use upon a specific job, the job 
 should be stated, with the weight, quantity, etc. 
 
 (6) If material of the same kind is distributed to various men for the 
 same purpose, a comparison should be made between the results produced by 
 each. If discrepancies are found, inquiries should be made, and doubtless 
 in some cases a good explanation could be given : e. g., use of old machinery 
 or appliances, etc. 
 
 (c) The storeroom should be situated in a convenient place, and be in 
 charge of a competent man who combines practical knowledge of the stores 
 with sufficient bookkeeping experience to appreciate the importance of account 
 keeping. 
 
 (d) The principal, or manager, should make a point of examining at 
 times the stock ledgers and exercising general supervision of the department. 
 Frequent and unnotified visits should be made, and the store keeper, if pos- 
 sible (it is not always possible), changed (occasionally). 
 
 (c) Some kinds of stores should never be given out unless the used-up 
 stores are returned. For example, a workman making requisitions for files, 
 brushes, and like things, should be supplied only on his giving up the old 
 articles. This is a very good check when the nature of the stores will allow 
 of its application. 
 
 Stock accounts should show quantities as well as values, the 
 one forming a good check upon the other. 
 
 The forms used should provide for an opening balance or in- 
 ventory, to which are added daily the quantity and value of the 
 material purchased or manufactured. There should be provision 
 for totaling these debits and for deducting therefrom the quantity 
 sold and the cost value of same. The balance should agree with an 
 actual inventory. 
 
 A more detailed form used by many concerns provides 
 columns to show not only the balance and purchases daily, but 
 also the sales and the new balance. Noted at the top of the sheet 
 or card is the minimum quantity of stock to be carried, as well 
 as the maximum quantity. Whenever the stock reaches a low 
 
THE DETAILED AUDIT 313 
 
 point, the records are checked by comparison with an actual 
 inventory. Thus the taking of inventory is not left until the end 
 of the period, but is taken continuously. 
 
 Business to-day is so varied in its nature that some lines will 
 not permit of a regular system of stock accounts — nor is it espe- 
 cially necessary, as in the case of traders dealing in small articles 
 broken from bulk. While different methods of check must be 
 employed in such cases, there are some general forms which may 
 be adopted and will be found practicable for ordinary lines of 
 business. 
 
 Every trade is supposed to earn a certain percentage of gross 
 profit, which should be based on the cost price of goods and not on 
 the selling price. If, therefore, a stock account is started with the 
 actual stock on hand valued at the purchase price, and there are 
 added to it the total quantity purchased from time to time (say 
 monthly), and also the estimated gross profits referred to, this 
 amount, less the total sales, should show the stock on hand, 
 assuming that the gross profit named has been exactly earned. 
 By deducting the gross profit from the sales and then credit- 
 ing the stock account, the same result would be secured. This 
 book-figure can easily be verified or corrected at the time of 
 actual inventory. 
 
 Another common and often useful practice in testing the ac- 
 curacy of the stock at any time is to make a comparison between 
 the stock and sales for a particular period and a corresponding 
 period of prior years, though this is only a rough test and not 
 definite. 
 
 The accounts of an establishment handling various kinds 
 of goods should be so kept that the position of the various de- 
 partments as to purchases, sales, etc., may readily be secured. 
 Such a system serves two most useful purposes, (i) Attention 
 is directed to any discrepancy between actual and estimated 
 gross profits by means of a like difference between a physical and 
 the book inventory. (2) Needed information is furnished from 
 month to month as to the probable amount of stock in each 
 department, and this knowledge serves as a guide to and check 
 upon the various departmental managers, as well as affording 
 material for an interim balance sheet, if one is desired. 
 
 Where a more accurate check on the various departments is 
 
314 AUDITING 
 
 desired, the following method is employed: All goods are 
 charged to departments at the selling price, this having been de- 
 termined in advance. Any changes in value are recorded and 
 when the inventory is taken it is priced both at cost, for the 
 private office, and also at selling price, for the purpose of verifi- 
 cation, and the account is supposed to balance exactly. Houses 
 whose business reaches a large volume find this system gives 
 satisfactory results with but slight discrepancies. It can be 
 extended, too, with advantage to other trades, such as retail 
 branch stores selling cigars, groceries, men's furnishing goods, 
 and similar lines. 
 
 To furnish conclusive information relative to gross profits 
 made in various retail lines is, of course, impossible. Situation, 
 nature of the business, policy of the management, local condi- 
 tions — all enter into the result so that any attempt to outline 
 even approximate figures would be unwise and misleading. 
 However, any auditor might compile a table out of his own expe- 
 rience that would prove of value. 
 
 If it becomes necessary for the auditor to design stock ac- 
 counts for any particular business, he may well take advantage 
 of whatever practical experience is possessed by his clients or 
 their managers, supplementing such knowledge by his own expe- 
 rience, and if he should be so fortunate as to have an intimate 
 acquaintance with the special business in hand, he will undoubt- 
 edly find it of the greatest assistance. 
 
 Controlling Subsidiary Ledgers: There will be found in 
 nearly every concern some device adopted by the individual 
 bookkeepers for balancing their ledgers. This is usually in the 
 shape of a large "proofsheet," on which are recorded the totals 
 of the various books or columns from which the details were 
 posted. Where there are a number of ledgers, each dependent 
 upon all the others for its balance, even such a makeshift is help- 
 ful in locating the ledger that is out of balance. 
 
 But a much more practical and a more scientific method em- 
 ploys in the general ledger a controlling account with each sub- 
 sidiary ledger. From the various books of original record the 
 details are posted to the subsidiary ledgers, but the totals are 
 posted to the respective controlling accounts in the general 
 ledger, keeping that ledger in balance. For instance, there may 
 
THE DETAILED AUDIT 315 
 
 be two sales ledgers (A-M and N-Z) to which the details of the 
 sales book are posted. In the general ledger "Sales" account 
 would be credited as usual, but in addition each of the sales 
 ledger controlling accounts would be debited with its part of 
 the total sales. 
 
 Ledger A-M Controlling Account 
 
 Ledger N-Z Controlling Account 
 
 To Sales Account 
 
 Columnar Ledgers: Another form of ledger, to which the 
 term "self-balancing" is fully as applicable, is the columnar 
 ledger. Its advantage lies in the fact that a large number of 
 customers or accounts can be carried in a comparatively small 
 space and can be referred to with a minimum of effort. It can be 
 used, however, only when the number of transactions with each 
 customer is small. 
 
 The ledger gives a line or a double line to each account and 
 provides columns for posting the debits and the credits once 
 each month or at other intervals. The totals in each column are 
 carried forward from page to page or are recapitulated, and the 
 final totals should agree with the totals in the controlling ac- 
 counts in the general ledger. 
 
 Another use of the tabular ledger is as a summary of charges 
 where customers have a very large number of transactions 
 monthly. The details are kept in a subsidiary ledger and are 
 posted in total to the tabular ledger. It then becomes a ledger 
 of controlling accounts, and is in turn controlled by an account in 
 the general ledger. 
 
 Efficiency of Organization: An auditor is peculiarly fitted, 
 upon the completion of an audit, to comment intelligently upon 
 the efficiency of the organization. He has had access to all the 
 records and has seen the performance of the staff under a variety 
 of conditions. The average client to-day wants suggestions 
 relative to the perfection of his organization, and it is only right 
 that he should have them. The auditor should be able to judge 
 whether the staff is too large, whether the arrangement of the 
 office and the layout of the work is capable of improvement, and 
 whether there is needless repetition of records in dififerent depart- 
 ments. 
 
 Many times it is possible to show laziness or pure inability 
 
3i6 AUDITING 
 
 on the part of employees by the application of the efSciency 
 theory that for any task there is a determinable standard. Sup- 
 pose it had been demonstrated that a clerk under favorable con- 
 dition should be able to post three hundred items per day. A 
 little investigation shows that because of the use of the old- 
 fashioned index and awkward books he is able to post but two 
 hundred items, therefore the work is only 66^ per cent efficient. 
 The book of original entry is being used by two people, so he 
 has to lose lo per cent of the time waiting for it. That brings the 
 efficiency of the work down to only 90 per cent of 66^ per cent, 
 or 60 per cent. He is fifteen minutes late in the morning, begins 
 to put his books away fifteen minutes before closing time at 
 night, and reads the paper for half an hour after lunch. Another 
 12^ per cent of the 66^ per cent is gone ! His efficiency, then, 
 would be 51^ per cent. But he has so little faith in the accuracy 
 of his work that he checks every posting back to the original 
 record, losing at least one-third of the possible 100 per cent, and 
 bringing his net efficiency to 18 per cent. 
 
 If he were paid $18 per week and another man were obtained 
 who could perform the work according to the standard set, or 
 100 per cent, it would be profitable to pay the efficient man even 
 $50 per week and still receive from him twice the service-value of 
 the inefficient man. 
 
CHAPTER XXI 
 DEPRECIATION 
 
 With the modern development of business and industry and 
 the enormous additions to the value of property, plant, appli- 
 ances, and stock in trade, the question of depreciation or allow- 
 ance for loss of value has naturally gained much in importance. 
 
 Indeed, the settlement of the question of what shall be 
 allowed for depreciation is one of the most important which 
 accountants are called upon to discuss. The auditor must always 
 consider the adequacy or inadequacy of the provision made, be- 
 fore he can determine the form of the certificate or report which 
 he can give. 
 
 It is important at the outset to distinguish between fluctua- 
 tion and depreciation. The former may be a change for the 
 better or the worse in the value of the assets and is attributable 
 to causes apart from the business itself. Entirely extraneous 
 influences may cause fluctuation in the value of assets and, there- 
 fore, it is generally admitted that as the actual manufacturing 
 profits are not affected thereby one way or the other, these fluc- 
 tuations in value need not be considered in the current accounts. 
 
 Depreciation, however, is a decline in the value of property 
 such as may reasonably be expected to occur as a result of wear 
 and tear and gradual obsolescence. It is due to the possession 
 and use of the assets, and therefore is a part of the cost of 
 [operation. A concise definition of depreciation which has been 
 widely used is that it is the deterioration of anything by time or 
 use. P. D. Leake's definition, "expired outlay upon productive 
 plant," is a good one, as is also "accrued renewals." 
 
 Before leaving the subject of fluctuation it may be well to 
 consider for a moment what treatment may be accorded to a 
 favorable fluctuation in the value of fixed assets and current 
 assets. In the former case it is generally conceded that the in- 
 crease may be treated as a secret reserve. In the latter case it 
 is temporarily a secret reserve which will be included in trading 
 
 317 
 
3i8 AUDITING 
 
 profits when the assets affected are realized. An unfavorable 
 fluctuation, if apparently of a temporary character, may be disre- 
 garded, but when it is probable that the unfavorable conditions 
 will remain until the time of realization of the assets affected, 
 provision should be made for the loss; in other words, an un- 
 favorable fluctuation should be charged against the period in 
 which it occurred (as an extraordinary item) instead of against 
 the period of realization. * 
 
 In general it is not necessary from a legal standpoint to 
 charge an unfavorable fluctuation in fixed assets against revenue 
 before the declaration of dividends from current profits. While 
 these fluctuations may be disregarded in accounts, it may be 
 desirable, however, to present the true state of affairs to stock- 
 holders by means of a note attached to the balance sheet or in- 
 cluded in the auditor's report. 
 
 The New York Court of Appeals, in one of its decisions, 
 stated the theory of a depreciation reserve in a most lucid 
 manner, as follows: 
 
 Judicial notice may be taken of the fact that in the conduct of many- 
 industrial enterprises there is a constant deterioration of the plant which is 
 not made good by ordinary repairs and which, of course, operates continu- 
 ally 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. 
 
 Although the charge for depreciation is recognized by the 
 law, and provision is made therefor in the forms supplied by the 
 Treasury Department in connection with the Federal Corpora- 
 tion Tax Law, there is a wide difference of opinion as to the 
 amount of the allowance to be made from time to time. Many 
 company officials — particularly railway officials — prefer to re- 
 gard depreciation charges as flexible. They adjust them to meet 
 the conditions of different years, so that in time of large profits 
 the allowance shall be large, and during bad years the allowance 
 small, or none. 
 
 This, however, is entirely opposed to sound accounting prin- 
 ciples, and the Treasury Department in this instance agrees with 
 
DEPRECIATION 319 
 
 the opinion of the accounting profession. It is important that 
 there should be some fixity in regard to the rate of depreciation 
 to be allowed. Under the system of varying charges for depre- 
 ciation it would be impossible to fix an intelligent basis of rates, 
 and comparisons with other years would be practically worth- 
 less. If the business man, whether in the railroad world or else- 
 where, is to pass over one year without making any allowance 
 for depreciation, it will rfesult in a misrepresentation of condi- 
 tions at the end of that year, and it is unjust and incorrect in 
 every way to expect a good year to bear the burden of depre- 
 ciation which has occurred in one or more bad years. 
 
 Causes for Depreciation: The various elements of deprecia- 
 tion have been very clearly described by Professor M. E. Cooley : 
 
 (i) Depreciation Due to Wear and Tear and Exposure to the Elements. 
 This is continuous. All elements have a wearing 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 func- 
 tion. In practice the average condition of all elements must be maintained at 
 a high percentage of the original cost if the property is to serve its purpose 
 properly. This percentage varies from seventy-five per cent to eighty-five 
 per cent of the cost new of the property. The difference between this per- 
 centage of from seventy-five to eighty-five and the original one hundred 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 investment becomes lost. 
 
 (2) Depreciation Due to Accidents; a Sudden Depreciation. An engine 
 or a boiler may be wrecked, and with it, other machinery. This might, and 
 probably would, involve a considerable expense for repairs or replacement 
 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 floods. 
 A storm, as 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 al- 
 ready been superseded 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 inade- 
 quate. The public demand is largely responsible for this depreciation due 
 to inadequacy. 
 
 (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 general use during the 
 past five years and the art of steam turbines is at the beginning. Generators 
 
320 AUDITING 
 
 adapted to piston-engine practice are not adapted to steam-turbine practice 
 and must also 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. 
 
 Repairs and Maintenance : It is an accepted rule that repairs 
 and all other expenses of maintenance should be charged against 
 profit and loss, but the auditor should not decide on the amount 
 required for depreciation until he has scrutinized the. repairs 
 account, as in this account he may find that charges have been 
 made for renewals and replacements which, as far as they go, 
 apply in lieu of a depreciation reserve. 
 
 If a machine could be built like the "one-hoss shay," this 
 question would not arise and a depreciation reserve would work 
 out exactly, but under modern conditions it invariably happens 
 that a machine wears out one part at a time, and if the parts are 
 replaceable, the life of the machine as a whole may be extended 
 almost indefinitely. Obsolescence and inadequacy are the prac- 
 tical factors which operate against a fair test of the possible life 
 of present-day plant and equipment. 
 
 Mr. Henry Floy, the eminent engineer, cites the following 
 instance : 
 
 For example, the life of the ordinary steam engine may be taken at 
 twenty years, but it is not uncommon to find engines still in use that are very 
 much older than this. The writer noted, within a few months, that a vertical 
 engine installed in England in 1856 had recently been equipped with con- 
 denser, supplied with superheated steam, and was still in use at fifty-five 
 years of age, giving economical and satisfactory results. 
 
 Methods of Applying Depreciation in the Books: (i) The 
 
 FIXED PERCENTAGE BASIS is the most popular and is the one in gen- 
 eral use. It is applied : 
 
 (a) On a flat basis, e. g., if the life of a machine is ten years, 
 one-tenth, or ten per cent, is charged off annually. 
 
 (b) On a reducing scale basis, i. e., a rate is ascertained 
 which, when applied to the original cost and on the diminished 
 
DEPRECIATION 321 
 
 value thereof as periodically determined, will reduce the book 
 value to scrap value at the end of its estimated life. 
 
 Method (a) is more generally followed than (b), although 
 there is in use a method which is a cross between the two and 
 which is not scientific. It consists in charging the rate as de- 
 termined under (a), but in applying it to the reducing value 
 instead of to the original cost. For instance, if the life of a boiler 
 is estimated at ten years, ten per cent per annum is set aside, but 
 on the diminishing value. If the table on page 326 were cal- 
 culated on this basis, the book value would be $348.68 at the end 
 of the tenth year, instead of $100 as under the other methods. 
 
 Nevertheless, this is a popular method and must be reckoned 
 with. The fact of the matter is that when an executive directs a 
 clerk to "charge off ten per cent for depreciation," he does not 
 stop to consider whether it means off the original cost or the 
 reduced value. 
 
 The theory of and advantage claimed for (b) is that repairs 
 and maintenance are very light during the early years of a 
 machine and very heavy during the later years. In both (a) and 
 (fc) it is contemplated that all maintenance costs are to be 
 charged oflE in addition to the depreciation. 
 
 Roughly speaking, with (b) the aggregate of depreciation 
 and maintenance would be the same each year, whereas under 
 (a) the aggregate during the first years would be light and dur- 
 ing the last years heavy. 
 
 (2) Sinking fund method : If it is proposed to set aside such 
 a sum periodically as will equal the original cost of a machine 
 (less scrap value) at the end of its estimated life, it is customary, 
 after taking into consideration the average rate of interest which 
 can be secured, to pay into a fund a fixed amount periodically. 
 The aggregate thereof, together with the accumulated interest, 
 will equal the amount required to renew the machine in question. 
 This method is seldom followed. 
 
 There is good authority, however, for its use where a single, 
 large piece of property is being operated. 
 
 This point is well expressed by Mr. Floy : 
 
 In all cases involving a consideration of the expenses of keeping a 
 property in operation, there should invariably be included allowances to cover 
 all ultimate depreciation and replacement. For a small company or where 
 
322 AUDITING 
 
 relatively large proportions of the invested capital are locked up in a few 
 or single pieces of property, it is preferable to accumulate, in advance out of 
 operating income, reserve funds from which to provide for all classes of 
 depreciation. But such method may be unnecessary and possibly an inex- 
 pedient accounting complexity with large corporations, where the invest- 
 ments in any single piece of physical property are small, relative to the total 
 investment. The truth of the above will be at once recognized from the 
 following illustration. If the company which erected the Metropolitan Life 
 Insurance building had only that property, it would be essential that funds 
 should be laid aside annually in amounts sufficient to replace the original in- 
 vestment at the end of the useful life of said building. 
 
 The unsettled conflict between the Third Avenue Railway 
 Company and the New York Public Service Commission with 
 reference to the actual setting aside of an amortization fund and 
 a depreciation fund is of considerable interest. The Third 
 Avenue Railway Company had gone through a receivership and 
 the par value of the securities of the reorganized company ex- 
 ceeded by a considerable amount the value of the physical prop- 
 erty owned by the company. The Commission directed that a 
 fund be created into which the Company pay annual installments 
 out of its income, so that at maturity of the outstanding secur- 
 ities an amount would have been accumulated which, together 
 with the company's other property, would equal the par value of 
 the outstanding securities. 
 
 The Commission also directed that there be set aside annu- 
 ally at least 20 per cent of the earnings for current maintenance 
 and future replacements (depreciation), the unexpended portion 
 of this amount to be "credited" to a separate depreciation fund 
 at the end of each year. 
 
 The opinion of the Commission is of sufficient importance 
 and interest to warrant the reproduction in full of that part deal- 
 ing particularly with the amortization and depreciation funds. 
 
 Amortization of Discounts. The requirement that discounts shall be 
 amortized is a generally recognized principle. The unanimous conclusion of 
 the Railroad Securities Commission in its recent report to the President of 
 the United States was to this effect: "It seems to be generally agreed that 
 no limitation should be placed on the price at which bonds can be sold, but 
 any discount should be canceled or amortized during the life of the bonds by 
 the appropriation each year out of annual income or surplus accumulated 
 after the issue of the bonds of not less than the proportionate amount of the 
 discount." The Securities Commission also said, regarding the issue of stock 
 
DEPRECIATION 323 
 
 below par, that the difference between par value and cash received should be 
 amortized within a short term of years, thus : 
 
 If a document says one hundred dollars has been paid, one hundred 
 dollars ought to be paid. The most that can properly be done is to allow 
 companies which cannot sell such stock at par to arrange for the "amortiza- 
 tion," or gradual cancellation, of any necessary discount by appropriating, 
 out of future income or surplus which may accrue subsequent to the issue of 
 such stock an annual sum having precedence over dividend-payment, to be 
 so applied on capital account as to make the deficiency good in a period of 
 no very great length. 
 
 The Public Service Commission has approved the issue of approximately 
 $100,000,000 par value of bonds exclusive of the securities of the reorganized 
 Third Avenue and Metropolitan Street Railway companies. Probably 90 per 
 cent of these securities have been 35^, 4, or 5 per cent bonds, issued at less 
 than their par value. It has been the invariable practice of the Commission to 
 require the difference between the cash proceeds of the bonds and their par 
 value to be treated the same as bank discount or interest paid in advance and 
 to be amortized within the term of the obligations. The propriety of this 
 requirement has never been contested by any of the corporations affected. 
 This procedure is in accordance with well-established principles of accounting 
 and with the rules of accounting prescribed by the Interstate Commerce Com- 
 mission and the two Public Service Commissions of New York and other 
 regulatory bodies. 
 
 In the previous opinions in this case the Commission found the total 
 liabilities of the entire Third Avenue system, after eliminating book entries, 
 intercompany accounts, etc., to be approximately: 
 
 Receiver's certificate and notes $3,755,000.00 
 
 Funded debt of Third Avenue Company 5,000,000.00 
 
 Funded debt of underlying companies 5,892,000.00 
 
 Funded debt — other liens 1,240,000.00 
 
 Real estate mortgage 12,000.00 
 
 Other current liabilities — estimated 2,811,744.34 
 
 New refunding bonds 15,790,000.00 
 
 New income bonds 22,536,000.00 
 
 New stock 16,590,000.00 
 
 Total $73,626,744.34 
 
 Upon the other side of the account the Commission found the following 
 assets and funds to be paid over: 
 
 Physical property estimated to have a value at that time 
 
 of about $35,100,000.00 
 
 Current assets 1,746,637.72 
 
 Cash assessment 7,200,000.00 
 
 Total $44,046,637.72 
 
 The excess of liabilities over assets is thus seen to be nearly $30,000,000. 
 If the revisions in current liabilities and assets requested at a former hearing 
 were allowed, the excess would be nearly $29,000,000. Even assuming that 
 the current liabilities unfunded would be paid out of operating expenses, 
 there would still remain an excess of upwards of $26,000,000. 
 
324 AUDITING 
 
 The Bondholders' Committee estimated that the 4 per cent bonds might 
 sell for about 80, which is equivalent to a yield of slightly more than 5 per 
 cent per annum when account is taken of the fact that a bond now bought 
 for $800 will be redeemed by the company at its maturity for $1,000. The 
 market value of the income bonds was estimated at 70, and the stock at 
 about 30. Thus, upon the Committee's own estimate, the par value of the 
 new securities exceeded the cash by $21,500,000, shown as follows : 
 
 Par value Cash value 
 
 $15,790,000 4% refunding bonds @ 80 $12,632,000 
 
 22,536,000 5% income " @ 70 I5.77S,200 
 
 16,590,000 Stock @ 30 4,977,000 
 
 $54,916,000 Total $33,384,200 
 
 (From the letters of Henry Floy, engineer, and Guthrie, Bangs & Van 
 Sinderen, counsel to the Bondholders' Committee, printed in the proceedings 
 of the directors of the Third Avenue Railway Company and filed as Exhibit 
 F with the petition of the company, May 26, 1910.) 
 
 Assuming that the property is maintained by annual cash expenditures 
 and a depreciation fund, it would follow that in i960, when the bonds become 
 due, there would still be a difference between the total capitalization and the 
 value of the property (assuming that the amount of cash now paid in 
 will be used to increase the value of the property) of approximately $25,- 
 000,000. 
 
 In order that this difference, which is in the nature of a discount upon 
 securities, may be eliminated during the life of the bonds, it is necessary that 
 an amount should be set aside annually out of income before dividends and 
 interest on the income bonds may properly be paid. It is evident that the 
 annual amount is determined by the rate at which the fund will accumulate. 
 It is certainly not less than four per cent, and upon this basis the annual 
 payment would be $180,000, plus four per cent upon previous payments and 
 accumulations. If this course is followed, the company in i960 will have a 
 fund which, together with its other property, assuming it to be maintained as 
 above stated, will be equivalent to the par value of the securities then out- 
 standing. 
 
 It is apparent that if the company is able to earn only four per cent 
 upon this fund, either through investments in securities or in its own prop- 
 erty, the net deduction will be $180,000 per annum. If, however, the com- 
 pany is able to earn even more than four per cent per annum, the income 
 above four per cent will work to reduce the net annual charge against income 
 by the precise amount which the actual earnings exceed four per cent. If, 
 for example, the company should be able to earn six per cent per annum, 
 the net amount would be less than $100,000. 
 
 Unless some such plan is followed, the company will not be able in i960, 
 in refunding the bonds then due, to present as the basis for such refunding 
 property which is equal to the par value of the securities. They will be repre- 
 sented in part by discounts upon issues of 1912, fifty years before. 
 
 Depreciation. The foregoing requirement has reference only to the 
 
DEPRECIATION 325 
 
 present impairment of capital. This impairment of capital has resulted to a 
 considerable extent from the neglect of the old campany to make proper pro- 
 vision for depreciation. If the company does not reserve a sufficient portion 
 of its revenue to replace capital consumed during the year but not requiring 
 replacement within the year, and then proceeds to treat the entire surplus as 
 divisible profits, it is actually violating the corporation law against the declara- 
 tion of dividends out of capital just as effectually as though it sold stock and 
 distributed the proceeds immediately in the form of dividends. Unless, there- 
 fore, careful provision is made for the creation of a depreciation reserve, 
 there may be another repetition of the financial collapses that have been so 
 conspicuous in the history of the street railways in Manhattan. 
 
 Under the Third Article of the first refunding mortgage and the Fifth 
 Article of the income mortgage, the company agrees and covenants to main- 
 tain property, by making needful repairs, renewals, and replacements, and 
 under the Second Article of the refunding mortgage it further agrees that no 
 bonds shall be issued for replacements or operating expenses. To provide 
 for such replacements, however, there ought to be some definite provision 
 for a depreciation reserve. The matter assumes a special importance in 
 view of the fact that the declaration of interest upon the income bonds will 
 depend upon a precise definition of expenses and other deductions that may 
 be made from revenue. Without clear definitions there is an almost certain 
 likelihood of disputes between the income bondholders and the stockholders 
 as to the true amount of the profits. The Second Article, Sub. a, of the in- 
 come mortgage enumerates the various items of expense to be deducted from 
 revenue and specifies depreciation or obsolescence, but leaves the amount of 
 such charge to be determined entirely by the discretion of the Board of 
 Directors. When it is recalled that in one case where it was the object of 
 the company to show small earnings Receiver Whitridge testified before the 
 Commission that the total annual depreciation amounted to $600,000, and that 
 in a second case, where it was the object of the company to show large 
 earnings, the same Receiver testified that depreciation amounted only to 
 $300,000, one will realize the necessity of a more specific definition of de- 
 preciation. 
 
 In the opinion of the Commission, there should be reserved out of 
 revenue for the upkeep of the property, including both current maintenance 
 and future replacements, in accordance with the accounting rules of the 
 Commission, at least twenty per cent of the operating revenue of the Third 
 Avenue Railway. This minimum rate has been used in other mortgages 
 and contracts, is practically the standard percentage used by engineers in 
 appraising street railways, and more especially is the rate estimated by the 
 Chairman of the Reorganization Committee of the Metropolitan Street 
 Railway Company. 
 
 The Commission does not fix twenty per cent as the maximum rate or 
 as the rate applicable to all cases. Further, if this rate should prove to be 
 too high after a number of years, the facts may be presented upon applica- 
 tion to the Commission for a modification of this order. But it is of prime 
 importance that the situation into which the street railways of Manhattan 
 
326 
 
 AUDITING 
 
 drifted a few years ago be not repeated. Therefore, the Commission directs 
 the company to provide and maintain two reserve funds, one for depreciation 
 and one for the amortization of excessive capitalization so that the bond- 
 holders may have property of some sort wherewith to reimburse the holders 
 of securities. 
 
 February 7, 1912. 
 
 The President (formerly the Receiver) of the Third Avenue 
 Railway Company has taken decided exceptions to the rulings of 
 the Public Service Commission and the matter will probably be 
 settled only after protracted litigation. 
 
 The following table shows the results of different methods of 
 calculating depreciation over a period of ten years upon an 
 article costing $1,000 with a break-up value of $100 at the close 
 of the decade. 
 
 
 
 Fixed Percentage 
 
 Sinking Fund 
 
 
 Fixed Percentage 
 
 Method. _ 20.67% 
 
 Method. At 6% 
 
 Year 
 
 Method. 10% on 
 ■Original Value 
 
 on Diminishing 
 Value 
 
 Compound 
 Interest 
 
 I 
 
 $90 . GO 
 
 $205.70 
 
 $71-55 
 
 2 
 
 90.00 
 
 163.38 
 
 71-55 
 
 3 
 
 90.00 
 
 129.78 
 
 71-55 
 
 4 
 
 90.00 
 
 103.08 
 
 71-55 
 
 5 
 
 90.00 
 
 81.88 
 
 71-55 
 
 6 
 
 90.00 
 
 65 03 
 
 71-55 
 
 7 
 
 90.00 
 
 51.66 
 
 71-55 
 
 8 
 
 90.00 
 
 41 03 
 
 71-55 
 
 9 
 
 90.00 
 
 32 -59 
 
 71-55 
 
 10 
 
 90.00 
 
 25-87 
 
 71-55 
 
 
 $715-50 
 
 Compound In- 
 
 
 
 
 terest at 5% . . 
 
 
 
 184.50 
 
 Totals 
 
 $900.00 
 
 $900.00 
 
 $900.00 
 
 (3) Production method: A method of making depreciation 
 allowances which has its advantages under certain conditions is 
 that of charging an established rate per unit of output. This is 
 especially applicable in the case of, say, a blast furnace where 
 the frequency with which the linings will need to be renewed 
 depends on the extent to which the furnace is being used. If it 
 is being run at full capacity night and day, the wear on the lin- 
 ings is obviously much greater than if the furnace had not been 
 in continual use during the entire fiscal period. 
 
 Another species of depreciation which may be said to come 
 
DEPRECIATION 327 
 
 under the above caption is that caused in a plant by the exhaus- 
 tion of the mines or timber lands in connection with which 
 the plant was constructed. Most of the value of coke ovens, 
 for instance, is gone when the mines for which they were con- 
 structed are worked out. Consequently, in determining the 
 amount to be written off for depreciation of mining and lumber- 
 ing plants, the factor of the probable future output of the mines 
 or lands will be an important one and it will frequently be found 
 advisable to base the plant depreciation charge on the output. 
 Certainly this should be done where it is evident that the plant 
 will outlive the exhaustion of the mines or lands. In such cases 
 the depreciation charges should be sufficient to absorb the entire 
 cost of the plant, less residual value, by the time the mines or 
 lands are exhausted, even though at that time the plant might' 
 still be in good operating condition. 
 
 Sinking Fund Requirements to Retire Bonds, etc., Must Not 
 be Confused with Depreciation Allowances : The trained account- 
 ant or engineer recognizes the distinction between depreciation 
 and sinking funds and never confuses the two terms. Not so, 
 however, with lawyers and business men. The modern indus- 
 trial bond is not popular unless a provision is inserted in the 
 trust deed requiring that a sufficient sum be set aside annually, 
 or otherwise, to retire the bonds before or at maturity. 
 
 It is usual to provide that the installments must be provided 
 out of earnings, and this is a wise course to follow, as it serves 
 to keep down dividends declarations during the life of the bonds. 
 Nevertheless, the sinking fund installments are capital expend- 
 iture and do not properly appear among operating expenses, but 
 should be stated as deductions from the net profits when ascer- 
 tained. This course fulfills the obligation imposed in the trust 
 deed and yet does not permit the surplus to be overstated. 
 
 Now the sinking fund provision may be greater or less than 
 the amount required for depreciation, aside from the fact that 
 one is an operating expense and the other is a discharge of a 
 capital obligation. Therefore, depreciation should be calculated 
 and charged against earnings before the net profit is determined 
 irrespective of the existence or nonexistence of sinking fund re- 
 quirements. 
 
 The common misconception of the proper treatment of com- 
 
328 AUDITING 
 
 pulsory sinking funds can be explained by an illustration taken 
 from actual practice. A manufacturing corporation handling a 
 patented device issued bonds aggregating $375,000, payable in 
 installments of $25,000 annually for fifteen years. Having in 
 mind possible competition and obsolescence of its property, it 
 was provided that the sinking fund installments be charged 
 against earnings. The president of the company had a contract 
 under which he was to receive a bonus of five per cent of the net 
 profits in addition to his salary, but it was specifically provided 
 that as to him the charges against earnings should not include 
 the sinking fund installments. In making up the first year's 
 accounts the auditors decided that the depreciation reserve, as 
 nearly as could be determined, should be stated as $25,000, and 
 this amount was included among the operating expenses. 
 
 When their report was submitted to the directors, the presi- 
 dent referred to his contract and stated that the sinking fund pro- 
 vision and depreciation were synonymous and that he was en- 
 titled to five per cent of the earnings before any deduction was 
 made for depreciation. The majority of the directors agreed 
 with him, with the result that the company has overpaid the 
 president $1,250 per annum for several years. 
 
 Perhaps the time will arrive when depreciation will be gen- 
 erally considered as a prime operating cost. If it is so treated 
 throughout the accounts, no such misunderstanding as that 
 above cited could occur. 
 
 Depreciation Is an Operating Expense : We often see a state- 
 ment in published reports that a corporation has realized net 
 profits amounting to a certain sum, and that out of these profits 
 an allowance for depreciation has been made. It would be just 
 as logical to state that a candy manufacturer had earned a net 
 profit of one hundred thousand dollars and that out of said one 
 hundred thousand dollars there had been set aside twenty thou- 
 sand dollars to pay for the sugar consumed in the manufacture of 
 the product. 
 
 The use of that which is consumed is a loss or expense. Ma- 
 chinery is consumed; sugar is consumed. You cannot say that 
 one is an operating expense and the other is an item which need 
 not be ascertained nor taken into account until the net profit is 
 shown. Net profit means only one thing in the vocabulary of the 
 
DEPRECIATION 329 
 
 professional auditor, and that is the excess of income over oper- 
 ating costs, expenses, and losses. It cannot be determined by 
 taking into account all of the income and a part only of the 
 charges against income. If the provision for depreciation is not 
 such an item as can be included among the costs of operation, 
 then it is a misnomer. 
 
 This view of depreciation is well expressed by Professor 
 Henry C. Adams, writing with respect to railroad accounts, but 
 the principle enunciated applies with equal force to industrial 
 accounts. 
 
 When carried to its final analysis the question of formal depreciation 
 charges to operating expenses is simply a question of what constitutes cost 
 of operation, and the time when such cost shall be acknowledged in the 
 accounts. The position which the Interstate Commerce Commission's system 
 of accounts assumes on this point is, that the depletion of an asset which 
 represents an investment through the use of that asset in operation creates 
 an item of cost of operation which should be reflected in the accounts when 
 the fact of such depletion takes place, and that a statement of net revenue 
 made without including this element of cost in operation expenses is an 
 erroneous statement. 
 
 Depreciation a Local Issue: The auditor must use his own 
 judgment in passing on rates of depreciation just as much as he 
 does when he inspects purchase vouchers. In one locality steam 
 coal may be two dollars a ton, in another four dollars. The varia- 
 tion may be entirely legitimate. In one locality boilers may de- 
 preciate 7J^ per cent annually, in another the rate may be 15 per 
 cent. 
 
 It is not merely a question of the life of the boilers, because 
 no experienced engineer or boiler manufacturer would answer 
 the question unless he knew the use to which the boiler would be 
 subjected, the climate, the water, the class of labor, the probabil- 
 ities of shut-downs, etc. And similarly with almost all other 
 classes of property which depreciate by wear and tear. There- 
 fore, wherever rates of depreciation are mentioned in this chap- 
 ter, they must be taken as suggestive only and in a relative sense. 
 The student without other experience can thus broadly acquaint 
 himself with general observations and modify his views later on 
 as he gains experience. 
 
 Investment of Depreciation Reserves : It has been urged that 
 unless an amount corresponding to the reserve for depreciation 
 
330 
 
 AUDITING 
 
 is invested in marketable securities, it is not a de facto reserve, 
 but merely a book account. This is a matter of secondary im- 
 portance. The principal point to consider is whether or not there 
 has been charged to income a sufficient sum to cover the loss by 
 wear and tear and obsolescence. So long as this is done there 
 is no possibility of the amount thereof being paid out in divi- 
 dends. It is left in the business in the form of cash or any other 
 undivided asset. The question of its investment is immaterial. 
 
 The concern that can and does purchase securities equal to 
 its depreciation reserve and retain such securities until the pro- 
 ceeds are needed for the purchase of machinery, etc., could cer- 
 tainly be depended upon to renew its machinery when necessary 
 even though its depreciation reserve was represented among its 
 current or fixed assets. 
 
 The life of plant and equipment is too uncertain to warrant 
 the purchase of bonds which are to be sold to finance renewals. 
 A well-managed plant is attended to daily as to its up-keep, and 
 renewals and changes are made as needed. 
 
 Importance of Provision for Obsolescence: It has been 
 pointed out that actual depreciation is ascertainable. That is to 
 say, machinery, for instance, cannot be operated efficiently if it 
 falls below, say, 70 per cent of its condition when new. If its 
 theoretical life is ten years and 30 per cent has been set aside 
 during the first three years, the question then arises as to what 
 to do at the end of the fourth year. If the shop is properly man- 
 aged, it is probable that the machine is worth 70 per cent of its 
 cost and will remain so until superseded. But no manufacturer 
 can depend on keeping up his equipment by renewing old ma- 
 chines in whole or in part. It is inevitable that improvements 
 will come so long as the times produce inventors and men of 
 initiative. Therefore the manufacturer who is willing that the 
 product of a machine shall bear the cost of the machine con- 
 tinues to charge operating and credit reserve for depreciation 
 with such an amount as will enable him to discard his old ma- 
 chine as soon as a better one appears. 
 
 One of the foremost efficiency engineers in this country told 
 the author that the tendency to scrap old machines and buy new 
 ones had often been carried to an extreme ; that in some cases a 
 new machine of twice the capacity of an old one costs much more 
 
DEPRECIATION 331 
 
 than twice as much, and that the interest, depreciation, and other 
 charges against the new machine more than offset the saving 
 in time or increase in production. 
 
 Nevertheless, the tendency to discard is strong, and the 
 auditor who endeavors to charge out the cost of a machine 
 against its product must set up a reserve for obsolescence or he 
 will find the reserve for depreciation insufficient. 
 
 It is not advisable to separate the accounts in the books nor 
 on financial statements. No manufacturer cares to publish his 
 estimate of that part of his equipment which is getting out of 
 date. 
 
 Depreciation of Different Classes of Property : Passing from 
 a general discussion of the rules which have the approval of com- 
 petent authorities, it is desirable to study their application to 
 various classes of assets. For the sake of convenience we will 
 take up the depreciation of fixed assets as they appear in Chapter 
 IX (page 117). 
 
 Land : It is usual to dismiss this item with the statement that 
 land does not depreciate. Nothing could be further from the 
 fact. The great bulk of land in the United States is depreciating 
 through use just as much as depreciation occurs in machinery 
 through use. 
 
 The land on which buildings are erected or which is used for 
 storage purposes, etc., may not depreciate, and the aggregate of 
 such holdings is very large, but the auditor must inquire into the 
 purpose for which land is used, its location, etc., before he can 
 decide offhand that the land has not depreciated. 
 
 Land used for agricultural purposes may depreciate through 
 use and does depreciate unless a certain rotation of crops is fol- 
 lowed or unless fertilizers are used. The latter is equivalent to 
 the cost of maintenance and repairs in a factory. 
 
 The price of flax seed has increased enormously because dur- 
 ing the early years of farming in the West the vitality of the land 
 was exhausted by raising a crop which impoverished the soil to 
 such an extent that the farmers were obliged to discontinue the 
 raising of flax. During the period when this crop was using up 
 the value of the land the farmers should have set up a reserve for 
 depreciation, and it would have been apparent that the net price 
 realized from the flax crop was not nearly so high as it seemed. 
 
332 AUDITING 
 
 and that wheat, while bringing in less cash per acre, would have 
 been more profitable. 
 
 This illustration may not seem pertinent enough to warrant 
 its inclusion in a book which is intended to be practical, but the 
 author wishes students in particular to use their imagination on 
 every possible occasion, and this is a convenient place to reiter- 
 ate the advice. Heretofore textbooks on auditing have stated 
 without qualification that land does not depreciate. If it is a fact 
 that three-fourths of the land in the United States is depreciating 
 through use, these statements should not have been allowed to 
 go unchallenged so long. 
 
 Land fluctuates in value, sometimes violently, but such vari- 
 ations are not to be confused with depreciation. 
 
 Buildings: It is difficult to foretell at what rate buildings 
 will depreciate, and it is practically impossible to set a standard 
 common to all the different classes of buildings which may be 
 found among the assets of different enterprises. When the 
 ledger account includes land with buildings, the depreciation 
 usually must be confined to the buildings only. As a general 
 plan, if the allowances for depreciation take the form of the 
 installment plan, the annual rate of deduction will range from 
 one per cent to five per cent of the origirial amount, the rate vary- 
 ing according to the workmanship, material, service to which 
 the building is put, climate, and any other factor which may influ- 
 ence the life of the building. By the sinking-fund system the 
 sum to be set aside must be such as will accumulate to the cost 
 of the building during the probable life of the building. Repairs 
 will have to be borne by the income, in addition to the item of 
 depreciation. 
 
 It must be remembered that no building will last forever; 
 and this statement is made in the face of the claims of the advo- 
 cates of concrete construction. Possible appreciation in land 
 should not be used as an offset against the depreciation of build- 
 ings unless the former is set out clearly on the income side of 
 the accounts and the charge for depreciation included among the 
 expenses. It will then be apparent that an anticipated profit is 
 being used to offset an actual expense. 
 
 The following rates of depreciation on buildings are taken 
 from different authorities. 
 
DEPRECIATION 333 
 
 U. S. Government Allowance Per Cent Per Annum 
 
 Brick buildings : Occupied by Owner i to iJ4 
 
 Do. Tenant 1% " 114 
 
 Frame buildings : Do. Owner 2 " 2}4 
 
 Do. Tenant 2^ " 3 
 
 Wisconsin Commissions Years of Life 
 
 First-class stone and brick (office buildings) 75 
 
 Second-class shops, car-barns, and power stations 50 
 
 Brick gas retort houses 30 
 
 Frame dwellings 35 
 
 Frame stables and coal sheds 20 to 25 
 
 Public Service Commission, New York 
 
 Brick buildings 2% 
 
 Chicago Traction Co. Valuation 
 
 Brick buildings l}4% 
 
 Leaseholds: Premiums paid for leases may be considered as 
 the price of a terminable annuity of an amount equal to the dif- 
 ference between the annual value and the annual charges. In the 
 case of short-term leases it will be found most convenient to 
 charge a proportionate part against each year's revenue, but this 
 method would not be desirable in the case of longer leases, as it 
 is not sufficiently accurate. The annuity method would be more 
 desirable where long leases are concerned, as it is not proper that 
 the early years should bear the carrying charges on the full pur- 
 chase price in addition to a prorated installment of the principal. 
 
 It sometimes happens that at the end of a lease there is a 
 claim for damages based on the condition of the premises. It is 
 not usually possible to restrict the use under a long lease to 
 ordinary wear and tear. The amount thereof will vary accord- 
 ing to circumstances, and the possibility of this contingency 
 must be taken into consideration in making the calculation. 
 When there is an agreement in a lease calling for the restoration 
 of premises to the original condition at the termination of the 
 lease, the estimated expense may be accumulated and spread over 
 the years of the life of the lease. 
 
 In England, where leaseholds are far more common than 
 here, the annuity system is usually applied and the interest on 
 the investment is charged each year on the diminishing value of 
 the lease. The amount of depreciation is fixed, but as the reserve 
 grows larger the interest charged decreases. 
 
334 AUDITING 
 
 When new buildings are erected on leased land the full cost 
 thereof will have to be provided for during the term unless there 
 is a provision for revaluation at the expiration. In any event the 
 amount which will disappear from the assets at the end of the 
 lease must be absorbed equitably during the period. The annuity 
 system is suggested as the plan most suitable. 
 
 Machinery and Equipment: The rate of depreciation to be 
 allowed in the case of machinery has been the subject of more 
 discussion than any other allowance of this nature. So many 
 factors enter into the life of machinery that it is absolutely neces- 
 sary for each machine to carry its own individual rate, and this 
 can be determined solely by experience. In the case of two 
 machines exactly alike in the beginning used in different fac- 
 tories, there may be a considerable difference in length of life and 
 service; consequently no hard-and-fast rule can be laid down. 
 But in addition to charging all repairs and part renewals to oper- 
 ating, from 7J/2 to 12J/2 per cent should be written off annually 
 from the original cost to provide for normal depreciation by wear 
 and tear and obsolescence. 
 
 It is invariably desirable that a subsidiary ledger should be 
 kept containing details of the machinery accounts in the general 
 ledger. This assists in arriving at rates of depreciation and is of 
 great value in case of fire or in determining the amount to be 
 written off in case of sale. 
 
 A considerable part of the ordinary wear and tear for which 
 depreciation reserves are created is usually charged to operating 
 expenses in the form of repairs and maintenance. Small parts 
 of machines are wearing out or breaking and are being constantly 
 renewed. In some cases nearly every part of a machine may be 
 renewable, and it is quite conceivable that at the end of five or 
 six years a machine may be largely renewed and be about as 
 good as new. If in the meantime depreciation at the rate of 10 
 per cent per annum has been reserved without any adjustment 
 for new parts supplied it is evident that the reserve is too large. 
 
 It is not intended to advocate any reduction in ordinary de- 
 preciation rates, but it is suggested that the careful auditor 
 should study the relation between the depreciation reserve and 
 the physical condition of the machine. Reference to Professor 
 Cooky's description on page 319 herein will remind us that ma- 
 
DEPRECIATION 
 
 335 
 
 chinery to serve its purpose properly must be maintained at from 
 75 per cent to 85 per cent of its original condition, therefore there 
 is no necessity for providing the cost of maintenance plus the 
 wear and tear element of depreciation if the latter is fully cov- 
 ered by the former. 
 
 The following tables compiled by Mr. George A. Cravens 
 and published in the Electrical Review, April 23, 1910, are of 
 interest. Rates of depreciation on various kinds of equipment as 
 estimated in connection with litigation and by recognized au- 
 thorities are shown. 
 
 Table II indicates the variation caused by light or heavy use. 
 
 TABLE I 
 
 Itemfl 
 
 |:i 
 
 
 l| 
 
 fi 
 
 go 
 1 
 
 1 
 
 ■5 
 
 > 
 < 
 
 1 
 
 p. 
 
 1 
 
 So 
 
 F 
 
 11 
 
 S^ 
 
 
 3-5-10 
 3-5 
 
 6 6 
 
 7-5 
 75 
 
 6.6-8.5 
 5 
 
 5 
 
 5 
 
 5 
 
 8-10 
 
 5 
 
 5 
 
 2-5-3-3 
 2-5-3-3 
 
 4-6.6 
 
 5-8 
 
 7-5 
 
 5 
 
 Steam Piping 
 
 6.6 
 
 8-10 
 
 Auxiliaries 
 
 5-10 
 
 6.6 
 
 5 
 
 6.6-8.5 
 
 ,s 
 
 5 
 
 8-10 
 
 5 
 
 4-6.6 
 
 V5 
 
 7-5 
 
 Steam Engines .... 
 
 3-10 
 
 6.6 
 
 5 
 
 5-6.6 
 
 5 
 
 5 
 
 4-6 
 
 5 
 
 2.5-5 
 
 4-6.6 
 
 5 
 
 Steam Turbines . . . 
 
 
 
 ,S 
 
 
 5 
 
 5 
 
 7-9 
 
 5 
 
 2.5-5 
 
 4 
 
 4 
 
 Belted Generators . 
 
 5-10 
 
 6.6 
 
 7-5 
 
 5 
 
 5 
 
 5 
 
 5-10 
 
 5 
 
 6.6 
 
 3-3-4 
 
 7-5 
 
 Wires and Cables. . 
 
 2 
 
 6.6 
 
 5 
 
 2 
 
 ,S 
 
 3 
 
 3-5 
 
 5 
 
 4-6.6 
 
 5 
 
 5 
 
 Switchboards, etc. . 
 
 2 
 
 6.6 
 
 .5 
 
 2 
 
 7-5 
 
 5 
 
 8-10 
 
 5 
 
 2-5 
 
 
 S 
 
 
 5-10 
 
 6 6 
 
 5 
 
 ID 
 
 5 
 
 5 
 
 5 
 
 5 
 
 5 
 
 5-8 
 9-1 1 
 
 5 
 5 
 
 4-6.6 
 5-10 
 
 5 
 6.6 
 
 5 
 10 
 
 Storage Batteries . . 
 
 6.6 
 
 Shop Equipment . . 
 
 3-10 
 
 5 
 
 7-5 
 
 3-3-10 
 
 7-5 
 
 7-5 
 
 12-15 
 
 5 
 
 4-10 
 
 
 7-5 
 
 TABLE II 
 
 Items of Equipment 
 
 Light or 
 
 Intermittent 
 
 Service 
 
 Heavy or 
 
 Continuous 
 Service 
 
 Boilers, Water Tube 
 
 Boilers, Fire Tube 
 
 Piping, Steam, and Water .... 
 
 Auxiliaries, Steam 
 
 Engines, Steam 
 
 Turbines, Steam 
 
 Generators, Belted 
 
 Wires and Cables 
 
 Switchboards and Instruments 
 Motors (A. C. and D.- C.) . . . 
 
 Storage Batteries 
 
 Shop Equipment, Tools, etc . . 
 
 5-8-3 
 6.6-10 
 
 5-5-8-3 
 4-6.6 
 5-6.6 
 4-5 
 5-8.3 
 4-6.6 
 5-8.3 
 5-8-3 
 
 6.6-10 
 
 7-5-15 
 
S36 AUDITING 
 
 Small Tools: Small tools should be revalued periodically, 
 thus fixing accurately the rate of depreciation. If this plan is 
 followed for several years and a dependable rate is secured, it 
 may be feasible to omit the revaluation for a year or two, apply- 
 ing the rate previously ascertained. 
 
 Furniture and Fixtures : Many concerns write down this item 
 to $1, and the practice is to be commended unless stockholders, 
 partners, or other interested parties are being deceived. Where 
 the asset is a large one such a course is not so feasible, but there 
 is no doubt that this item is usually overvalued so far as any 
 possibility of realization is concerned. 
 
 Usually in a going business, assets are not treated on the 
 basis of realization values, but in the case of furniture and fix- 
 tures so many changes are made to suit the convenience and 
 whims of executives and clerks, and offices are moved so often 
 from one place to another, that furniture and fixtures have a 
 most uncertain value. 
 
 Office partitions are frequently built at the expense of tenants 
 and are worthless at the end of the lease. In the meantime 
 changes are often made, and if the auditor is careful he may find 
 duplications in the account. 
 
 If it is important to write ofif actual depreciation only, it will 
 be found that 15 per cent per annum will represent a fair average 
 allowance. 
 
 Landlord's Fixtures: Leaving out of consideration the com- 
 plex question as to what are and what are not landlord's fixtures, 
 it may be laid down as a general rule that the minimum rate of 
 depreciation upon machinery and fittings erected upon lease- 
 hold property should be written ofif at a rate at least sufficient to 
 wipe off the book value before the expiration of the lease. 
 
 In the case of machinery, etc., which will not become land- 
 lord's fixtures, a less rate may be permitted, but it is imperative 
 that in such a case it should be clearly understood and agreed 
 what are to be the landlord's fixtures and what are not. 
 
 Horses: It will be readily seen that the depreciation of horses 
 and other animals is rapid and inevitable. The rate of allowance 
 may be from 15 to 25 per cent of the cost. By means of revalua- 
 tion, which can be more accurately done in the case of horses 
 than with most other assets, it should soon become possible to 
 
DEPRECIATION 337 
 
 determine the actual rate of depreciation. These revaluations 
 should be fairly frequent. 
 
 Wagons, Automobiles, etc. : In the case of wagons it will be 
 found that 8 to 10 per cent per annum is an ample allowance, 
 provided that all repairs, renewals of parts and maintenance are 
 charged to operating expenses. 
 
 As with wagons, most of the parts of an automobile can be 
 replaced. Under ordinary conditions the rate of depreciation on 
 automobiles should be fixed at from 15 to 20 per cent per annum. 
 The most expensive parts, such as tires, motors, and bodies, may 
 be easily replaced, and if charged to operating will leave unpro- 
 vided for only accrued depreciation and obsolescence. 
 
 Ships : Although the depreciation of ships is invariably great 
 and must be the subject of allowance, it is a difficult matter to 
 lay down any fixed rate to be written off. The amount of depre- 
 ciation should be certified by an engineer, and unless there ap- 
 pears to be some reason to doubt the correctness of his report, 
 the auditor is not responsible. The auditor's certificate should 
 state clearly that inadequate allowance for depreciation has been 
 made unless an amount has been provided which in his opinion 
 is ample. 
 
 Patents : Although it is true that some value may attach to a 
 patented article even though the patent has run out, it is gen- 
 erally conceded that it is well to write ofif the entire cost of a 
 patent during the period of protection. The patent derives its 
 value in great measure from the fact that it is a monopoly, and 
 the moment the monopoly has ceased by the termination of 
 patent rights, the value is seriously affected, if not entirely wiped 
 out. In the case of a patent which has been leased and not pur- 
 chased, the item should not be treated as an asset except to the 
 extent of its actual cost in fees, etc. To capitalize a patent lease 
 at any sum in excess thereof would be as incorrect as to capital- 
 ize good will, although both are latent assets in every paying 
 concern. 
 
 Copyrights may be treated in a similar manner, except that 
 their commercial value generally expires long before the termina- 
 tion of the copyright. (See also "Publishers' Accounts.") 
 
 The original life of a patent is seventeen years, and renewals 
 are dependent upon the introduction of some essential novelty. 
 
338 AUDITING 
 
 Good Will: While good will does not depreciate, it is con- 
 stantly liable to fluctuations. Good will is not usually written 
 off, and the question of the amount at which it shall stand in the 
 balance sheet was not formerly deemed to be within the scope of 
 the auditor's work, but the present range of an auditor's duties 
 compels him to give serious thought to this item. The various 
 points connected with the valuation of good will are fully dis- 
 cussed on pages 131-135 and should be referred to in case a 
 question arises as to writing ofif all or any part of the amount at 
 which good will is carried. 
 
 WASTING ASSETS 
 
 Mines: Depreciation of mines is equivalent to a depletion of 
 mineral wealth. The value of the mine to the owner or lessee 
 has decreased at the end of a year by exactly the amount of ore 
 extracted. But on account of the uncertainty in the total amount 
 of ore, its quality and grade and the expense which may be 
 involved in mining, it is a difficult matter to set such a rate of 
 depreciation as will represent the average depletion during the 
 life of the mine or the term of the lease, as the case may be. The 
 only way in which this can be done is by estimation, which is 
 naturally inaccurate and may be misleading. 
 
 Under most State laws a mining company is not compelled 
 to write off any depreciation before declaring a dividend, but it 
 is generally considered better finance to write off annually such 
 proportion of the total cost less residual value of plant as the 
 output bears to the estimated content of the mine, or, in case of a 
 leased mine, such proportion of the total cost as the output bears 
 to the output estimated for the duration of the lease. 
 
 On account of the great uncertainty of mining, and the fact 
 that stockholders object to the accumulation of large reserve 
 funds, which would earn only a low rate of interest and might 
 just as well be distributed as dividends, it may be better policy 
 that mines should be regarded as non-permanent undertakings 
 in which excesses of current revenue might be distributed with- 
 out regard to the value of the remaining assets in their relation 
 to the amount of paid-up capital. 
 
 Timber Lands: In just the same way that the removal of a 
 ton of ore or coal reduces by so much the value of the mine, so 
 
DEPRECIATION 
 
 339 
 
 the cutting of each thousand feet of timber likewise reduces the 
 value of the land on which it stood. It is obvious that there 
 should be written off from year to year such proportion of the 
 cost of the lands as the quantity of timber cut during the year 
 bears to the quantity standing on the entire tract at the time of 
 its purchase. 
 
 In some cases allowance for the value of the cut-over lands 
 may be made in determining the amount which should be 
 charged off for depletion of the timber. Very frequently, how- 
 ever, the cut-over land has but little value. 
 
 Inasmuch as the total quantity of timber standing on a tract 
 of land can be determined with much greater certainty than is 
 the case with the contents of a mine, it follows that the depletion 
 charge per thousand feet of timber cut can be more accurately 
 fixed than is true of the depletion charges for mining operations. 
 
 PUBLIC UTILITY COMPANIES 
 
 Out of the agitation for municipal ownership and regulation, 
 and the litigation resulting therefrom, has arisen a considerable 
 amount of information bearing on the depreciation of such prop- 
 erties. 
 
 The following quotation and rates of depreciation are taken 
 from Foster's Valuation of PubHc Utilities, page 198. 
 
 In the Milwaukee Three-Cent Fare Case a number of engi- 
 neers testified as to rates of depreciation, and these have been 
 tabulated in comparison with rates specified by other engineers 
 and companies. 
 
 Cooley-Beegs-Starret-Pence 
 
 Chicago 
 
 
 goo 
 
 "Sll 
 
 Milwaukee Three-Cent Case 
 
 Ib" 
 
 
 4&2 
 
 
 2 
 
 2 
 
 2 
 
 2 
 
 8 
 
 8. .5 
 
 8 
 
 
 7-75' 
 
 7.2 
 
 
 
 
 12.5-7 
 
 7-75 
 
 7.2 
 
 10 
 
 8.5 
 
 8 
 
 
 10-4 
 
 10-4 
 
 8 
 
 6.66 
 
 6 
 
 6.66-5 
 
 5 
 
 5 
 
 
 8.5 
 
 
 
 8.5-6f 
 
 8.5-6f 
 
 8 
 
 8. .5 
 
 7 
 
 
 
 
 
 
 
 2-5 
 
 5 
 
 5 
 
 
 
 
 8J-6f 
 
 14-10 
 
 14-10 
 
 
 
 
 4 
 
 
 
 Offi- 
 cials 
 
 S^ 
 
 Improvements 
 
 Track Main 
 
 Special Work 
 
 Paving 
 
 Cars, Bodies, and Trucks 
 
 Electrical Equipment 
 
 Electrical Distribution. . . 
 
 Poles — Iron 
 
 Poles — ^Wood 
 
 Wiring, etc 
 
 Feeders and Cables 
 
 3 
 
 7-5 
 12 
 10 
 
 7-5 
 
 6 
 
 7-5 
 
 7-5 
 
 5 
 
CHAPTER XXII 
 THE CORPORATION TAX LAW AND DEPRECIATION 
 
 Until recently judicial decisions on the subject of deprecia- 
 tion were rare, arising chiefly in those cases where the point at 
 issue was the payment of dividends out of capital. With the 
 passage of the Federal Corporation Tax on August 5, 1909, there 
 arose the necessity on the part of every corporation of consider- 
 ing whether or not there had been any loss during the period 
 covered by the returns which might be included among the de- 
 ductions permitted by the Treasury Department. The law pro- 
 vides : 
 
 Such net income shall be ascertained by deducting from the gross amount 
 of the income received within the year ****** (2) all losses actually sustained 
 within the year **** including a reasonable allowance for depreciation of 
 property, if any. 
 
 In the regulations subsequently issued by the Treasury De- 
 partment it was ingeniously argued that "received within the 
 year" meant exactly the same as "accrued within the year," and 
 that "actually paid" meant the same as "accrued," which accounts 
 for the use of the word "accrued" in the following official ex- 
 planation of the clause relating to depreciation. 
 
 Depreciation. The deduction for depreciation should be the estimated 
 amount of the loss, accrued during the year to which the return relates, in 
 the value of the property in respect of which such deduction is claimed that 
 arises from exhaustion, wear, and tear, or obsolescence out of the uses to 
 which the property is put, and which loss has not been made good by pay- 
 ments for ordinary maintenance and of repairs deducted under the heading 
 of expenses and maintenance and operation or in the ascertainment of gross 
 income. This estimate should be formed upon the assumed life of the prop- 
 erty, its cost value, and its use. Expenses paid in any one year in making 
 good exhaustion, wear, and tear, or obsolescence in respect of which any 
 deduction for depreciation is claimed, must not be included in the deduction 
 for expense of maintenance and operation of the property or in the ascer- 
 tainment of gross income, but must be made out of accumulative allowances 
 deducted for depreciation in current and previous years. 
 
 Immediately after the returns for the first year were filed, 
 
 340 
 
DEPRECIATION 341 
 
 the inspectors of the department (evidently inspired in their rul- 
 ings, as all of those of whom the author has heard disagree with 
 the instructions) commenced to pass arbitrarily on the allow- 
 ances for depreciation which many corporations claimed in the 
 returns. The statement was made that the Government pro- 
 posed to decide every doubtful point against the corporations, 
 relying on the latter to litigate the particularly unjust rulings and 
 thus provide the Department with precedents which they could 
 use subsequently if they so desired, Unfortunately for the cor- 
 porations, the rulings against them individually usually aggre- 
 gate a few hundred or a few thousands of dollars only, and they 
 have hesitated to proceed against the Treasury Department and 
 the Department of Justice combined. A vast number of these 
 decisions are unjust and indefensible from an accounting or any 
 other point of view. It is believed that if corporations would 
 refuse to pay the additional amounts assessed against them by 
 irresponsible and unqualified inspectors, the courts would not 
 sustain the Treasury Department. 
 
 Recently the Nipissing Mines Company was assessed some 
 thousands of dollars of additional tax on the ground that the de- 
 preciation claimed by it and deducted from its gross income was 
 not entered on its books. The company resisted the payment 
 and was sued by the government. The case was tried before a 
 jury and a verdict rendered for the company. 
 
 The opinion of the court is interesting, as an evidence of 
 what may be expected if other unjust suits are brought by the 
 government. 
 
 United States District Court 
 Southern District of New York. 
 
 The United States 
 
 V 
 
 The Nepissino Mines Company. 
 
 iTacombe, C. J. (charging jury.) 
 
 This statute provides for a deduction of all losses actually sustained 
 within the year, including reasonable allowances for depreciation of property, 
 if any. That is within the second subdivision of Section 38. The circum- 
 
342 AUDITING 
 
 stance that in the third subdivision of Section 38, where the form of making 
 the return is provided for, the same words are repeated, with a slight modi- 
 fication requiring a separate statement of any amounts allowed for deprecia- 
 tion of property, does not, in i^y opinion, change the meaning of the words 
 used in the second subdivision of the paragraph. The word "allowed" refers 
 . to an allowance by the Commissioner of Internal Revenue and his allowance 
 or disallowance ends the matter unless some case is made out upon the 
 strength of which a party may come into court to test the reasonableness of 
 the allowance or disallowance by the Commissioner. The suggestion that 
 there can be no allowance for depreciation unless such depreciation is en- 
 tered in the books of the company, recorded from time to time, seems to me 
 without force. The books may be very badly kept ; kept in such a way as 
 will in the end bring them into trouble and difficulty, but this act doesn't 
 provide any penalty for bad bookkeeping. It simply provides that one per 
 cent of the net profit of the various corporations shall be turned over to the 
 Government, and provides that in finding out that net profit there shall be a 
 reasonable allowance for depreciation. Now, the testimony here seems to me 
 entirely reasonable, and certainly it is not contradicted, that the value of the 
 ore as it lies in the ore beds is, as stated by the witness to be, 31. i cents. 
 The Government does not controvert the testimony by other witnesses, nor 
 does it dispute the expert's method of calculating. This unit of value 31. i 
 cents multiplied by the total amount of ore that was removed during the 
 year, indicates in dollars the amount by which the total assets of this com- 
 pany were depleted through the operation of the mine during that year. It 
 seems to me to be a reasonable allowance for depreciation within the mean- 
 ing of the statute. Certainly so much value has been eliminated from the 
 property of the company forever. Granting the proposition that such is a 
 reasonable allowance for the depreciation, upon the figures here there is no 
 net profit remaining, which would indicate that the Government's claim for 
 $8,534.68 should be dismissed, and that a verdict should be directed in favor 
 of the defendant for the counterclaim, being the amount taxed, which it 
 paid, $5,188.62, with an exception to the Government on each of these rulings. 
 
 If the evidence had shown that the unit value 31. i cents is too high, 
 there would be some net profit despite the depreciation, but the case must be 
 determined on the testimony. It makes no difiference that in filling up the 
 form of return under the direction of the Revenue Officers this claimed allow- 
 ance was called "return of capital," which it certainly is not, instead of "de- 
 preciation of deposits," which it clearly is. 
 
 If the known value of an ore bed were exactly $2,000,000 and exactly 
 $500,000 were taken out of it each year, in four years there would be nothing 
 left. It is difficult to say why it may not reasonably be said that the ore bed 
 suffers each year a depreciation of $500,000, just as a $10,000 piece of ma- 
 chinery with a life of ten years suffers a depreciation of $1,000 each year. As 
 I read the statute. Congress intended to allow all reasonable depreciations to 
 be deducted from the gross profits to find the net, and the reasonableness of 
 any deduction asked for depends upon the nature of the claim on which it is 
 based, not upon the amount of dollars it may aggregate. Nor is it apparent 
 
DEPRECIATION 343 
 
 ■why it should make any difference that one cannot tell with reasonable cer- 
 tainty the total value of the deposit so long as the value of the amount re- 
 moved in any one year can be ascertained with sufficient accuracy. Nor is it 
 apparent why the problem is altered in any way by the circumstance that the 
 property was bought at a very high or at a very low price, or that the 
 capitalization of the company which owns it is large or small. 
 Verdict directed for defendant for $5,188.62. 
 
 The official decisions bearing on the subject are quoted in 
 full, as it is probable that many corporations have followed them 
 blindly, not knowing that they are subject to judicial review, 
 and that if an additional assessment is made which is not war- 
 ranted by commercial or accounting practice, the courts will not 
 permit the collection of such assessment. 
 
 It may be noted that the first official ruling quoted is very 
 neatly disposed of by Judge Lacombe : 
 
 The suggestion that there can be no allowance for depreciation unless 
 such depreciation is entered in the books of the company, recorded from 
 time to time, seems to me without force. 
 
 The author does not advocate the practice of omitting depre- 
 ciation charges from the books of account. On the contrary, he 
 urges the entry of depreciation allowances wherever such a loss 
 is accruing, but this need not deter an auditor from advising a 
 client that depreciation may be claimed as a deduction in the cor- 
 poration tax reports, even though it has not been entered in the 
 books. In this case the only point at issue is whether the depre- 
 ciation allowance can be sustained. 
 
 The client can very properly be warned that if the charge 
 does not appear in his books, the burden of establishing its pro- 
 priety is cast upon him, whereas if entered in the books in due 
 course, the burden of eliminating or cutting down the item is 
 upon the government. 
 
 It will be observed by those familiar with the terms of the 
 corporation tax law that many of the decisions of the Treasury 
 Department are somewhat at variance with the exact letter of 
 the law. Indeed, it has become impracticable to follow strictly 
 along the lines of the act and the Bureau of Internal Revenue 
 has been obliged to reconcile a not altogether workable law with 
 existing conditions. 
 
344 AUDITING 
 
 In Treasury Decision 1742, paragraphs 83-94 inclusive and 
 96-105 inclusive, we find the following decisions : 
 
 83 Depreciation to be an allowable deduction in the return of annual 
 net income of a corporation must be charged off on the ledger of the cor- 
 poration, so as to show a reduction in the capital assets of the corporation to 
 the extent of the depreciation claimed. 
 
 Note. On May 9, 1912, a letter of instruction was sent to 
 Internal Revenue agents in which this arbitrary rule was re- 
 versed, it being found that the corporations whose accounts were 
 in the best order were those who maintained depreciation reserves. 
 In other words, the Treasury Department was not powerful 
 enough to order corporations to depart from proper standards. 
 
 The Commissioner's letter follows : 
 
 Referring to Item 83 in T. D. No. 1742, and the various letters written 
 from this office in which it has been stated that such depreciation to be allow- 
 able must show an actual shrinkage in the value of the capital assets with 
 respect to which the depreciation is claimed, you are informed that it appears 
 that the interpretation placed upon this in some cases has been that there must 
 be an actual change in the figures representing the value of the capital assets 
 against which the depreciation charge has been claimed. It is desired to 
 modify this to meet the needs of corporations whose books are kept in 
 various ways, but which in the main are kept in accordance with the prin- 
 ciples laid down by the highest authorities among public accountants, and it 
 is requested that hereafter when the depreciation account of a corporation 
 is entered as such on the books of the corporation so as to constitute an 
 actual charge against the property account affected thereby, the charge so 
 made may be accepted as a sufficient compliance with the requirements of the 
 rules of this office with respect to claims for depreciation made in returns 
 of annual net income for the special excise tax on corporations. 
 
 Attention, however, is called to the fact that no part of the funds set 
 aside for depreciation may be diverted for any purpose other than making 
 good the depreciation in the property affected without actually reducing the 
 valuation of the property against which the same was charged, if the same 
 shall be desired to be claimed as a deduction in the return of annual net 
 income. 
 
 84. Deduction on account of depreciation of property must be based on 
 lifetime of property, its cost, value, and use, and must be evidenced by a 
 ledger entry and a like reduction in the plant and property account with 
 respect to which the depreciation is claimed. 
 
 85. In the case of corporations owning stocks and bonds or other securi- 
 ties, if an annual adjustment of the value of such securities is made and the 
 adjusted values made a matter of ledger entry, the appreciation of such 
 securities as so entered must be accounted for as income, and the deprecia- 
 tion may be deducted from gross income. If no annual adjustment is made, 
 and the securities are carried from year to year as a permanent investment, 
 there will be neither gain nor loss, as to the principal of such securities, 
 until the same shall have been disposed of, when the gain or loss as com- 
 
DEPRECIATION 345 
 
 pared with the original cost shall be prorated, and the amount of such gain 
 or loss apportioned to the years since the incidence of the tax, to wit, Janu- 
 ary I, 1909, shall be added to or deducted from the gross income of the year 
 in which the securities were so disposed of. 
 
 86. Where increase or decrease during the year in the value of real 
 estate acquired in previous years, sold or held for sale, is taken upon the 
 books and the rate cannot be accurately determined with respect to individual 
 years, such increase or decrease may be prorated as provided by regulations 
 in cases of sale of capital assets. 
 
 87. Premiums on stocks and bonds arbitrarily charged off on the books 
 of a corporation do not constitute a proper deduction on account of depre- 
 ciation, unless there shall have been an actual shrinkage in value of such 
 stocks and bonds to the extent of the deduction claimed during the year for 
 which the return is made. 
 
 88. Net income on uncompleted contracts may be estimated on the basis 
 of the percentage of the work completed as compared with the contract price 
 of the whole work. 
 
 8g. Cost of drilling new wells by oil corporations is considered better- 
 ments and additions to the capital assets of the corporation. The expense 
 of drilling dry wells may, however, be charged to profit and loss. 
 
 go. Discounts, other than bank discounts on notes executed by a cor- 
 poration, should be segregated from the interest item on the return, and 
 should be included under expenses, item 4. 
 
 91. The mere removal of timber by cutting from timber lands, unless 
 the timber is otherwise disposed of through sales or plant operations, is con- 
 sidered simply a change in form of assets. If said timber is disposed of 
 through sales or otherwise, it is to be accounted for in accordance with 
 regulations governing disposition of capital and other assets. 
 
 92. Deduction on account of depreciation of property must be based on 
 lifetime of property, its cost, value, and use. 
 
 93. Loss due to voluntary removal of buildings, etc., incident to im- 
 provements, is either a proper charge to the cost of the new additions or to 
 depreciation already provided, as the facts may indicate, but in no case is it 
 a proper deduction in determining net income, except as it may be reflected 
 in the reasonable amount allowable as a deduction for depreciation. 
 
 94. Depreciation of company's stock is a loss to the stockholders, but 
 not a loss to the company issuing the same, and therefore not a proper de- 
 duction. 
 
 DEPRECIATION IN MINERALS, OILS, ETC. 
 
 96. In case of corporations whose business consists in part or wholly 
 of mining, producing, and disposing of deposits of nature (ores, coals, gas, 
 petroleum, and sundry minerals), the conduct of such business will be 
 understood to comprehend two classes of gains or losses, viz. : 
 
 (a) The gain or loss resulting from the sale of capital assets, i. e., either 
 the increment or the loss, arising through possessing over a period of time 
 the investment in the same. 
 
346 AUDITING 
 
 (6) The trading or commercial gain attached to the conduct of the 
 industry, the employment of working capital, the effort and risk involved. 
 
 97. In the ascertainment of net income deduction will be allowed for 
 depreciation arising from exhaustion of deposits of ore, mineral, etc., and 
 for depreciation and obsolescence of improvements, in accordance with gen- 
 eral regulations respecting depreciation allowances, on the basis of the origi- 
 nal capital investment cost of the properties concerned to the company 
 reporting. 
 
 98. A further deduction will also be allowed, through not including the 
 same at all in the item of gross income (item 3, Form 637), for the unearned 
 increment represented in such properties as at January I, 1909, which will 
 be determined in general as follows : 
 
 99. An estimate should be made as of January i, 1909, of the fair market 
 value at that date of the minerals, etc., in deposit. This estimate should be 
 formed on the basis of the disposal value of the minerals in total and ex- 
 clusive of value of improvements and development work. This valuation 
 should also be reduced to a unit value per ton, barrel, etc. 
 
 Note. Values, as aforesaid, should not be estimated on the basis of the 
 assumed salable value of the output under current operative conditions, less 
 the actual cost of production, because, as hereinbefore stated, the^ selling 
 price under such conditions comprehends a profit both for carrying the in- 
 vestment in minerals, improvements, and working capital, and for conducting 
 operations in respect of production and disposal of product. The value to be 
 determined as stated must be on the basis of the salable value of the entire 
 deposit of the aggregate units of minerals considered en bloc if disposed of 
 in that form. Nor must such valuation comprehend any speculative value 
 which might attach to a sale of the minerals en bloc; i. e., a value which 
 might be obtained on the ground that the future would develop a much 
 greater reserve of mineral deposits than were believed to exist at the time 
 the estimate as of January i, 1909, was formed. Any value of this latter 
 character would attach obviously to such additional reserves when developed 
 in future. 
 
 100. The unit value as of January i, 1909, ascertained as above out- 
 lined, would indicate the value to be attached at that date to the capital assets 
 disposed of during any calendar year succeeding, and should be used in de- 
 termining the unearned increment at January I, 1909, which may be excluded 
 entirely from the item of gross income, as before explained, in the following 
 manner,' viz. : 
 
 Value at January i, 1909, determined in manner outlined, of minerals, 
 etc., which may be removed and disposed of in any year subsequent 
 thereto $ 
 
 Less the following: 
 
 (o) Proportion of depreciation charge applying to ex- 
 haustion of minerals disposed of, ascertained as first 
 explained herein on basis of original cost ..$ 
 
 (6) Royalty paid, if any, on minerals disposed of $- 
 
 Balance, being unearned increment at, January 1, 1909, 
 
 to be excluded from gross-income item $ . 
 
DEPRECIATION 347 
 
 loi. The precise detailed manner in which the estimate of value of 
 minerals, etc., as at January i, 1909, shall be formed, must naturally be de- 
 termined upon by each corporation interested, but formal record of such 
 estimates, together with all sustaining information, should be carefully filed 
 so as to be readily accessible for reference. Values as stated, as determined 
 at January i, 1909, should be used in compilation in all subsequent years' 
 excise tax returns. The question as to whether it subsequently develops the 
 property possessed a greater quantity of mineral, etc., reserve than was in the 
 aggregate estimated as of January I, 1909, is immaterial. Any excess which 
 may be developed will be considered as possessing the same value at Janu- 
 ary I, 1909, as that which then may have been known to be in the property. 
 
 102. Each excise tax return (Form 637) should be accompanied with 
 memorandum setting forth the extent in amount of the exclusion made 
 from the item gross income for unearned increment realized during the year, 
 as above outlined. 
 
 103. As the amount to be deducted for depreciation (paragraph 2 pre- 
 ceding) is to be formed on basis of the estimated reserve of minerals, etc., 
 it follows that if it develops such estimate is understated, the cost investment 
 in the capital asset may be wholly extinguished before all mineral reserves 
 are removed. When this is reached, further deductions for exhaustion of 
 minerals should be discontinued, but in such event, it will be noted, the 
 allowance for unearned increment which is to be excluded entirely from 
 gross income will be correspondingly increased. 
 
 104. In case of corporations leasing mines and paying royalties on 
 minerals, etc., removed, the royalties paid are to be treated as expenses and 
 deducted in ascertaining net income, as provided in general regulations. Any 
 leasehold investment which the operating corporation may have in such 
 properties, either through a payment originally made for acquirement thereof 
 or for improvements made upon the property, to be accounted for in accord- 
 ance with regulations governing depreciation allowances and disposition of 
 capital assets. 
 
 105. In respect to properties of the character in question which may be 
 acquired by a corporation after January I, 1909, a deduction will be allowed 
 only as to depreciation arising from exhaustion based on original cost. No 
 exclusion from gross income can be made for unearned increment, as profit 
 arising in sale of such capital assets applies wholly to the period subsequent 
 to January i, 1909. 
 
CHAPTER XXIII 
 
 SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS 
 
 FINANCIAL 
 
 Introductory: It is impracticable to discuss in one book all 
 the special points which arise in the audit of various enterprises. 
 The general principles which underlie all audits have received 
 full consideration and the rules which have been formulated will 
 serve as a working program for the audit of any concern. Never- 
 theless, it is of great value to a practitioner to acquire special 
 knowledge of as many kinds of business as is feasible. 
 
 The knowledge of the possible weak spots and the points of 
 greatest importance in any given audit enables an auditor to make 
 a better start than if his equipment consists solely of a knowl- 
 edge of general principles. 
 
 Human activity, so far as the relation of one person to an- 
 other is concerned, finds expression in the universal medium of 
 exchange — money; and the records of any or all of these activ- 
 ities, no matter how well or poorly kept they may be, constitute 
 the field of the professional auditor. 
 
 The various classes of accounts with which an auditor has 
 to deal are : 
 
 Financial. 
 
 Insurance. 
 
 Manufacturing. 
 
 Mining. 
 
 Trading. 
 
 Transportation. 
 
 Public Utilities. 
 
 Governmental. 
 
 Executors and Trustees. 
 
 Professional. 
 
 Institutional. 
 
 Miscellaneous. 
 348 
 
BANKS 349 
 
 The foregoing groups will be considered with reference to 
 those points only in which peculiar conditions exist or where 
 special emphasis is required. No attempt will be made to cover 
 any class of business in detail. 
 
 NATIONAL AND STATE BANKS 
 
 In recent years the subject of bank examinations has re- 
 ceived much more attention than formerly. This is largely due 
 to the passing away of the opinion once held by many bank 
 directors that the examinations made by Government examiners 
 for the Comptroller of the Currency and for the Banking Com- 
 missioners of the various States covered all that was necessary 
 in the way of inspection of a bank's condition and accounts. 
 
 Despite these Governmental examinations, reports of bank 
 failures and defalcations are frequent, and subsequent investiga- 
 tion has often brought out the fact that the defalcations had been 
 more or less cleverly concealed for a period of years. 
 
 Government examiners should not be too sharply criticized 
 for their failure to detect such conditions, as the time allowed for 
 separate examinations is limited, and it is physically impossible 
 for them to make thorough audits within the time available. 
 Again, it must be remembered that the chief object of these 
 examinations is to ascertain that the banks are solvent and are 
 complying with the law. Some degree of protection is afforded 
 depositors by these examinations, but the examiners do not 
 represent the stockholders or the directors, and the directors 
 should not regard the work of the examiners as being done for 
 their benefit. 
 
 Official examiners recognize this state of affairs and are mak- 
 ing a determined effort to improve the unsatisfactory conditions 
 which exist. 
 
 The New York Times reported a meeting of the official ex- 
 aminers in its issue of July 9, 1912, as follows: 
 
 LOW PAY ENDANGERS BANK EXAMINATIONS 
 
 Paltry Fees for Inspection of Country National Banks Result in Slurring 
 
 of Work 
 Dishonesty Is Undetected 
 The subject that received the most attention in the meetings was the 
 low rate of pay of the National Examiner working in the country, both from 
 
350 AUDITING 
 
 the standpoint of its inadequacy and from that of the coiTesponding menace 
 to depositors, caused by the hurried way in which he must complete his 
 task and get on to the next town, if he is to make enough to pay for his 
 keep and traveling expenses. It seems that the rate of compensation was 
 fixed in 1875 and has never been changed. 
 
 For examining a bank with less than $100,000 capital the Examiner gets 
 $20. At least two days, it was declared yesterday, should be devoted to a 
 thorough examination, and sometimes it is necessary to employ an assistant. 
 All this comes out of the $20, including the assistant and his expenses. The 
 rate advances with the size of the bank, but never gets up very high. For a 
 bank capitalized at $100,000 to $300,000 the fee is $25; for a $300,000 bank, 
 $35; for a $400,000 bank, $40; for a $500,000 bank, $50, and for a bank 
 capitalized at $600,000 or over, $75. 
 
 A recent defalcation in this State was cited as an instance of what may 
 happen under a system where the National Bank Examiner has not time 
 and cannot aflford to take time to make much more than a superficial in- 
 spection. One of the officers had been robbing this bank for years, his 
 peculations aggregating some $350,000. It had been examined by three or 
 four different men in that time, but none of them had found anything 
 wrong, and one of the examiners said yesterday that this affair was the 
 worst black eye the Government examining system had received in many 
 years. 
 
 Because of the agitation for Government guarantee of bank 
 deposits, in which case losses would probably be paid from a 
 fund sustained by a tax levied against the banks, the latter have 
 in some large cities made a determined effort to allay public feel- 
 ing by decreasing the number and size of bank failures. The 
 outcome of these efforts has been that in some cities all of the 
 local banks clearing their cheques through the Clearing House 
 are now examined periodically by a salaried examiner appointed 
 by the Clearing House Association. 
 
 Clearing House examiners have been appointed in compar- 
 atively few cities, and in some quarters much opposition has 
 been shown toward the movement, as it is argued that so long as 
 a bank is solvent and is permitted by the government to continue 
 business, it should have the privilege of naming its own inde- 
 pendent auditor, and that the information received and reports 
 rendered by such auditors should not be in the hands of anyone 
 with discretionary power to discuss the bank's affairs with com- 
 petitors who are members of the Clearing House Association 
 committee. 
 
 While the examinations made by Clearing House examiners 
 
BANKS 351 
 
 are usually quite thorough, they will in all probability be limited 
 to a few of the larger cities, as in small cities and rural commu- 
 nities no Clearing House Associations exist. 
 
 Some States require semiannual examinations to be made by 
 committees of directors of each bank, with liberty to the com- 
 mittee to employ professional accountants for the purpose, the 
 latter to report to the committees and the committees to report 
 to the State. 
 
 The following quotation from an address by James B. 
 Forgan, President of the First National Bank of Chicago, deHv- 
 ered on September 17, 1909, at the Convention of the American 
 Bankers' Association, at Chicago, is of especial interest, as it 
 refers to the responsibility of bank directors and the necessity for 
 the employment by them of competent auditors to make investi- 
 gations : 
 
 The same ordinary prudence which men exercise in their own affairs is 
 required of bank directors. The application of it differs with the varying 
 circumstances of the banks. Just as men of small or moderate affairs can 
 undertake the personal management in detail of their own businesses, while 
 those of large affairs must of necessity employ others to manage for them 
 and must relieve themselves of details, so bank directors, under similar cir- 
 cumstances, may assume the details of management or appoint others to do 
 so. Their delegating authority to others does not, howeyer, relieve them of 
 responsibility for the direction and supervision of the management or of 
 keeping in touch with what is done. In banks of moderate size this can be 
 accomplished by committees. In the largest banks, however, it becomes 
 necessary for the directors to delegate even the details of their supervisory 
 duties to experts and to rely on their investigations and reports for an in- 
 telligent knowledge of what is being done and of their bank's condition. 
 Systematic organization is necessary, whether a bank is small or large, and 
 directors must see to it that one of its results is that they are kept fully 
 posted as to the bank's operations and condition. This can be accomplished 
 quite as effectively in large as in small banks through the employment of 
 competent auditors, either permanently or when they are wanted. Such 
 auditors, in their investigations, should represent the directors and should 
 report direct to them, uninfluenced by any of the executive officers. But, 
 however it may be accomplished, it is up to the directors to keep themselves 
 posted as to their bank's operations to the extent of enabling them to form 
 a correct opinion of actual conditions in them and to judge of the integrity 
 and ability of the management, as it is conducted by the officers to whom 
 they have delegated managerial powers. Only thus can they intelligently 
 exercise their control of the management, a responsibility from which there 
 can be no escape. 
 
352 AUDITING 
 
 The auditor engaged to examine the affairs and accounts 
 of a bank should procure a copy of the statement published by- 
 it in response to the latest call of the Comptroller of the Currency 
 or the State Banking Commissioner. A careful scrutiny of this 
 statement will give him a good idea of the volume of the work 
 and nature of the assets and liabilities which will shortly demand 
 his attention. 
 
 The audit should be started without notice to either officers 
 or employees of the bank, and a large staff should be available 
 so that all the changeable assets can be examined on the first day. 
 
 Cash and Securities: The verification of the balance-sheet 
 items should receive attention first. This involves the actual 
 count and examination of such assets as may be actually on hand, 
 and comparison thereof with the general ledger accounts; the 
 independent outside confirmation by correspondence of such of 
 the assets as admit of such verification ; and a thorough test of 
 the integrity of every other account in the general ledger. 
 
 If there is a large quantity of cash on hand and the entire 
 staff must be used to count it, the other changeable assets, such 
 as securities owned by the bank, notes discounted, notes for se- 
 cured loans and the collaterals therefor, etc., should be locked up 
 in a safe and the latter sealed, and access thereto refused, except 
 with approval of the auditor, until they have been examined. 
 
 All of one class of the assets above mentioned should be 
 brought to the auditor before the examination of each is begun 
 so as to prevent duplication in counting; e. g., all cash should 
 either be brought from the vaults and tellers' cages to one point, 
 or the auditing staff should be so distributed that counting of the 
 cash at all points will begin simultaneously ; transfer of cash be- 
 tween the cages and the vault should be prohibited until all of 
 the cash has been counted and the aggregate amount is proved 
 with the general ledger account therefor. 
 
 It is important that the genuineness of the cheques on hand, 
 which are to be sent to the Clearing House, be verified. The 
 only safe method to accomplish this is for the auditor to insert in 
 each Clearing House envelope a confirmation slip (and stamped 
 envelope addressed to himself) requesting verification of the ag- 
 gregate amount of the inclosed cheques and detailed advices as 
 to any which may be returned as unpaid. The failure to do this 
 
BANKS 353 
 
 may be serious, as forged or "fake" cheques may be returned to 
 the bank without being brought to the auditor's attention. In 
 addition to this, it is desirable that the source of cheques of large 
 amount to be sent either to the Clearing House or to out-of- 
 town correspondents, or to be collected by runner on the follow- 
 ing day, be ascertained, and that examination be made to see that 
 the depositor has received credit therefor. 
 
 Correspondents' Accounts: Accounts current should at once 
 be requested (to be sent direct to auditor) from reserve agents 
 and out-of-town correspondents with which the client carries 
 deposit accounts. It is also important to make note of the last 
 deposits made and the number of the last draft drawn by the 
 client against these banks for use in later reconciling the accounts 
 current with the client's records. The auditor should examine 
 these draft books carefully to ascertain that none have been used 
 out of consecutive order or from the back of the book, as missing 
 drafts may have been cashed and the proceeds counted as cash, 
 or the cheque may have been included that very day with other 
 cheques and sent to another out-of-town correspondent and 
 charged to the latter as a deposit. Defalcations have been clev- 
 erly concealed for some time by this method, as the account with 
 the bank on which the draft was drawn was not reduced on the 
 client's books until after the date of the audit, and the item did 
 not appear on the account current of the depository until the end 
 of the month. 
 
 Confirmation of Demand Notes, etc. : All borrowers on unse- 
 cured demand notes should be requested by mail to confirm the 
 amounts of their loans direct to the auditor. If any payments 
 on account have been misappropriated and not indorsed on 
 the notes, these confirmations should reveal that fact. Similar 
 confirmations, showing the collateral as well as the amount of 
 the loans, should be secured from borrowers on time or demand 
 collateral notes. 
 
 All securities owned by the bank or deposited by customers 
 as collateral for loans should be carefully examined. Denomina- 
 tions of stock certificates have in the past been so cleverly raised 
 as to deceive bank officials, who accepted them as collateral for 
 loans. 
 
 Correspondents who may hold notes or securities for the 
 
354 AUDITING 
 
 bank's account should be requested to confirm the amounts 
 thereof direct to the auditor. 
 
 In the case of a National Bank the Treasurer of the United 
 States should be requested to confirm the amount of bonds held 
 by him to secure circulation and Government deposits, and the 
 amounts of the circulation redemption fund, outstanding circula- 
 tion, Government deposits, and any balances which may be due 
 by him to the bank. 
 
 Certificates of Deposit and Certified Cheques: The balances 
 in the cashier's cheques, certificates of deposit, and certified- 
 cheque accounts should each agree virith the aggregate of the re- 
 spective classes of items outstanding. In this connection the 
 canceled items should be inspected and compared with the 
 stubs or original records in order that the auditor may assure 
 himself that none posted on the ledger as paid are outstanding. 
 
 Capital Stock: The capital stock certificate book and stock 
 ledger should be examined and the aggregate of the outstanding 
 stock proved with the general ledger account. Recently in New 
 York the vice-president of a National Bank was arrested, con- 
 victed, and sentenced for forgery and fraud in connection with 
 the misuse of his bank's stock certificates. He had torn certifi- 
 cates from the stock book, forged the cashier's name thereto, 
 added his own name, and had deposited them as collateral for a 
 personal loan from a large trust company. 
 
 Depositors' Accounts: Opinions differ as to the responsi- 
 bility of an auditor in connection with the verification of depos- 
 itors' accounts. As these form the largest portion of the liabil- 
 ities, he should make some effort to verify their correctness, in 
 addition to merely taking a trial balance from the depositors' 
 ledgers. He should ascertain that trial balances are taken off 
 regularly, that the ledger clerks are transferred occasionally from 
 one ledger to another, that some one other than the ledger clerks 
 compares the balances in the ledgers with the pass books when 
 the latter are "settled" and delivered to the depositors, and that 
 the clerk initials the pass books and ledgers as to correctness. 
 In addition to this the bank should insert in the pass books a 
 form of confirmation of the depositors' balance, which should be 
 carefully filed when signed and returned by the depositors. 
 
 The auditor should mail statements of their balances to all 
 
BANKS 355 
 
 depositors with inactive accounts, should verify the settlements 
 of all pass books in the bank, send out request for pass books 
 of all other active accounts and verify the settlements of the 
 latter when received and balanced. It is hardly to be expected 
 that every depositor will send in his confirmation or pass book 
 promptly, and it will be necessary for the auditor to keep a list of 
 all depositors on which to make note of those accounts which 
 have been verified, and which may be used as a guide at future 
 dates for the confirmation of all accounts. 
 
 In comparing pass books with the ledgers it is important 
 not only that the balances be compared, but that the deposit 
 entries in the pass books for some time prior to the settlement 
 date be examined. This will disclose any ledger cross entries 
 which may have been made and which should be especially 
 investigated. They should not be permitted, except upon offi- 
 cially signed debit or credit slips, as defalcations have been clev- 
 erly concealed through the use of such cross entries. 
 
 In banks where the practice of balancing pass books has 
 been superseded by the system of rendering monthly accounts 
 current to depositors and returning to them at the same time all 
 paid cheques, the auditor should compare the statements with 
 the ledgers, inclose his confirmation form, and mail them him- 
 self. 
 
 Verification of Income: Tests should be made to ascertain 
 that the bank is receiving at proper times and in correct amounts 
 the income on its securities and interest on the loans it has made 
 or notes it has discounted. Almost all banks include discounts 
 among their earnings as soon as the notes are discounted, and the 
 conservative and proper method of carrying reserve for unearned 
 discounts is not generally followed. In the middle West, how- 
 ever, a number of large institutions now show such a reserve in 
 their balance sheets, and it is to be hoped that in time the prac- 
 tice will become general. 
 
 Expenses: The details of the charges to expense accounts 
 should be scrutinized, the unusual items thoroughly investigated, 
 and tests made of the correctness of the usual ones. The salary 
 rolls should be checked and thorough tests should be made of 
 the correctness of interest paid on deposits. Postage-stamp pay- 
 ments are usually large and should receive careful attention. 
 
356 AUDITING 
 
 Secret Reserves: If these are found they should be noted in 
 the auditor's report if the audit is made for the first time. Such 
 reserves are hidden in various ways, generally in understating on 
 the books the value of the banking house or in carrying an ac- 
 count in the depositors' ledgers. This latter method should be 
 discouraged, as only bona fide depositors' accounts should appear 
 in these ledgers. 
 
 Internal Checks : The auditor should carefully investigate all 
 of the bank's methods of conducting its affairs for the purpose 
 of ascertaining that the work is so divided and carried out as to 
 reduce to a minimum the opportunity for fraud, and that in so 
 far as possible the system in use provides for internal check on 
 the integrity of the accounts. 
 
 Employees handling cash, securities, notes, or cheques should 
 not have access to or assist in writing up or proving the general 
 bookkeeping records, nor should bookkeepers have access to the 
 records of the tellers. Clerks making original entries should not 
 see the records, which are a check on those entries, and so far 
 as possible the clerks should occasionally be transferred from 
 one set of records to another, so that if fraud be committed, it 
 cannot remain concealed for any length of time. Ledger trans- 
 fers and other unusual entries should not be permitted except 
 upon written order bearing official signature. 
 
 Scope of Report: The auditor's report should be very com- 
 plete, including not only statements of the bank's condition and 
 income and expense accounts for the period under review, but 
 also detailed statements of the securities owned, collateral loans 
 and value of collateral, single name and indorsed paper, and total 
 liability of each borrower. He should also call particular atten- 
 tion to any memoranda which may have been carried as cash, all 
 overdue notes, insufficiently secured collateral loans, loans to 
 officers and employees, overdue interest, and uncollected income 
 on securities. 
 
 The auditor should bear in mind, when examining the affairs 
 and accounts of banks and financial institutions generally, that 
 his certificate will be regarded as an assurance of the reliability 
 of the statement so certified, and that while he does not guar- 
 antee the security of the deposits made by the public, the latter 
 will, and justly so, severely criticize him if subsequent develop- 
 
BANKS 357 
 
 ments show that at the time of his examination the bank was 
 insolvent, but that his report did not reveal the fact. 
 
 Instances of Fraud: Defalcations are especially to be guarded 
 against in financial institutions. The following are some of the 
 schemes which have been used by defaulters. 
 
 A note teller in a bank, in order to cover up cash abstracted, 
 would increase the amount of total of loans made for the day. 
 He would turn in to the general bookkeeper, accompanying his 
 voucher, an adding-machine list which, if it had been footed, 
 would have been found not to be the same as the total shown by 
 the adding-machine list. Later on, at such times as the accounts 
 were examined and the notes proved either by a bank examiner 
 or others, he would put in forged notes to cover the amount 
 short, using the name of some concern which had a good line of 
 credit with the bank. 
 
 A note teller started in this way by taking about $200 and 
 was finally short $7,000. He made no false entries in the books, 
 outside of the adding-machine list and the total of the daily ticket 
 which he turned in to the general bookkeeper. The defalcation 
 was not discovered until the bank was merged with another bank. 
 If the notes had ever been checked back with the original dis- 
 count register, it would have been found that the forged notes 
 were not entered therein. 
 
 Another note teller, among whose duties it was to send out 
 items for collection, would abstract cash and enter in his accounts 
 certain items as being out for collection. These items he repre- 
 sented to be notes deposited for collection for which he had paid 
 cash, and the record was made to show that the notes were on 
 some distant point which would take several days for return. In 
 doing this he always used the name of some good customer 
 whose line of credit was unquestionable. This practice went on 
 for a long time until a bank examiner, who had been over the 
 accounts several times before, happened to question the teller 
 about one of these particular items at a time when the teller had 
 just returned after a few days' absence from the bank. The teller 
 became nervous and somewhat evasive in his answers. The 
 examiner then wrote to the firm whose name was used in con- 
 nection with these items and found they had deposited no such 
 items for collection. 
 
3S8 AUDITING 
 
 In this connection the auditor would have discovered the true 
 condition if he had verified the outstanding items for collection, 
 either by correspondence with the bank to which the collection 
 was sent, or by writing to the individual or firm who it was 
 claimed had deposited the item. 
 
 Another bank teller in a large bank opened an account with 
 a small bank in another part of the city. He would draw cheques 
 on the bank in which he worked, using some fictitious name, and 
 deposit them in the bank in which he had an account. When 
 those cheques came in through the Clearing House to the bank 
 in which he worked, they came to him and he would promptly 
 tear them up. At the end of the day his department would be 
 short and this shortage would be charged to an "over and short" 
 account, as would other items, until such time as the errors 
 would be discovered, when they would be taken out of this ac- 
 count. 
 
 He continued this practice over a long period, taking small 
 amounts, till he was finally discovered, when the bank's "over 
 and short" account amounted to some $40,000, a part of which 
 represented the stealings of this teller; but it was not known 
 just how much. It was extreme carelessness on the part of the 
 bank to allow such an account to assume large proportions. The 
 bank stated that there were certain losses which it could not 
 guard against, and it estimated that these losses would amount 
 to several thousand dollars a year, no matter what precautions it 
 might take. 
 
 The following extract from the (New York) National City 
 Bank's, July, 1912, circular is of particular interest in that it 
 states the latest suggestions made by the Comptroller of the Cur- 
 rency to examining committees of national banks: 
 
 Bank Examinations by Directors: On June i the Comptroller of the 
 Currency requested the boards of directors of National Banks to send to 
 his office a copy of the reports of the annual or semiannual examinations 
 made by the examining committees or by other parties at the instance of the 
 directors, and not a single bank has declined to comply with such request. 
 
 A review of the reports that have been received shows that many of 
 these examinations are deficient in their scope and that many features essen- 
 tial to a thorough understanding of the bank's affairs are not covered. As 
 heretofore pointed out in this circular, a number of States have provided by 
 law for reports by the examining committees of State banks to their State 
 
BANKS 359 
 
 Banking Departments, and in these States a form of report has been pre- 
 pared for that purpose. At the beginning, however, the Comptroller of the 
 Currency does not intend to prescribe a form for the directors to use in 
 making reports to his office, or to require examinations of a technical 
 character, but rather to offer such suggestions as will lead to really effective 
 examinations. The following list of general points to be covered has been 
 drafted by the Comptroller with a view to sending the same to those banks 
 where the report of the examining committee shows the examination to be 
 superficial : 
 
 1. The cash should be counted and the total compared with the books 
 of the bank. Cash items should be carefully scrutinized, and any improper 
 items, such as unposted cheques held for the purpose of not showing over- 
 drafts, and any other items that cannot be readily converted into cash should 
 be reported. 
 
 2. The bonds and other securities of the bank should be examined and 
 those not on hand should be verified by reference to the receipts of the 
 parties with whom they are deposited. The market value and the amount 
 at which carried on the books in the aggregate should be shown, and any 
 stocks held by the bank should be listed with a statement showing the 
 reasons the securities were taken by the bank. 
 
 3. The notes should be carefully checked and their total compared with 
 the general ledger. The genuineness, value, and security of each note, and 
 of any collateral thereto, should be carefully determined, and any losses 
 ascertained, or probable, ift the judgment of the committee, should be noted. 
 The liabilities of each of the larger borrowers, and loans to affiliated in- 
 terests, should be aggregated and carefully considered. The report should 
 also show the general character of the loans; whether well distributed; the 
 general character of the collaterals; whether corporations in which officers 
 or directors are interested borrow to an undue extent; also any large 
 liabilities of the officers or directors. It should also be shown whether all 
 paper claimed by the bank as its own property, including collaterals, is 
 properly indorsed or assigned to it, and all mortgages recorded. Any loans 
 exceeding ten per cent of the capital and surplus of the bank should be 
 reported. The signatures of all note makers and indorsers should be care- 
 fully scrutinized and any erasures and alterations or any indications of 
 manipulation should be carefully investigated and reported to the full board. 
 All overdue paper should be listed and comment made as to its collectibility. 
 
 4. The certificates of deposit and the cashier's cheques should be verified 
 by totaling those outstanding and as shown by the register and comparing 
 with the general ledger, and also by comparing the canceled certificates and 
 cheques with the register and checking them against the stubs. 
 
 5. The copy retained by the bank of the report of condition made to the 
 Comptroller at the last call should be compared with the bank's books at that 
 date, particularly with reference to the excessive loans and directors' and- 
 officers' liabilities reported to the board of directors. 
 
 6. The bank's last reconcilements of accounts with correspondents should 
 be compared with the bank's books and a transcript of the bank's account 
 
36o AUDITING 
 
 frpm the date of the last reconcilement to the date of the examination sent 
 to the corresponding bank, with a request for verification. 
 
 7. Individual ledger balances should be verified in such manner as the 
 directors may deem advisable, by calling in pass books, by sending out recon- 
 cilements of certain accounts selected by the directors, or in some other 
 suitable way. A trial balance of the ledger should be taken by some member 
 of the committee, or at least by some person other than the clerk engaged 
 on the ledger. 
 
 8. Overdrafts should be totaled and carefully considered and the report 
 should show any estimated losses. 
 
 g. The committee should consider carefully the Profit and Loss and the 
 Expense account, with a view of determining whether the charges against 
 those accounts are proper and whether the earnings of the bank warrant the 
 expense charges, and the bank is making a legitimate profit. 
 
 10. The examining committee should inquire carefully into the arrange- 
 ment of the working affairs of the bank and ascertain whether any employee 
 who keeps the individual ledger receives deposits or balances pass books, 
 and whether the employees are properly bonded and in whose custody the 
 bonds are lodged. 
 
 11. Any liability of the bank for borrowed money should be listed and 
 the proper authority and the necessity for such borrowing ascertained. The 
 total amount of the present liabilities of that nature should be reported to 
 the board, including money borrowed from other banks on certificates of 
 deposit. 
 
 The Comptroller desires that the report of the directors or the examining 
 committee should 'show that the above points have been covered and that it 
 should recite any deficiencies discovered. The report will also be expected 
 to contain a complete statement of the total assets and liabilities of the bank, 
 with any additions or deductions that in the judgment of the directors 
 should be made as a result of their investigation; and a detailed statement 
 of the loans which the directors estimate as worthless, doubtful, or insuffi- 
 ciently secured, giving reasons therefor, and as nearly as possible the real 
 value. It is furthermore desired that the report contain a statement of any 
 matters which in the opinion of the committee affect in any way the bank's 
 solvency, stability, or prosperity. 
 
 The Comptroller believes that there are few instances where the ex- 
 amining committee cannot, if they will take the necessary time, cover these 
 points fully and satisfactorily, and that an examination twice a year, along 
 the above lines, by a committee of the directors who will give sufficient time 
 to the work to make it thorough and complete, cannot fail to be of great 
 benefit to all concerned, especially to the shareholders who have placed them 
 in their positions of trust. 
 
 SAVINGS BANKS 
 
 The general procedure in auditing a savings bank is more or 
 less similar to that necessary in auditing a National or State 
 
TRUST COMPANIES 361 
 
 bank. Savings banks are limited by the laws of most States to 
 certain classes of investments and are not permitted to discount 
 notes or to make unsecured loans. For this reason most of their 
 assets consist of bonds, mortgages, and other long term invest- 
 ments. At the time of examining the mortgages the- auditor 
 should ascertain that in those cases where the mortgage 
 covers improved property, sufficient insurance is carried (pay- 
 able to the bank as mortgagee), to protect it in case the improve- 
 ments are destroyed by fire. 
 
 Some trouble will probably be experienced in procuring the 
 addresses of all the depositors for the purpose of sending out 
 requests for confirmations of their accounts. Any neglect on the 
 part of the employees to make every effort to get these addresses 
 and keep them up to date should be mentioned in the auditor's 
 report. Defalcations in savings banks are more often concealed 
 through manipulation of depositors' inactive accounts than in 
 any other way. 
 
 It will be found to be just as effective and less expensive to 
 mail to depositors such a form of confirmation as will require 
 the depositor to communicate with the auditor only in case of a 
 difference rather than to send a form which every depositor must 
 sign and return. As a great many savings bank depositors are 
 of the working class, usually a smaller percentage of the con- 
 firmations of the last-mentioned kind are returned to the auditor 
 than in the case of depositors in National and State banks. In 
 sending the suggested form of confirmation it is desirable for 
 the auditor to insert an unstamped envelope for the depositor's 
 use in case he finds it necessary to communicate with the auditor. 
 
 TRUST COMPANIES 
 
 The name "Trust Company" indicates that it was the original 
 object of such institutions' to act in a fiduciary capacity and 
 exercise trust functions only. A few companies still limit them- 
 selves to these purposes, but most of them now conduct a bank- 
 ing business in addition thereto. Their charters are usually very 
 liberal. While they may not issue circulating notes, and in some 
 States are forbidden to discount commercial paper, they are, on 
 the other hand, allowed to make loans on real estate, which priv- 
 ilege is denied National banks. 
 
362 AUDITING 
 
 The audit of the banking department of a trust company 
 should be conducted along lines similar to that followed in the 
 audit of a National or State bank. The audit should, however, 
 also embrace such other departments as the trust company may 
 be operating. These departments usually are the trust fund, safe 
 deposit, bond, real estate, and corporate trust departments. 
 
 None of these departments should carry any cash on hand, 
 as all necessary funds should be deposited with the banking de- 
 partment. All securities which should be on hand must be ac- 
 counted for, and the general records of each department should 
 be carefully checked. Such tests of the detailed work should 
 also be made as will satisfy the auditor that the trust company 
 is properly accounting to the beneficiaries of all trusts, and to 
 the principals for whom it may be acting as agents, of the income 
 collected by it. 
 
 The collection of the trust company's income from these 
 departments, such as commissions on the transactions of the 
 trust and real estate departments, income and profits on bonds 
 handled by the bond department, income from safe-deposit boxes 
 and silver-storage vaults, and fees from corporations whose se- 
 curities are handled by the corporate trust department, should be 
 thoroughly tested. The expenses of the various departments 
 should also be given careful attention. 
 
 It is physically impossible, as well as unnecessary, in the 
 audit of a large trust company for the auditor to check in detail 
 all of the transactions during the audit period, and the efficacy 
 of the internal check provided by the system in use should guide 
 him in determining to what extent to carry the tests of the 
 detailed work. 
 
 INVESTMENT COMPANIES 
 
 The theory on which investment companies are formed and 
 operate is that by merging the capital of many investors and dis- 
 tributing it over a large number of investments the proportionate 
 risk of loss incurred by any one investor is very small. The oper- 
 ation of the law of average also permits of investing in securities 
 yielding a somewhat higher rate of income without the probabil- 
 ity of the total capital being lost, which latter is not infrequently 
 the case with an individual investor who may have but a small 
 amount to invest and hence cannot distribute it over a number of 
 
INVESTMENT COMPANIES 363 
 
 investments. Aside from holding companies which are organ- 
 ized more for the purpose of practically merging a group of 
 companies than for trading in their securities, investment com- 
 panies are much more common in Europe than in the United 
 States. 
 
 Purchases and sales of securities should be verified by the 
 brokers' memoranda therefor. Especially important is it in this 
 connection to see that accrued interest on bonds and dividends 
 on stocks bought or sold ex-dividend are properly treated. 
 Entries for purchases and sales of securities made at a flat price 
 should be made so as to apportion the cost of sale between the 
 interest or dividend accrued to date of purchase or sale and the 
 net capital cost or realization. 
 
 Income accruing from all investments held during the audit 
 period should be accounted for. The securities held at the date 
 of the balance sheet will, of course, need to be examined. 
 
 If the net result of the year's changes in investments is a 
 profit, it may be paid out in dividends ; if the net result is a loss, 
 it must be charged against surplus, unless a reserve already exists 
 against which the loss may be charged. The most conservative 
 policy for the treatment of profits realized from changes of in- 
 vestments would be not to credit them at all to the current in- 
 come account, but to a special reserve or surplus account to pro- 
 vide for possible future losses on investments owned which can- 
 not be foreseen at the present time. When profits on invest- 
 ments are treated as income, they should be separately shown in 
 stating the income account. 
 
 The complexion of the balance sheet will necessarily depend 
 very largely on the valuations at which the investments held are 
 entered therein. Consequently the verification of the investment 
 valuations may well be said to be the most important single 
 feature of the audit. 
 
 Should investments have been acquired in exchange for the 
 company's own stock and be carried on the books at values 
 which are obviously in excess of their real values, even though 
 the latter may not be definitely ascertainable from market quo- 
 tations, it is clearly the duty of the auditor to call attention to the 
 fact that such investments are not being carried at their actual 
 value. 
 
364 AUDITING 
 
 Each individual investment need not be written down to 
 market value when there has been a fall in price. If the aggre- 
 gate market values of all the investments equal the total cost 
 thereof, that is sufficient. Should the aggregate market values, 
 however, be less than cost, it is preferable to credit the net 
 difference to a Fluctuation Reserve rather than to adjust the 
 book value of each individual investment. It is also preferable 
 to show the Fluctuation Reserve as a deduction ("in short") 
 from the total value of the investments in the balance sheet 
 rather than as an item among the liabilities. This reserve is not 
 an actual liability, but exists solely for the purpose of bringing 
 the book value of the investments down to market value. It is 
 quite in order to readjust the reserve from year to year to accord 
 with changed market conditions. Care should be taken, how- 
 ever, that reserves for losses or decreases in market values are 
 not treated as an extraordinary charge in the Profit and Loss 
 account of the year in which the reserves are made, and then 
 when prices go up again, that part of the reserve which is no 
 longer needed, be treated as ordinary income. 
 
 The book value of investments should not be increased when 
 market prices exceed cost. The same reasons which are efifect- 
 ively urged against the increasing of plant or merchandise values 
 above cost apply in valuing the investments held by an invest- 
 ment company — in a sense they form both its plant and stock-in- 
 trade. Should it be desired to show the investments at market 
 values which are in excess of cost, the excess should not be 
 credited to the ordinary income or surplus account from which 
 dividends are paid, but should be credited to a special reserve or 
 surplus account. 
 
 A distinction should be made between bona fide investment 
 companies and speculative securities companies. The former's 
 income is derived principally from the income received from in- 
 vestments owned, whereas the latter's chief source of income is 
 the profit realized from purchases and sales of securities. It 
 follows that the investments of a real investment company are to 
 a certain extent fixed assets, and that this may be taken into con- 
 sideration in treating them in the accounts, but that the invest- 
 ments of a speculative finance company are its stock-in-trade and 
 should be valued in the same way as stock on hand is valued in 
 
STOCKBROKERS 365 
 
 the case of mercantile undertakings, viz., "cost or market, which- 
 ever is the lower." 
 
 A difficulty which will frequently be encountered is that of 
 ascertaining the real value of the investments. Nominal stock 
 exchange quotations for securities with a restricted market do 
 not always indicate the realizable value of a large block of stocks 
 or bonds. As already stated in the case oi bona fide investment 
 companies, the book values of the individual investments need 
 not be varied to conform to changes in market values. The 
 object in view, viz., to reduce the aggregate book value of the 
 investments to the aggregate market value thereof, is just as 
 effectively accomplished by setting up a reserve for the differ- 
 ence between total cost and total market value. 
 
 Apparent increases in investment values by reason of rising 
 market prices should not be treated as income until they have 
 actually been realized by sale of the securities. It is important 
 for the auditor to see that all profits on sales of investments 
 which may be shown were actually reahzed, and that they have 
 not been brought into the books by placing a higher value on 
 securities received in making exchanges. So far as possible, the 
 auditor should also satisfy himself that no part of the profit 
 shown is the result of "wash sales" or other transactions of a 
 similar character. 
 
 The valuation of marketable investments was well treated in 
 Mr. Dickinson's admirable paper on "The Profits of a Corpora- 
 tion" (Proceedings of the Congress of Accountants, 1904, pages 
 183-184). 
 
 In conclusion, it may be stated that, even though under cer- 
 tain circumstances the payment of dividends by investment com- 
 panies without first making good decreases in the value of in- 
 vestments may not conflict with existing laws, such a procedure 
 is so at variance with the canons of sound finance that the auditor 
 should be certain that the published reports, and particularly his 
 certificate, clearly show the actual condition of affairs. 
 
 STOCKBROKERS 
 
 Without doubt a practical knowledge of the "inner work- 
 ings" of a stockbroker's office is valuable to the auditor engaged 
 to make an audit of accounts of this nature, but the lack of such 
 
366 AUDITING 
 
 special knowledge is not an insuperable obstacle to a competent 
 accountant. From good articles which quite often appear in 
 financial magazines, and from talks with stockbrokers, a good 
 idea of the methods in use can be obtained. It is, however, im- 
 portant that prior to beginning an audit of such accounts, the 
 auditor have a knowledge of the books used. It often occurs that 
 stockbrokers require special accounting work done at busy 
 periods, and such work affords the future auditor a good oppor- 
 tunity to familiarize himself with the books of account. 
 
 Brokers buy and sell securities for customers and, at times, 
 for their own account. The customers may pay for such pur- 
 chases in full and request the delivery to them of the securities 
 purchased, or they may be carried "on margin" by brokers for 
 the customers' accounts. Customers may desire brokers to remit 
 the entire proceeds of sales of securities or may leave the pro- 
 ceeds on deposit with the brokers for future use in purchasing 
 other securities. 
 
 Brokers therefore not only handle cash, but securities as well. 
 Usually the values of the securities carried by brokers are many 
 times larger than the cash on hand and in bank. Brokers find it 
 necessary to borrow large sums of money from banks as collat- 
 eral for which they are required to deposit securities, which in 
 most cases are those which are being carried "on margin" by the 
 brokers for their customers. At times, brokers must borrow se- 
 curities from other brokers, or may find it desirable to lend them 
 securities. It is also necessary to send securities to the trans- 
 fer offices of various companies to have certificates transferred 
 to customers' names, and securities are at times deposited with 
 stockholders' or bondholders' committees, or for other reasons 
 may not be in the office of a broker at the time the audit is begun. 
 
 Obviously brokers' books must account for all securities, as 
 well as for all cash,' and for this reason they are radically dififer- 
 ent in form and nature from the books of account usually found 
 in other lines of business. The books generally used in stock- 
 brokers' offices in New York City are the following: 
 
 Cash Book: For recording the cash receipts and payments, 
 and the securities received and delivered. 
 
 Clearing House Blotter: For recording the purchases and 
 sales on the floor of the Stock Exchange of securities listed on 
 
STOCKBROKERS 367 
 
 the Exchange. Settlement of the net difference between the 
 value of the securities purchased and sold each day is made direct 
 with the Stock Exchange Clearing House on the following day, 
 instead of with each broker with -whom the transaction was 
 made. 
 
 Ex-Clearing-House Blotter: For recording the purchases and 
 sales of securities not listed on the Exchange. Settlements are 
 usually made for such transactions direct with the party from 
 whom the securities are purchased or to whom sold. 
 
 In both of the blotters above mentioned columns are provided 
 for entering the commission charged for executing the customers' 
 orders, the value of revenue tax stamps required by the New 
 York law to be attached to certificates when sold, the amounts 
 to be paid to or received from other brokers, and the amounts to 
 be charged or credited to customers for the purchases or sales of 
 securities. 
 
 General Ledger: This ledger contains the various asset, lia- 
 bility, income, and expense accounts of the business. The 
 customers' and stock and money loan accounts are usually 
 carried in this ledger in total by the use of controlling accounts. 
 
 Customers' Ledger: Separate accounts are kept herein for 
 each customer, which show not only the customers' transactions 
 and cash balance due by or to them, but also the stocks "long" 
 and "short" in their accounts. 
 
 Stock Record: Under accounts with each security are re- 
 corded on the "long" side the customers who are "long" of the 
 securities, from whom securities are borrowed, or the investment 
 accounts in which are carried the securities owned by the brok- 
 ers; and on the "short" side the securities on hand (usually 
 termed "in the box") , the customers who are "short" of the secur- 
 ities, the brokers to whom securities are loaned, the banks or 
 others holding securities as collateral for loans, and the securities 
 in transfer. The accounts with stocks are kept in shares, and 
 those with bonds are kept in their par value and the aggregate of 
 the "long" and "short" sides must agree. Numerous vertical 
 columns are provided for rebalancing at the close of each day 
 those securities in which transactions were made. 
 
 Margin Record: The status of each customer's money bal- 
 ance and the shares of stocks and par of bonds held as security 
 
368 AUDITING 
 
 for his account, and the market value thereof, are recorded herein, 
 and this information is kept up to date (to the minute) at all 
 times. It is the indicator of weak margins and a most important 
 book. In large offices it is netessary to have several such records. 
 Margin clerks must be alert and thoroughly familiar w^ith each 
 account under their supervision. Laxity or neglect in this de- 
 partment may result in large losses if the market is active. 
 
 Record of Money Loans: Entries are made herein of money 
 loaned or borrowed, and the collateral received or deposited 
 therefor. Separate accounts are kept with each loan and the 
 aggregate of all the loans must agree with the controlling ac- 
 counts for "Money Loaned" or "Money Borrowed" in the Gen- 
 eral Ledger. 
 
 Record of Stock Loans: For recording the securities bor- 
 rowed from or loaned to other brokers and the amounts of money 
 deposited or received as security for their return. The aggregate 
 of these loans must agree with their respective controlling ac- 
 counts in the General Ledger. Securities sold or bought osten- 
 sibly for cash, but which are not delivered or received for various 
 reasons on the day following the transactions, but which non-de- 
 liveries are not intended to act as "loans," are termed "Failed to 
 Deliver" and "Failed to Receive" items respectively, and are usu- 
 ally covered by controlling accounts in the General Ledger and 
 the details entered in a separate portion of the Record of Stock 
 Loans. 
 
 Other Books: In addition to the books specifically referred 
 to, there are daily records of stocks in box, bank pass books, 
 cheque books, petty cash books, order books, register of securities 
 received and delivered, customers' press-copy books for copying 
 notices of purchases and sales and customers' statements, pay 
 rolls, and other subsidiary expense and memorandum records. 
 
 Use of Abbreviations : In most brokers' oiifices the names of 
 securities are rarely written out in full in the books. The Stock 
 Exchange initials are generally used in referring to listed secur- 
 ities, while the names of unlisted stocks are abbreviated. It is, 
 therefore, essential that the auditor be familiar with these cus- 
 tomary abbreviations. 
 
 Program of Audit: A large and competent staff should be 
 used on the audit of a broker's oiifice, as the work must be done 
 
STOCKBROKERS 369 
 
 rapidly and accurately. The cash and revenue stamps on hand 
 must be counted and the balances checked with the general 
 ledger accounts. The securities on hand must be examined and 
 scheduled, and confirmation forms prepared of all money and 
 securities borrowed and loaned and the collateral therefor, which 
 should be sent at once to the proper parties, and the aggregate 
 of each class of transactions proved with the controlling accounts 
 in the General Ledger. Confirmation forms should also be 
 sent to the transfer offices of companies holding securities for 
 transfer. 
 
 * The Stock Record should be checked from the schedule pre- 
 pared of the securities on hand, and from the duplicates of the 
 confirmations covering money and stocks loaned and borrowed 
 and the collateral therefor, and of the securities in transfer. The 
 stocks "long" and "short" in customers' accounts should be 
 checked to the Stock Record from the statements to be sent to 
 the customers. The securities "long" and "short" in the client's 
 own investment accounts may be checked from the General 
 Ledger. 
 
 It is extremely important that the stocks be balanced quickly, 
 as in an active market numerous changes are made and the in- 
 vestigation of dififerences is very troublesome. 
 
 The customers' statements referred to are copies of their 
 ledger accounts, which are usually written up daily and press- 
 copied at the end of the month and sent to them. The balances 
 at the beginning of the month, the transactions during the 
 month, and the balances at the end of the month, as well as the 
 calculations of interest on each transaction, are shown on these 
 statements. The securities received and delivered and "long" and 
 "short" at the beginning and end of the month are also shown 
 thereon. 
 
 These customers' statements should be press-copied before 
 being turned over to the auditor, who should mail them, after 
 checking the stocks "long" or "short" at the time of the audit, 
 and scheduling the customers' names and money balances, for 
 checking with the trial balance of the customers' ledgers to be 
 verified later. When mailing them, a form for confirming the bal- 
 ances and securities in their accounts at the date of the audit 
 should be sent to all customers, as well as return envelopes, so 
 
370 AUDITING 
 
 as to insure the confirmations being sent direct to the auditor's 
 office. Accounts for which no statements are sent should be par- 
 ticularly investigated and called to the client's attention, as they 
 may prove to be "blind" accounts which are being used for 
 improper purposes. 
 
 Accounts of the client with other brokers, usually in other 
 cities, are termed "Our Accounts" (with others) ; statements are 
 usually sent monthly to the client of the monthly transactions, 
 together with the money balance, and the stocks "long" and 
 "short" at the end of the month. These statements from other 
 brokers should be compared with the corresponding accounts oh 
 the client's ledgers, and the genuineness of the statements re- 
 ceived should be verified by confirming the money balance and 
 securities in the account by correspondence. 
 
 The margins in the customers' accounts should be carefully 
 scrutinized, and accounts with weak or no margins called to the 
 client's attention. 
 
 The bank accounts should be reconciled with the general 
 books and the trial balances of all ledgers verified. No nominal 
 accounts should be kept in the Customers' Ledger, and all of 
 the accounts in the General Ledger should be carefully scruti- 
 nized, and such as are not covered by the work usually done in 
 an audit of brokers' accounts should be carefully investigated 
 and their correctness determined. 
 
 The correctness of the interest charged customers and paid 
 to banks and brokers, and of the commissions charged for exe- 
 cuting customers' orders and paid to floor brokers for executing 
 orders, should be thoroughly tested. 
 
 The collection of income due during the audit period on se- 
 curities owned by the client should be verified, and all of the 
 charges to the various expense accounts should be carefully 
 scrutinized, and vouchers and pay rolls examined and compared 
 with these entries. 
 
 The most satisfactory audit of brokers' accounts is the con- 
 tinuous audit, in which the auditor makes frequent visits and 
 detailed examinations into various departments of the business 
 at different times, in addition to verifying completely the cash, 
 customers' accounts, money and stock loans and collaterals, and 
 balancing the securities at least twice annually. 
 
STOCKBROKERS 371 
 
 Brokers collect considerable sums in dividends for their cus- 
 tomers, a part thereof being in turn paid to the latter, but the 
 larger part credited to their ledger accounts. The collections 
 made are credited to one or more dividend accounts. These ac- 
 counts are debited with the payments to customers (or to other 
 brokers who hold stock certificates which still stand in the name 
 of the broker who sold them some time before) and with the 
 amounts transferred to the credit of customers whose accounts 
 are "long," the stock on which the dividend has been collected. 
 The dividend account is also credited with the amounts charged 
 to customers who are "short" of the stock on which a dividend 
 has been paid. Theoretically the nature of the dividend jaccount 
 is such that it needs little or no inspection, but as dividends are 
 sometimes not called for until long after their declaration, it is 
 necessary to verify the entries in the account to make certain 
 that advantage has not been taken of the condition mentioned 
 to abstract dividends which may not be called for or which 
 should have been credited to some customer's account, but on 
 which a "chance is taken" that the customer will not detect the 
 failure to credit the dividend to his account. 
 
 Instance of Fraud: A recent case of fraud discovered in a 
 stock broker's office was accomplished in the following manner : 
 
 The cashier was allowed to do part of the work on the ledg- 
 ers. The footings of the receipts entered in the Ex-Clearing- 
 House Blotter were reduced to the extent of the amounts to 
 be taken or already obtained. Cheques were taken from the 
 back of the cheque book and given the same numbers as current 
 cheques. Money was obtained thereon and the cheques destroyed 
 when they were returned by the bank, when the pass book was 
 balanced. No entry was made in the blotter for these items, but 
 the items posted in the ledger or the footings of different accounts 
 were falsified in order to show a correct trial balance. Most of 
 the erroneous entries were made in the interest account, which, 
 for the most part, showed only totals of the interest for the 
 month as entered in the different customers' accounts. The 
 totals were ascertained from a detail sheet, which was later 
 destroyed, and the amount actually entered was not in accord- 
 ance with the aggregate of the items for the month. At other 
 times payments were charged to personal accounts for which no 
 
372 AUDITING 
 
 statements were sent out. The charges were sometimes ficti- 
 tious entries entered in the ledger account only or a posting 
 made from an item in the blotter which was not covered by one 
 of the regular cheques. 
 
 BUILDING AND LOAN ASSOCIATIONS 
 
 Building and loan associations are usually organized on the 
 mutual plan, and the by-laws of most, if not all of them call for 
 an annual audit of the association's accounts. Unfortunately for 
 the stockholders, however, this requirement is most frequently 
 complied with by the appointment of an auditing committee 
 composed of two or three members of the board of directors, and, 
 as is usual in the case of amateur audits, examinations made 
 under such circumstances and by such agencies are not always to 
 be relied upon. When it is considered how much power, as far 
 as the finances and accounts are concerned, is exercised by one 
 man (usually the secretary) in these associations, it would cer- 
 tainly pay them in the end to have the accounts periodically 
 audited by public accountants. 
 
 The fact that the accounts are as a rule so completely in the 
 hands of one person renders it obligatory on the auditor to make 
 a thorough and detailed examination. In an audit under such 
 circumstances tests of the work are not usually sufficient. 
 
 The audit of a building and loan association differs from that 
 of most financial institutions in that it has to deal with an organ- 
 ization the capital stock of which is not fixed in amount, and that 
 the borrowers are, for the most part, stockholders as well, and 
 both interest and principal of the loans are paid in small install- 
 ments, such payments being made either monthly or weekly at 
 the same time that dues, i. e., payments on account of capital 
 stock, are paid. 
 
 The capital stock consists of a number of series, a new series 
 being started each year, each six months, or in some few cases 
 even as often as every three months. A fixed amount, usually 
 one dollar, though sometimes fifty cents or twenty-five cents 
 (the latter very infrequently), is paid, say, monthly, on eacb 
 
BUILDING AND LOAN ASSOCIATIONS 373 
 
 share of stock held, and when these periodical contributions, to- 
 gether with the accrued profits, reach a specified amount, say, 
 $200, the series of stock is paid off. In this way there is a con- 
 stant contributing and withdrawing of capital going on, one or 
 more new series of stock being started each year, and one or 
 more series maturing in each year. In addition to matured 
 stock, withdrawals are made by the stockholders who for one 
 reason or another cannot or do not care to continue until the ma- 
 turity of their series. In the case of such withdrawals a penalty 
 is imposed by paying somewhat less than the full amount of the 
 profits accrued on the stock. In a well-managed association, the 
 by-laws of which call for monthly payments of $1 per share and 
 fix the full value of a share at $200, a series usually matures 
 about eleven or twelve years after its inception. 
 
 Verification of Income: The dues paid in by members are 
 not, of course, income or earnings. They are contributions of 
 capital, and a very careful accounting thereof is essential. By 
 ascertaining the total shares outstanding in each series at the 
 beginning of the year and allowing for withdrawals during the 
 year (after the year in which a series has its inception no addi- 
 tional shares can be issued), the receipts from dues can be proven 
 as a whole. 
 
 The interest on loans will need to be carefully verified. Much 
 of the interest is paid in monthly installments, and as many of 
 the loans are made on a six per cent basis, the interest can be 
 quickly verified. In connection with loans to stockholders the 
 item of premiums must not be overlooked. The by-laws of many ■ 
 associations provide for what practically amounts to competitive 
 bidding by the stockholders for the funds in the treasury. When 
 the applications for loans exceed the available funds, a premium 
 is paid by the successful applicants. The granting of these loans 
 should be recorded in the minutes, and the premiums to be ac- 
 counted for should be ascertainable from this source. 
 
 Fines on delinquent dues and interest are other items of 
 income. They are usually fixed at a high rate, e. g., two per cent 
 per month, to compel promptness in making payments, but do 
 not usually form a large item of income. 
 
 In the case of associations which charge admission fees (usu- 
 ally twenty-five cents per share) these are readily verified in total 
 
374 AUDITING 
 
 on the total number of shares in the new series issued during 
 the year. 
 
 Building and loan associations do not invest in real estate 
 except when compelled to buy it in to protect an investment in a 
 mortgage loan which is foreclosed. When real estate is owned, 
 the income therefrom should be verified. A comparison of the 
 net income with the book value of the properties should be made 
 so as to be sure that real estate is not being carried at excessive 
 figures. 
 
 The best verification of the dues and interest appearing as 
 unpaid on the books is to publish a list of the account numbers 
 and amounts of such arrearages in the association's published 
 annual statement. A good verification of the capital stock out- 
 standing would be for the auditor to be present at the meeting 
 next following the commencement of the audit and to examine 
 each stockholder's pass book as it is presented at the time of 
 paying dues. The numbering of all stockholders' accounts and 
 the consecutive numbering of the pass books by the printer, all 
 pass books to be accounted for, is also a safeguard. 
 
 Expenses: These are verified in the usual manner. To the 
 credit of these associations it must be said that most of them are 
 economically conducted and the direct outlays for salaries, etc., 
 are seldom excessive. 
 
 Inspection of Securities: A very important feature of the 
 audit is naturally the examination of the securities owned. 
 Mortgages, insurance policies, and other documents pertaining 
 to real estate loans, assigned capital stock certificates, notes 
 for loans on stock collateral, and real estate deeds are all to be 
 carefully scrutinized. 
 
 Distribution of Profits : An important part of the audit is the 
 verification of the annual statement. Most associations publish, 
 in addition to a balance sheet, a statement of cash receipts and 
 payments, and not the profit and loss account, although it is on 
 the basis of the results shown by the latter that the apportion- 
 ment of profits among the various series of stock is made. There 
 are several plans of profit distribution in use, not all of equal 
 merit. 
 
 The most equitable and accurate plan is to treat as the cap- 
 ital for the year the dues paid in and the profits accrued thereon 
 
BUILDING AND LOAN ASSOCIATIONS 375 
 
 up to the beginning of the fiscal year under review, plus the 
 equivalent sum for one year of the installments paid in during 
 the year, and less the entire dues paid in and the accrued profits 
 to the beginning of the fiscal year on stock withdrawn during the 
 year. On the average working capital for the year so determined, 
 the percentage of the year's earnings as shown by the balance of 
 the profit and loss account is ascertained. The calculation of 
 the average working capital is made by separate series as well as 
 in total, and the percentage earned added to each series. The total 
 earnings for the year are thus apportioned among the various series. 
 The accrued profits in excess of the amounts actually paid to 
 withdrawing stockholders are included as a part of the year's 
 earnings. 
 
 A plan which is in use by many associations, but which is 
 misleading, in that the apparent percentage of earnings to capital 
 is higher than is actually the case, is that by which accrued profits 
 are not treated as a part of the capital, the profits being calcu- 
 lated and apportioned simply on the basis of the dues paid in. 
 As this constitutes a smaller amount on which to calculate the 
 percentage w^hich the earnings are of the capital stock, the ap- 
 parent rate of earnings is higher than the actual rate. 
 
 Some associations even go so far as to reapportion each year 
 all the profit earned, not only in the current year, but in preced- 
 ing years, on all unmatured series of stock. This is clearly wrong 
 and inequitable. Each year, which usually marks the entrance 
 of a new series of stockholders, should witness the apportion- 
 ment of its earnings in accordance with the actual earnings, 
 which apportionment should remain undisturbed in the remain- 
 ing years which the various series have yet to run. 
 
 It should be stated, however, that in many cases the by-laws 
 of the association prescribe the basis on which profits shall be 
 apportioned among the various series, and in such an event the 
 auditor cannot do otherwise than comply with them. Even in 
 such cases, however, it would seem desirable to call the attention 
 of the directors or the stockholders to the desirability of adopt- 
 ing the most accurate method. 
 
 Most associations publish balance sheets, statements of re- 
 ceipts and payments, and statements of capital stock more or less 
 like the following forms: 
 
P-I 
 
 o 
 
 o 
 o 
 
 CO 
 
 o 
 I-) 
 
 Hi 
 
 n 
 
 9 S"^ 9 
 art 
 
 iifi 
 
 1' 
 ■gg 
 
 5-So 
 
 "l3 s 
 
 H 
 
 O 
 
 •^ -51. 
 
 
 ■S&: 
 
 s g(S 
 
 .wSs 
 
 illllllll 
 
 C4 
 
 
 IIP 
 
 P^OQAO 
 
 
 376 
 
BUILDING AND LOAN ASSOCIATIONS 
 
 377 
 
 STATEMENT OF CAPITAL STOCK 
 
 Series Date of Bo> 
 No. Isaae rowed on Free 
 
 Total 
 
 
 Value 
 
 of 
 Series 
 
 With- 
 drawal 
 Value 
 
 Dues Proata Total 
 
 Share 
 
 * This amount should agree with the item of "Capital Stock" shown in the balance sheet. 
 
 Fewer associations publish the Profit and Loss Account, 
 though all ought to do so. The following is a form thereof : 
 
 PROFIT AND LOSS ACCOUNT 
 
 Year ended 191 
 
 Earnings 
 
 Interest 
 
 Premiums 
 
 lines 
 
 Admission and Transfer Fees 
 Rents of Real Estate 
 
 Leas — Insurance, Taxes, etc. 
 
 Profits on Stock Withdrawals 
 
 Expenses 
 
 Interest on Stock \fithdrawn 
 Interest on Borrowed Money 
 Administration Expenses 
 
 $ 
 
 Net Profit for Apportionment Among Stock Series 
 
 A few associations publish statements of capital stock show- 
 ing the dues paid in and the profits earned in each year on each 
 series of stock outstanding. This makes a very complete and 
 informing exhibit of an association's experience for a period of 
 years. 
 
 Being chartered by the States, building and loan associations 
 are usually subject to the supervision of the State banking depart- 
 ments. The forms of report required vary in different States. 
 The foregoing have been selected and adapted from the best ones 
 in use. 
 
CHAPTER XXIV 
 
 SPECIAL POINTS IN DIFFERENT CLASSES OF 
 AUDITS (Continued) 
 
 INSURANCE COMPANIES 
 
 In almost all States insurance companies cannot organize 
 under the general corporation laws, but must incorporate under 
 special laws. These laws usually provide inter alia that the com- 
 panies shall be subject to inspection by the Insurance Commis- 
 sioner of the State. Furthermore, such examinations are not 
 limited to the State in which a company is incorporated, but it 
 is' subject to examination by the Insurance Commissioner of 
 every State in which it is registered to do business. 
 
 The examinations made by State Insurance Commissioners 
 are similar in purpose to examinations of banking institutions 
 made by the National and State Governments. The chief ends 
 sought in these examinations are to ascertain whether or not the 
 company is solvent and to prevent any violation of the insurance 
 laws. While these are most important objects — even preemi- 
 nently so — they by no means embrace all the duties of the profes- 
 sional auditor. 
 
 As is to be expected, the State examinations vary consider- 
 ably as to the efficiency with which they are conducted. It is not 
 to be wondered at if the staff of a department, whose members 
 may have been recruited largely through the medium of political 
 appointments, does not possess technical ability or experience 
 of a very high order. In this connection it may also be men- 
 tioned that the abuses which were revealed by the investigation 
 of a number of the large New York life insurance companies had 
 been going on for years in spite of the fact that the companies 
 were supposed to be periodically examined by the New York 
 Insurance Department, and were reporting regularly to that 
 Department. It is a significant fact that in recent years quite a 
 
 378 
 
FIRE INSURANCE COMPANIES 379 
 
 number, of the large life insurance companies have adopted the 
 plan of having their accounts audited by pubUc accountants. 
 
 FIRE INSURANCE COMPANIES 
 
 Naturally the auditor will need to inform himself as to the 
 meaning of various technical terms and expressions. Aside from 
 this, the audit of a fire insurance company will offer no serious 
 difficulty, as the accounts are not very complicated. 
 
 Premiums form the largest item of income. The initial 
 record of the premium income appears in the agents' reports. 
 Enough of these should be traced into the books to satisfy the 
 auditor of the correctness of the books in this respect. 
 
 Balances due from agents at the close of the fiscal period 
 should be thoroughly verified. This may be done by analyzing 
 the agents' accounts and taking up with some one in authority 
 such balances as are in arrears. The balances should also be 
 verified by comparison with the closing balance on the agent's 
 last monthly statement. 
 
 Income from investments is another considerable item; this 
 can and should be completely verified. The securities them- 
 selves must also be examined; this will be done in the same 
 manner as in the case of banks or other financial institutions. 
 
 Unless the audit is specifically limited to the verification of 
 the balance sheet, the payments for losses and expenses will need 
 to be vouched. The vouchers for losses paid, expenses, and other 
 items of outgo, should be properly approved. Insurance policies 
 on which losses have been paid should be traced into the premium 
 income record to see that the company actually received a con- 
 sideration for the risk on which payment was made to the in- 
 sured. Irregularities in the accounting for premiums may per- 
 chance be brought to light by this plan. In connection with 
 losses, steps should also be taken to see that collection has been 
 made for such part of the loss as had been reinsured. The system 
 of recording reinsurances should be such as to insure the collec- 
 tion of the pro rata part of losses payable by other companies. 
 Credits to agents for return premiums, rebates, and commissions 
 should also receive attention. 
 
 The importance of safeguarding the payments for premium 
 refunds and rebates from the standpoint of establishing an ef- 
 
38o AUDITING 
 
 fective internal check, as well as the importance of the profes- 
 sional auditor's covering the matter thoroughly, is forcibly 
 brought out by the following extract from a newspaper account 
 of the embezzlement of $13,000 in a little over three years by 
 two clerks who asserted that they were not in collusion, but who 
 were both "operating" at the same time in the New York office 
 of a large British fire insurance company : 
 
 Walker and Bradford, as their depositions state, were employed in 
 the auditing department of the insurance company. . . . Their method 
 of obtaining money was to cause cheques to be issued which appeared to 
 be in payment of premium rebates on canceled policies. Both Walker and 
 Bradford prepared these cheques in the regular course of their day's work 
 and presented them to the cashier for his signature. Then they were sup- 
 posed to be sent to persons who had canceled policies. The accountants 
 discovered that no account was taken of the cheques thus issued and that 
 the returned vouchers were never examined. 
 
 Bradford said the idea of drawing cheques to fictitious persons, or of 
 duplicating cheques already issued and then forging the indorsements, came 
 to him through the suggestions of a fellow employee, who, however, had no 
 idea of operating it himself. 
 
 "I went broke one night," says Bradford in substance in his deposition. 
 "1 think I had been shooting craps in Dey Street. At any rate, the family 
 were all away. I had sent my wife to the country, and there was no one 
 at home. I was at my wits' end to raise money the next day. 
 
 "I went out to lunch with a fellow employee and in the course of the 
 meal he suggested how easy it would be to raise money by duplicating 
 cheques sent to policy holders who were withdrawing, or even by sending 
 cheques to purely fictitious persons. The fact of the sending of a cheque 
 was entered in a register, but when the cheque was returned from the 
 bank it was never examined beyond seeing if it bore the proper indorse- 
 ment. It was never compared with the policy which occasioned its issu- 
 ance, and so the company never knew whether a rebated premium had been 
 paid more than once or not. That started me thinking. 
 
 "I didn't have to make a study of it. It came just as naturally as 
 taking a drink. The cheques all went through. I got various persons 
 to cash them, and the company always paid without question. By this 
 time I had got to the point of drawing cheques for any name at all and 
 then indorsing them properly. Then it occurred to me once that if an 
 investigation were made of the register it would be found that the name 
 of the person who actually had received the proper cheque for his rebate 
 wouldn't agree with the indorsement on my cheque, which corresponded 
 in number to the good cheque, always supposing that it was my cheque 
 which chanced to be looked up. I never felt in any fear of their finding 
 both cheques. 
 
FIRE INSURANCE COMPANIES 381 
 
 "To cover myself I began erasing names from the register and sub- 
 stituting the names for which I had made out my cheques. These erasures 
 finally attracted the attention of the auditors, but they couldn't catch onto 
 the scheme then until I told them how it was worked." 
 
 Walker stumbled on the plan because he happened to notice once that 
 in eight years only one thorough examination of the canceled policies and 
 payments of rebated premiums was made by the auditors of the company. 
 As soon as he found how easily the scheme worked, he began to pay his 
 bills with cheques drawn on the insurance company. 
 
 He bought a piano with one of his early cheques, making the cheque 
 payable to the piano salesman from whom he made his purchase. In the 
 insurance company's office, had any one looked it up, it would have ap- 
 peared that this salesman was receiving a rebated premium on a canceled 
 policy. To the salesman himself it appeared merely that Walker had asked 
 his employer to make out a cheque for his convenience. 
 
 Walker said he paid his rent regularly each month with one of the 
 company's cheques, making it out in favor of his landlord. Walker said 
 that while Bradford never suspected him, he had known for six months 
 before their arrest that Bradford was doing the same thing, but said he 
 never had spoken to him about it until they met in police headquarters as 
 prisoners.' 
 
 Most of the cheques which Bradford and Walker drew were for 
 amounts less than $50, so that it required more than 200 falsified cheques 
 for them to obtain the $13,208. 
 
 Liabilities : By far the largest, as well as the most important, 
 item among the liabilities is the reinsurance reserve. The basis 
 on which this must be calculated is usually fixed by State law. 
 The plan most generally followed is to reserve one-half of the 
 gross premiums (net of reinsurance) on all unexpired one-year 
 policies and pro rata parts of the gross premiums on unexpired 
 poUcies written for a longer term than one year, allowance being 
 made for the full number of years of the term which have already 
 expired. The deposits reclaimable by the assured are taken as 
 the liability on perpetual policies. 
 
 The liabilities should include full provision for losses ad- 
 justed, but not yet paid, and for all unadjusted or disputed losses. 
 Unpaid expenses, accrued taxes, etc., should also be allowed for 
 in stating the liabilities. 
 
 An excellent article on "Auditing Insurance Accounts," by 
 George Wilkinson, C. P. A., is to be found in the May and June, 
 1910, numbers of The Business World. The article confines itself 
 to the auditing of fire company accounts. 
 
382 AUDITING 
 
 LIFE INSURANCE COMPANIES 
 
 In many respects the audit of a life insurance company will 
 follow the same lines as the audit of a fire insurance company. 
 There are, however, some points of difiference, as will presently 
 be seen. 
 
 The investments of even a moderate-sized life company will 
 be found to be very numerous, and their examination will require 
 considerable time and care. In addition to verifying the fact of 
 their being in the possession of the company or deposited with 
 properly constituted authorities, such as the State insurance de- 
 partments (when the latter is the case, the fact should be verified 
 by correspondence), the income which should have been received 
 from the investments is to be verified. 
 
 The auditor will do well to inform himself as to what secur- 
 ities are legal investments under the laws of the State in which 
 the company is incorporated. The valuation of the investments 
 is of great importance, and is considered somewhat at length, in 
 another part of this book. 
 
 Loans to policyholders secured by an assignment of the poli- 
 cies now form an item of considerable size in the assets of most 
 large companies. Inasmuch as the loan never exceeds the 
 amount of the reserve accumulated on the policy, such loans are 
 a very good asset. The notes and assigned policies should be 
 examined as a means of verifying the policy loans. 
 
 The laws of most States prohibit insurance companies from 
 investing in real estate except for their own use. These laws 
 have, however, been interpreted as permjitting the ownership of 
 large office buildings, of which a company may use but a small 
 part for itself. The companies must also buy in real estate occa- 
 sionally to protect their investments in mortgages. Conse- 
 quently, real estate may form another asset of considerable 
 amount. This necessitates a verification of the income from 
 rentals. Receipts from sales of real estate should also receive 
 attention, as it is usually the aim to dispose of foreclosed prop- 
 erty as soon as it can be done without loss. The valuations at 
 which the real estate appears in the balance sheet should be sup- 
 ported by independent appraisals. 
 
 The insurance reserve of life insurance companies is calcu- 
 lated on an entirely different basis from that of a fire insurance 
 
LIFE INSURANCE COMPANIES 383 
 
 company. The calculations are made by the company's actuary 
 and the auditor is not ordinarily expected to do more than see 
 that the reserve as stated in the balance sheet agrees with the 
 actuary's figures. Sometimes, however, the auditor is instructed 
 to make a test of the actuary's calculations. In such instances it 
 may be desirable for him to engage the services of an actuary to 
 do this work. On the other hand, the accountant who has a 
 good grasp of the underlying principles of life insurance can, 
 himself, by the use of tables which are prepared for the purpose, 
 test the calculations of the reserve and satisfy himself that it has 
 been properly summarized, and that it includes reserves for all 
 classes of outstanding policies which require them. 
 
 It is rather surprising that, with the magnitude which the 
 insurance business has attained, the companies are, or at least 
 until recently were, content to put up with the primitive account- 
 ing systems in use by most companies. This may have been due 
 in part to the fact that the forms of reports prescribed by State 
 insurance departments encouraged unscientific accounting meth- 
 ods. While the forms of report have been somewhat improved 
 in recent years, they still leave much to be desired. 
 
 A few years ago a committee of the American Association of 
 Public Accountants, acting jointly with a committee of the New 
 York State Society of Certified Public Accountants, appeared 
 before the Armstrong Committee of the New York Legislature. 
 In addition to forcefully presenting the necessity for reform in 
 insurance accounting methods (see the April, 1906, Journal of 
 Accountancy for a report of the Committee's criticisms and sug- 
 gestions), the Committee submitted a number of model forms, 
 which are reproduced herein. 
 
 It is a matter of regret that the insurance authorities did not 
 see fit to adopt the forms. They would have been a great im- 
 provement over the present forms. They give in a concise 
 manner the information which is of value to the policy- or stock- 
 holder, and by means of supplementary schedules they can be 
 amplified as much as may be desired. 
 
 The model forms, while designed primarily for life com- 
 panies, could easily be adapted to the needs of fire and other in- 
 surance companies. 
 
384 AUDITING 
 
 THE IDEAL LIFE INSURANCE COMPANY 
 BALANCE SHEET, DECEMBER 31, 19... 
 
 Real Estate— (Appraised Value): 
 Office Buildings: 
 
 Home Office . . 
 
 Domestic Branchea . .... 
 
 Foreign Branch® . . ... 
 
 Other Real Estate 
 
 Secured Loans: 
 
 On Mortgage . 
 
 On PoUcies . . . . ... 
 
 On Other Collateral 
 
 Bonds, Stocks and Other Makkbtablb SEcrmmES 
 — (Market Value): 
 Bonds: 
 
 Government, State and Municipal of the United 
 
 States and Canada . . ... 
 
 Raihroad and Traction Companira in the United 
 
 States and Canada . ... 
 
 Foreign — ^Held Chiefly to Comply with Statutory 
 Requirements . . . 
 
 Miscellaneous ... . . 
 
 Stocks: 
 
 Railroad and Traction Companies in the United 
 
 States and Canada ... . . . 
 
 Financial and Insurance Compames in the United 
 
 States and Canada . , . ... 
 
 Miscellaneous ... . . 
 
 Syndicate Subscriptions . . . . 
 
 Cash: 
 
 In Banks and Trust Companiea: 
 
 Home Office, Subject to Cheque 
 
 Branches and Agencies, Subject to Cheque . 
 On Deposit on Special Terms 
 
 Deposits with Foreign Governments . ... 
 
 In Transit . , . . 
 
 On Hand — At Home Office, Branches and Agencies 
 
 Premiums in Course op Collection or Collected 
 AND NOT Reported: 
 
 First Year Premiums $ 
 
 Renewal Premiums 
 Annuities . 
 
 1:1^ $. 
 
 Agents' Balances and Miscellaneous Advances S . 
 
 Interest and Rentals Due or Accrued: 
 Interest: 
 
 On Bonds and Dividends on Stocks . 
 On Secured Loans 
 
 On Agents' Advances and Balances 
 Miscellaneous . . 
 
 Rentafe 
 
LIFE INSURANCE COMPANIES 385 
 
 THE IDEAL INSURANCE COMPANY 
 BALANCE SHEET, DECEMBER 31, 19... 
 
 Liabilities 
 GENERiL Ihsdsahoh Resbbtb: 
 (Describing Basis) . 
 
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 CommiBsions and Current Expenses: 
 
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 [ Premiums, Interest and Rents Prepaid, and Sundry 
 
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 Capital Stock 
 
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 Surplus and Reserves: 
 
 
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INSURANCE AND SURETY COMPANIES 389 
 
 CASUALTY, HEALTH, SURETY, TITLE GUARANTEE 
 AND OTHER COMPANIES 
 
 In the main, the accounts of these companies will be similar 
 to those of fire companies. The most important difference is 
 that the basis of determining the reinsurance reserve is not al- 
 ways the same as for fire companies. For instance, it is custom- 
 ary to include the full amount of the gross premiums on unex- 
 pired risks in the reserve of marine and inland navigation com- 
 panies. Health companies resemble life companies somewhat 
 and their reserve may be based on actuarial principles. 
 
 Insurance Companies and the Corporation Tax: In auditing 
 the accounts of an insurance company the question of the correct 
 amount to pay under the Federal Corporation Tax will probably 
 arise. A decision bearing on insurance reserves and sums set 
 aside for amortization of bonds was rendered by the Commis- 
 sioner of Internal Revenue, August 25, 191 1, as follows: 
 
 First. The net addition to reserves required by law to be made within 
 the year to reserve funds may be the highest amount required by any State 
 in which the insurance corporation actually does business. In the case 
 of assessment insurance companies the law provides that the actual deposit 
 of sums with State or Territorial officers, pursuant to law, as additions 
 to guaranty or reserve fund, shall be treated as being payments required 
 by law to reserve funds. 
 
 Second. The reserves carried by various insurance corporations to 
 provide for taxes due and payable within the year for which the return 
 is made cannot be accepted as taxes paid unless such taxes were actually 
 so paid. The second paragraph of section 38 of the Act of August s, 1909, 
 referring to deductions from gross income, provides, "(fourth) all sums 
 paid by it within the year for taxes imposed under the authority of the 
 United States, or of any State or Territory thereof, or imposed by the 
 Government of any foreign country as a condition to carrying on business 
 therein.'' You will note that the language of the statute is "'all sums paid 
 by it v^^ithin the year for taxes," etc. 
 
 Third. Relative to amortization of bonds, where a corporation holds 
 bonds which were purchased at a rate above par and said corporation shall 
 proportionately reduce the value of those bonds on its books each year 
 so that the book value shall be the redemption value of the bonds when 
 such bonds become due and payable, the return of annual net income of 
 the corporation holding such bonds may show the depreciation on account 
 of amortization of such bonds. The requirement is, however, that the 
 amount carried to the amortization account each year shall be practically 
 proportioned with respect to the difference between the purchase price and 
 the maturing value and the number of years to elapse until the bonds 
 
390 AUDITING 
 
 become due and payable. With respect to bond issues where such bonds 
 are disposed of for a price less than par and are redeemable at par, it is 
 also held that because of the fact that such bonds must be redeemed at 
 their face value, the loss sustained by reason of their sale for less than 
 their face value may be prorated by the issuing corporation in accordance 
 with the life of the bond. 
 
 With respect to depreciation on real estate, it appears to be difficult 
 to say more than is set forth in the regulations. The depreciation must 
 have actually occurred before it can be allowed. Where it is necessary 
 to estimate the depreciation, such estimate must be in accordance with the 
 best data obtainable with respect to properties similar to that on which 
 the depreciation may be claimed. It is understood, of course, that such 
 depreciation should be charged off on the books of the corporation claiming 
 the same. 
 
 With respect to the last sentence see Chapter XXII. The 
 commissioner's ruling on this point has been reversed by a court 
 decision. 
 
 MANUFACTURING 
 
 The accounts of manufacturers are submitted to the auditor 
 probably as often as any one other class of accounts. Conse- 
 quently he should be well informed on such matters as are espe- 
 cially pertinent to manufacturing accounts. 
 
 Expenditures for wages should be thoroughly verified. It is 
 well for the auditor to be present at the paying off of a roll so 
 that he may observe the methods used ; in fact, he should follow 
 the system of handling the pay roll through from the initial steps 
 in making it up to the final paying out of the wages to the work- 
 men. 
 
 The system of receiving materials and checking the invoices 
 therefor, both as to quantity and quality, should also be made 
 the subject of careful observation. An especially important 
 matter is to see that freights which are chargeable to shippers 
 are duly deducted from the payments for purchasers. Similarly, 
 the freights on outgoing shipments should be examined to make 
 certain that none which are prepayments on sales made f. o. b. 
 factory, and which are consequently chargeable to customers, 
 have been absorbed in the manufacturing expense accounts. 
 
 Depreciation of plant is an item which, while not peculiar to 
 manufacturing industries, is of especial importance in that con- 
 nection. The basis on which the allowances therefor are made 
 varies in different industries. For textile mills, machine shops, 
 
MANUFACTURING 391 
 
 etc., it is customary to base the depreciation allowances on per- 
 centages of the plant values, the percentages being in turn based 
 on the estimated useful life of the plant or different parts thereof. 
 In industries like blast furnaces and coke works the allowance is 
 frequently based on a certain rate per unit of production, the 
 amount of the allowance for different fiscal periods varying in 
 direct proportion to the fluctuation in the output of pig iron or 
 coke respectively. A legitimate reason for such a basis is that in 
 industries such as those named, a very large output imposes a 
 correspondingly heavy strain on the plant, whereas when the pro- 
 duction is light, the wear and tear on furnace and oven linings, 
 etc., is much less. 
 
 Miscellaneous income needs to be carefully looked for and 
 verified. One such item which is quite frequently encountered 
 is the income from houses owned by manufacturers who are lo- 
 cated at a distance from cities and towns, and who rent these 
 houses to their employees. Most frequently, though not invari- 
 ably, the rents are deducted from wages payable to the employee 
 tenants. 
 
 As often as not, the record of rents is in crude form. A suit- 
 able form of rent roll should be suggested. The record should 
 be based on the rents accruing, not merely on the collections 
 when made. 
 
 In stating the operations of the undertaking, the taxes, re- 
 pairs, and other expenses which can be allocated to the houses 
 owned should be applied against the rents (though preferably 
 showing the gross of both rents and expenses), and the net 
 income or expense extended. 
 
 When the buildings used for manufacturing are leased and a 
 portion of the space is sublet, it is desirable that both the gross 
 amount of rent paid and the amount received for the space sub- 
 let be shown so that any fluctuations in the net amount of rent 
 paid which are due to the sublet premises becoming vacant may 
 carry their own explanation with them. 
 
 A comprehensive system of cost and stock accounts is very 
 desirablie. In the absence of such a system the inventory valua- 
 tions contain an element of guesswork and the auditor cannot be 
 certain that they represent actual manufacturing cost. Correct 
 cost and stock accounts are also of vital importance for the aid 
 

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394 AUDITING 
 
 which they give in carrying on the manufacturing operations to 
 
 the best advantage. 
 
 In those industries in which there is but a single unit of pro- 
 duction — such as tons, pounds, barrels, or gallons — at least the 
 sales accounts should be kept not only as to values, but also in 
 quantities. Under such conditions it will occasionally be pos- 
 sible to lay out the accounts on the general books in such a 
 manner as to show therein the average manufacturing cost per imit 
 of production. Keeping cumulative records of quantities in con- 
 nection with the values, not only of sales, but also of materials 
 purchased and used, will enable the auditor to make a compar- 
 ison of the quantity of materials used with the resulting quantity 
 of finished product, and ascertain whether the ratio of one to the 
 other is within a reasonable range of the average experienced in 
 the particular industry. 
 
 Uniformity of detail in the financial statements of manufac- 
 turing concerns is not to be expected. It will doubtless be of 
 interest to students, however, to see forms of statements which 
 are actually in use. On page 392 is shown the general form of 
 balance sheet which is used by quite a number of American 
 manufacturing corporations, following which is the form pre- 
 scribed by the English Companies Act. 
 
 PUBLISHERS OF BOOKS 
 
 Publishers who do not do their own printing and binding are 
 in the position of merchants who have goods manufactured for 
 them according to their special pattern and design. Those who, 
 in addition, have their own printing plants are both manufac- 
 turers and merchants. In practically all cases, even if there is not 
 a retail store connected with the business, there is a department 
 for filling retail mail orders. 
 
 There are several considerations nYore or less special to pub- 
 lishers' accounts, and reference will be made to these. Royalties 
 paid to authors; while not exclusively found in publishers' ac- 
 counts, are in point of proportion a more important item here 
 than in most businesses. Royalty accounts with authors should 
 be carefully checked. The credits thereto should be thoroughly 
 tested to see that they are for quantities actually sold and that 
 the rate per copy is in accordance with the contract between pub- 
 
PUBLISHERS 395 
 
 iisher and author. Sometimes the contract will be on a profit- 
 sharing basis, and in such cases the auditor will need to satisfy 
 himself that all costs have been taken into account. 
 
 Advance payments on account of royalty should not be in- 
 cluded among the accounts receivable from customers, but 
 should be set out separately in the balance sheet. The matter of 
 royalties also raises an important question regarding the valua- 
 tion of unsold books at inventory dates. If authors are credited 
 with royalties only as their works are actually sold, care should 
 be taken to see that the cost of production at which the books in 
 the inventory are valued does not include the item of royalty. Of 
 course, if authors are credited with royalties as books are bound, 
 even though they are not yet sold (there are some publishers 
 who pursue this plan, though they are in the minority), it is 
 quite proper to value the books at a figure which includes the 
 royalty. 
 
 Another very important question in connection with the 
 valuation of sheet stock and bound books is that of salability. 
 Cost is far too' high a valuation of books for which the demand 
 has died out, or for which there may never have been a demand. 
 
 The best way to determine the strength of the demand for 
 books of which large quantities are on hand is to ascertain the 
 number sold during the last fiscal period. The ratio of the 
 quantity on hand to the quantity sold will furnish data for de- 
 termining whether or not the stock should be valued at full cost 
 or only a fraction thereof, or, if quite unsalable, at the price of 
 waste paper. Even in applying this test, however, care must be 
 taken not to be misled by large sales early in the period which 
 may have dwindled away in the latter part of the period; the 
 facts in such a case probably being that the demand has died out. 
 
 Still another consideration in connection with inventories — 
 and this affects accounts receivable as well — is to see that the 
 latter do not include consigned stock in agents' hands. Such 
 stock should appear in the inventory at cost or less and not 
 among the accounts receivable at selling prices. 
 
 Such stock on hand as paper, ink, binding materials, and 
 other supplies presents no unusual problems. With regard to the 
 quantities of stock, books are an article of which the auditor can 
 readily verify the quantities stated in the inventory by making 
 
396 AUDITING 
 
 an actual count. It is very desirable to make some such tests, 
 especially of the larger quantities. 
 
 The overvaluing of artists' drawings (for illustrations), if 
 indeed, any value whatever is to be allowed for them, must be 
 guarded against. Such values are sometimes based on senti- 
 ment rather than on what would be realized if the articles were 
 sold. 
 
 Whether or not the values placed on the book plates are rea- 
 sonable, demands careful inquiry on the part of the auditor. "Cir- 
 cumstances alter cases," and this adage is true of book plates as 
 well as of other things. Obviously, it would be quite proper to 
 carry the plates of an edition of the Encyclopedia Britannica or 
 of some standard scientific work at a considerable part of their 
 cost long after the entire cost of the plates for a more ephemeral 
 piece of literature, like a novel, should have been written off in 
 toto. The plates for a novel should be written off entirely as a 
 part of the cost of the first edition — there may never be another ; 
 the great majority of novels don't run through more than one. 
 As already indicated, the plates of a work which will be stand- 
 ard for a number of years may be written ofif more gradually, 
 particularly as the greater initial cost frequently includes large 
 expenditures for contributions and editorial work which take the 
 place of royalties payable over a period. 
 
 The fact that the effective demand for such a work is real- 
 ized over a long period of time is another justification for charg- 
 ing off the cost of such plates more gradually. 
 
 At the same time, the world moves so rapidly and new dis- 
 coveries are so frequent that works which are standard to-day 
 are out-of-date to-morrow, and an issue of an encyclopedia or 
 other reference work is not authoritative for as long a period as 
 was formerly the case. 
 
 Some large failures in the publishing business are traceable 
 to the omission to charge against the cost of books a proper pro- 
 portion of the cost of plates. In view of the large profits which 
 were apparently being earned, liberal amounts of cash were with- 
 drawn from the business. The actual facts were that the liquid 
 assets or working capital of the business were being replaced 
 by a growing fictitious investment in plates and copyrights. The 
 only safe plan is to charge off liberally. 
 
PUBLISHERS 397 
 
 As a parting word on the subject it may be said that the value 
 of plates and copyrights should never be increased above cost. 
 Even though there is every indication that the demand for cer- 
 tain publications will continue, or even increase, and result in 
 large profits in the future, that is no reason for anticipating such 
 profits and capitalizing them by raising the book value of the 
 plates, and correspondingly crediting current income or even 
 surplus account. 
 
 Accounts receivable require especially close scrutiny in a 
 publishing business. One pitfall has already been referred to, 
 viz., that accounts will frequently be found among the receivables 
 which are in reality consignment accounts. Where books are 
 sold on the installment plan the balances on such accounts also 
 require careful examination. The right to reclaim such books 
 if they are not paid for in full does not put the accounts in the 
 secured class, as it usually costs about as much to recover 
 books sold on the installment plan as they are worth. 
 
 An especially liberal reserve for losses on installment ac- 
 counts should be made, as there is a large margin of profit in 
 installment sales to offset the losses which may confidently be 
 expected. The condition of the other customers' accounts as to 
 promptness of payment will naturally be an important element 
 in the determination of how large the reserve for possible losses 
 thereon should be. 
 
 Large amounts of postage are used in a publishing business. 
 A record of the purchases of stamps and of the quantities issued 
 for use on requisitions of the shipping, advertising, correspond- 
 ence, and other departments should be kept as a means of pre- 
 venting abuses which may otherwise occur. 
 
 There are quite a few sources of miscellaneous receipts in the 
 publishing business, particularly in the printing end, such as 
 waste print paper, cuttings, ink barrels, boxes, gilt sweepings, 
 etc. So far as possible all such items should be carefully ac- 
 counted for. 
 
 PUBLISHERS OF MAGAZINES AND NEWSPAPERS 
 
 These accounts present some problems quite different from 
 those of book publishers' accounts. Finished stock is usually a 
 minor item, consisting of back numbers and bound volumes of 
 
398 AUDITING 
 
 magazines. Past issues of newspapers are never given any value 
 in the inventory other than as waste paper. 
 
 Plates also are not a vital factor. Their value should be 
 limited strictly to that of the metal as such excepting, perhaps, 
 for the small amount of plates for advertisemlents under long 
 contracts and similar standing matter, on which a somewhat 
 higher value may be placed. 
 
 Two of the most important items which are peculiar to mag- 
 azines and newspapers are the revenues derived from advertis- 
 ing and "circulation" respectively. A century ago newspapers 
 may have been published on the basis of the income from sub- 
 scriptions furnishing the bulk of the wherewithal to pay the cost 
 of publication, but that day has past long since, and the same 
 thing may be said of magazines. Ordinarily, the subscription or 
 circulation revenue does not cover the cost of production and 
 distribution, and the only inducement to extend the circulation is 
 because of the higher rates for advertising space which the larger 
 circulation commands. 
 
 In the case of a monthly magazine, all the advertisements in 
 several numbers out of the year's issues should be compared 
 with the charges for advertising recorded in the books. Proper 
 authority should be shown for such advertisements as have been 
 inserted without charge. Some of the contracts should also be 
 consulted for the purpose of testing the correctness of the rates 
 charged. If the accounts of a newspaper are being audited, the 
 charges for the advertisement in one or two days' issues of each 
 month should be verified. More difficulty is likely to be encoun- 
 tered in verifying the revenue from classified advertising than in 
 verifying the income from display advertising, particularly if the 
 system of recording the classified advertisements is of the happy- 
 go-lucky kind which not infrequently obtains. The importance 
 of examining the commission accounts of advertising agents and 
 solicitors should not be overlooked. 
 
 Subscription income is difficult to verify. On account of the 
 immense volume of detail it is out of the question to check it 
 with any approach to completeness. The best that can be done, 
 in addition to making tests of the clerical work, is to assure 
 oneself that the system is the best that can be devised to safe- 
 guard the integrity of the subscription, or — as- it is usually 
 
PUBLISHERS 399 
 
 termed in the case of newspapers — cash circulation, and to com- 
 pare the total circulation revenue with the approximate amount 
 which it would seem that the number of copies printed, after 
 making due allowance for unsold and returned copies, should 
 have yielded. 
 
 Data for making the latter test will be obtained from the 
 press run record, the circulation manager's statement of the dis- 
 position of the number of copies printed (sold, exchanged, re- 
 turned, distributed free, etc.) and the news agency's reports. 
 That part of a magazine's circulation which goes directly to sub- 
 scribers by mail may be approximately verified by dividing the 
 weight per copy (including wrapper) into the total weight shown 
 by the post ofifice receipts for second-class postage paid. This 
 must be done separately for each issue, as the number of pages 
 will probably vary from one issue to another, and this will in 
 turn change the weight per copy. Knowing the circulation of a 
 magazine, some idea can be formed of the approximate amount 
 of subscription revenue which should have been received. 
 
 Precautions should also be taken to prevent abuses of the 
 free list. Names should be entered thereon only with the ap- 
 proval of some one in authority. 
 
 While on the subject of verifying circulation, it may not be 
 amiss to refer to so-called "circulation audits" which are at times 
 made on behalf of advertisers' associations or directly for news- 
 papers which desire to substantiate their claims of having a 
 certain circulation. 
 
 There are a number of ways of manipulating newspaper cir- 
 culation records which can be detected only by an audit of the 
 general accounts. For example, the cash sales (office sales and 
 mail subscriptions) may be inflated, making them, say, $ioo or 
 $200, or more, larger than the amount actually collected and then 
 charging off the' inflated amount monthly, quarterly, or at irreg- 
 ular intervals, to some expense account, no details accompany- 
 ing the entry therefor in the general cash book. Another method 
 which has been used is to overcharge news-agents' accounts or to 
 charge to fictitious agents papers which were never actually 
 delivered. Eventually such charges, which served the purpose of 
 inflating the circulation earnings when they were made, are 
 written off as bad debts or to some expense account (really an 
 
400 AUDITING 
 
 ofifset against the circulation earnings account and frequently so 
 treated in preparing the confidential statemlents for the manage- 
 ment). In the circulation accounts receivable ledger these 
 credits may be entered as cash instead of as allowances or as bad 
 debts written off. 
 
 From the foregoing it is obvious that a circulation audit 
 which is restricted to an examination of the circulation records, 
 and during which the auditor does not have access to the general 
 books, is absolutely worthless. It proves nothing except, per- 
 haps, that the circulation records may have been very cleverly 
 manipulated. A verification of the revenue purporting to have 
 accrued from circulation can be conclusive only when the dis- 
 position of the cash represented to have been received is traced 
 and the outstanding accounts receivable are satisfactorily veri- 
 fied. Other means, or rather partial means, of verifying the cir- 
 culation are the press-run book, which is a record of the number 
 of papers indicated by the automatic counters on the presses to 
 have been printed, and the quantity of paper used, the latter 
 being ascertained by referring to the purchase invoices and 
 applying the quantity of paper on hand at the beginning and end 
 of the period. The auditor must, of course, take steps to assure 
 himself that the press-run book which is submitted to him has 
 not been "faked" for his especial benefit. From either of these 
 sources only the gross circulation printed is obtained. It will 
 still be necessary to ascertain the number of copies spoiled, un- 
 sold, returned, sent to exchanges, etc., and deduct the total 
 thereof from the number printed before the net paid circulation 
 can be determined. 
 
 The subscription earnings account of a magazine should 
 include only that part of the subscriptions received which has 
 actually been earned during the period. That portion of sub- 
 scriptions received previous to the period under review, but 
 which has been earned during the period, should, of course, also 
 be included therein. The unexpired pro rata of subscriptions in 
 force at the close of the period should appear in an unearned sub- 
 scriptions account and be entered among the liabilities in the 
 balance sheet as unearned or deferred income. There are several 
 methods for determining the actual subscription earnings of the 
 period and the unexpired amount at the end of the period. 
 
PUBLISHERS 401 
 
 Under either plan the subscription receipts are credited to an 
 account termed, say, unearned subscriptions, and periodically, 
 usually monthly, the amount earned during the period is trans- 
 ferred to a subscription earnings account. One way of determin- 
 ing the amount of the monthly earnings is to classify the sub- 
 scription receipts according to expiration dates, from which the 
 actual earnings for a given month can readily be determined. 
 Another way is to ascertain the average annual realization per 
 subscription and then multiply the number of copies mailed by 
 one-twelfth of the average annual rate. While the second plan 
 can be safely followed if the data used in making the calcula- 
 tions is carefully verified, the first mentioned plan is, perhaps, 
 less liable to give rise to inaccuracies. 
 
 With many newspapers the annual or semiannual subscrip- 
 tions form such a small part of the total circulation that a re- 
 serve for unexpired subscriptions is almost or quite unnecessary. 
 Others again have a very large mailing list of individual sub- 
 scribers, and in such cases a reserve for unexpired subscriptions 
 should, of course, be created. 
 
 A reserve for returns should also be made in the case of both 
 magazines and newspapers. A very few of the magazines do not 
 permit agents to return unsold copies, but the great majority 
 do. Almost all newspapers accept from newsboys unsold copies 
 of the previous day's issue in exchange for the current day's 
 papers. In the case of regular news agents credit is allowed in 
 the monthly settlement for copies charged, but not sold by the 
 agents. The reserve should be based on past experience as to 
 the ratio of returns to gross circulation, and, if set up only at the 
 end of the fiscal period, will be determined by applying the per- 
 centage decided upon to the circulation accounts receivable. 
 
 Not all magazine publishers print the magazines themselves. 
 The printing and mailing is sometimes done by contract, the 
 publisher supplying the paper, which he buys direct to eliminate 
 the printer's profit thereon. Frequently, however, a newspaper 
 publisher will have his own printing plant. The accounts per- 
 taining to this end of the business will naturally call for much 
 the same general treatment as those of other printers. 
 
 Publishers who have their own printing plant frequently do 
 job printing. Even if there is not a regular job department, spec- 
 
402 AUDITING 
 
 ial work like circulars of newspaper-sheet size may occasionally 
 be run off. This, as well as other sources of miscellaneous re- 
 ceipts, which are often quite numerous, should not be overlooked. 
 Magazine and book publishing is very frequently combined 
 in one business, but this fact of itself does not introduce any 
 complications except in the apportionment of general charges. 
 The magazine and book departments will ordinarily be found 
 to be quite distinct. 
 
 BREWERIES 
 
 In breweries there is probably a greater opportunity for 
 theft of supplies or product and misapplication of collections 
 than in almost any other business. The containers — boxes, 
 bottles, kegs, and barrels — are never sold, but remain the prop- 
 erty of the brewer. The value of these should not be set up 
 in the balance sheet as accounts receivable if they are charged 
 against customers. This is sometimes done. It is easily seen 
 that the loss in such stock is considerable, and that the value set 
 upon it should be investigated carefully. The auditor should see 
 that adequate accounting methods are in force, not only for the 
 containers, but for all other stock, and, if not, report should be 
 made thereon. 
 
 The fact that collections are frequently made by the drivers 
 is a weak point, requiring special attention and necessitating 
 close scrutiny of all allowances and discounts. 
 
 Usually a large amount of money is invested in saloons either 
 owned or controlled by reason of loans made. Frequently the 
 brewery pays for the license and collects on same from the saloon 
 keeper in monthly installments. The auditor should see that the 
 income from these sources is properly taken up, and at the same 
 time see that adequate provision is made for bad and doubtful 
 accounts, as the loss on these advances is considerable and is 
 looked upon as being an expense of keeping the product before 
 the public. In addition to amounts actually loaned to customers, 
 the brewery frequently guarantees loans made to customers by 
 others. Such guarantees constitute a large contingent liability 
 and should be set up as such in a balance sheet or indicated in 
 a footnote. 
 
MINING 403 
 
 MINING— COAL MINES 
 
 A practitioner engaged to audit the accounts of a mining 
 enterprise for the first time will do well to make an inspection of 
 the entire mine workings and equipment, accompanied by the 
 client's engineer or mine superintendent. Careful observation 
 will give him some idea of the condition of the equipment and 
 scope of the undertaking, which should be of assistance to him 
 when auditing the books and preparing the financial statements. 
 
 As the largest source of income is from the sale of coal, the 
 inventories and the sales tonnages should be proved with the 
 production records. Deductions from miners' wages for "black- 
 smithing" (dressing their tools) are frequently made on the basis 
 of production ; when so, the collection of this income can be veri- 
 fied in total. Arrangements are usually made with companies 
 operating general stores at the mines (unless the mining com- 
 pany operates its own store,. which will, in that case, be audited 
 separately) to allow the miners to make purchases on credit, the 
 amounts due therefor being deducted from the wages of the 
 mining company's employees. Commissions on these collections 
 are generally charged by the mining companies. The collec- 
 lection of rents from houses occupied by employees and owned 
 by the mining company should also be checked. 
 
 Some coal companies own railroad cars, for the use of which 
 income should be received from the railroad companies on a mile- 
 age basis. 
 
 The matter of royalties on coal mined from leased lands 
 requires careful attention. They are based upon tonnage of pro- 
 duction or cubic yards or acreage of the seams worked, and the 
 royalty agreements usually provide for a minimum annual pay- 
 ment, in the event of the production being so small that the 
 regular royalty rate would not require payments equal to the 
 fixed minimum. 
 
 In the case of comparatively new mines, the minimum roy- 
 alties will usually be paid during the sinking of shafts and period 
 of development work. If the lease agreement allows a lessee to 
 recoup himself subsequently for the proportion of the minimum 
 royalty paid in excess of the amount earned (calculated on a 
 tonnage basis), such excess is usually carried among the assets 
 
404 AUDITING 
 
 as a deferred charge. As the production increases to a point 
 beyond that at which the royalty, calculated on a tonnage basis, 
 equals the fixed minimum, and the lessee begins to recoup him- 
 self for the advance royalties, the amounts of such retained roy- 
 alties should be applied in reduction of the deferred charge above 
 mentioned. 
 
 It is important that all royalty agreements be carefully ex- 
 amined, and if they do not provide that the lessee may recoup 
 himself for advance royalties, the latter should be charged 
 against revenue. It sometimes occurs, where a mine is being 
 operated under several leases, that only a portion of the leased 
 lands are being mined, and that portions thereof will never be 
 worked. Obviously, any minimum royalties paid under terms 
 of leases covering lands in that class should not be carried as 
 deferred charges, and for that reason the advance royalties ac- 
 count should be analyzed and such charges eliminated if included 
 therein. 
 
 If a time limit is set in which the lessee must recoup himself 
 for advance royalties, any portion still carried as a deferred 
 charge at the time the limit expires should be at once charged off. 
 
 All lands, plants, and equipment accounts should be scrutin- 
 ized, and only such charges should be included as represent the 
 cost of lands which add to the area of coal available for future 
 mining, or which cover expenditures for development, construc- 
 tion, and equipment which will result in increased production. 
 
 Provision should be made for reduction of equipment, de- 
 velopment, and construction accounts to the amount of the 
 residual value of the machinery included therein by the time the 
 mines are exhausted. This is usually done by charging mining 
 costs at a certain rate per ton of production. The depreciation 
 of railroad cars, if any are owned, and of live stock, should not 
 be taken care of on such a basis, however, but on the basis of 
 probable length of service. 
 
 While it is desirable to provide for depreciation in value of 
 lands by reason of the depletion of the coal thereunder, it is not 
 certain that mining companies are legally required to replace 
 such wasting capital by reserving any portion of their earnings 
 therefor. In instances where this is not done, the auditor can 
 only call attention to the advisability of such a course, which. 
 
MINING 405 
 
 when followed, is usually based on the number of tons produced. 
 The following extract from a paper prepared by A. Lowes Dick- 
 inson, C. P. A., and read at the St. Louis Congress of Account- 
 ants in 1904, is of interest in this connection : 
 
 In the case of minerals, the product taken out of the land becomes the 
 stock-in-trade of a corporation as soon as it is extracted, and whatever 
 the land was worth before its extraction, it is clearly worth an appreciable 
 amount less thereafter. The provision to be made should be on the basis 
 of the number of tons extracted, having regard to the total tonnage 
 available and to the realizable value of the property after the minerals have all 
 been extracted. The same principle would also apply to timber lands where 
 no provision is made for reforesting. The contention is sometimes made 
 that no provision need be made for exhaustion of minerals where the 
 amount of mineral known to be in a definite tract at the end of any period 
 is largely in excess of that which had been discovered at the beginning 
 of the period. This argument cannot, however, for a moment be admitted, 
 except as a reason for reducing the tonnage rate to be provided. As a 
 general principle, whatever there was in the land, whether known or 
 unknown, has been reduced during the period under consideration by what- 
 ever amount has been extracted; and while the new discoveries may be 
 accepted as reducing the necessary rate of provision for extinction from, 
 say, one dollar to one cent per ton, the original principle that provision 
 must be made holds good on the smaller figure, whatever it is. It may be, 
 of course, that the provisions made in earlier years have been sufficient 
 to cover a number of future years on the basis, from the commencement, 
 of the rate subsequently found to be sufficient in view of the new dis- 
 coveries, and in this case there is obviously no necessity to provide further 
 for extinction until the total production at the new rate is equal to the 
 total amount written off. 
 
 Mortgages upon coal and ore lands usually provide for the 
 establishment of a sinking fund from which to pay off the mort- 
 gage, either in installments or in full on a specified date. The 
 auditor should read carefully all the mortgages of the property of 
 his client and call attention to any unpaid sinking fund charges. 
 
 Some mortgages require payments to be made into the sink- 
 ing funds on the basis of the entire tonnage mined (which would 
 include all coal consumed in the company's operations), while 
 others base the charge only on commercial production, which 
 would be only that actually sold. 
 
 The cash held by trustees of sinking funds is to be used for 
 retiring mortgage obligations only, and therefore should be 
 
4o6 AUDITING 
 
 shown separately on the balance sheet and not mingled with cur- 
 rent cash accounts. 
 
 GOLD MINES 
 
 Accountants are often engaged by committees of dissatisfied 
 creditors or stockholders to investigate the disposition of the 
 cash capital invested in gold, silver, copper, and other mining 
 enterprises. In instances where the ore is found in profitable 
 quantities, the auditor should not feel compelled to accept the 
 periodical cash, production, and shipping statements received 
 from the mine ofHce, unless accompanied by original vouchers, 
 ore records, assay reports, and shipping data. 
 
 Not only should the shipping memoranda be compared with 
 the sales reports, the vouchers for expenditures at the mines 
 compared with the cash statements, and all of the mine reports 
 carefully checked and compared with the general books, but 
 every effort should be made to account for the entire production. 
 Where the product is sent to outside smelters for reduction, tests 
 should be made, using the client's assay reports of values shipped 
 as a basis, to ascertain that the smelter returns are correct. 
 
 The correctness of the distribution of expenditures between 
 capital and operating accounts should be certified to by the mine 
 manager. He should be requested to furnish a certificate setting 
 forth in detail the local current assets and liabilities or the fact 
 that none exist. 
 
 A report from the mine manager upon the efficiency of the 
 plant and equipment, and upon the age and condition of the build- 
 ings and other more or less permanent local assets, is necessary 
 in order to properly consider the question of depreciation which 
 should be allowed for in the accounts. 
 
 A large portion of the mine employees' wages is based on 
 production, and tests of the correctness thereof can readily be 
 made. The balance of the wages should be carefully scrutinized 
 and portions of the pay rolls compared with timekeepers' records. 
 
 Often mining companies own and operate stamping mills, 
 smelters, short connecting railroads, and other enterprises, the 
 accounts of which should also be carefully examined. 
 
 As the accounts and the conditions under which various min- 
 ing enterprises are carried on differ widely, no set instructions 
 
WHOLESALE MERCHANTS 407 
 
 for auditing them can be laid down; the audit should, however, 
 be thorough and detailed enough to cover all possible sources of 
 income, to reveal operating waste, if any exists, and to enable the 
 auditor to satisfy himself that no operating expenses are charged 
 to capital accounts. It is also desirable that the scope of the 
 examination be definitely stated in the auditor's report. 
 
 TRADING— WHOLESALE MERCHANTS 
 
 The audit of accounts of wholesale merchants demands ex- 
 treme vigilance on the part of the auditor, because unless the 
 system is complete, not only as to financial transactions, but also 
 as to accounting for the actual stock received and delivered, the 
 discovery of loss by error or fraud, if any exists, is exceedingly 
 difficult. 
 
 Comparisons should be made of the stock records with the 
 details of the sales and purchases entered in the general books. 
 These should reveal any payments charged as purchases which 
 are not bona fide or for which all the goods were not received. 
 Theft of stock or of the proceeds of such as may have been sold 
 for cash, as well as the shipment of stock without charging cus- 
 tomers therefor, should also be discovered by such comparisons. 
 
 Additional to the possibilities of fraud above mentioned are 
 those in which attempts at concealment are made by making false 
 entries on the financial records only, such as the theft of cus- 
 tomers' remittances, in whole or in part, and allowing their ac- 
 counts to remain open in the ledger, or writing them off through 
 the journal ostensibly as bad accounts, or as having been closed 
 by discounts, allowances, or return of goods; by erroneously 
 reporting the aggregate of cash sales, raising the amounts of 
 vouchers covering cash paid for freight and expressage, etc. 
 
 Particular care must be exercised (to avoid misstating the 
 business results) to ascertain that the mathematical calculations 
 of inventory are correct, that the unsold stock has been priced at 
 either cost or market price — whichever is v!:e lower — and that 
 sufficient allowance has been made for probabl." discounts on 
 customers' accounts not yet due in addition to the usral reserve 
 for uncollectible accounts, depreciation of fixtures, etc. 
 
 In establishments doing an export or import business, ac- 
 counts with foreign houses are usually kept in both foreign and 
 
4o8 AUDITING 
 
 United States currencies. As many of such accounts are settled 
 in foreign currency, it is necessary to calculate at the current 
 rate of exchange the equivalent in American money of the foreign 
 balances, and to take up in the profit and loss account the differ- 
 ences between these equivalents and the balances in the accounts 
 kept in American money. Differences between balances in 
 foreign banks and the equivalent in American money should be 
 similarly adjusted. 
 
 In stating the results from trading, the total sales, the cost of 
 sales, and the gross profit should be shown separately, so that the 
 auditor may judge if the percentage of the latter is up to the 
 rate which may reasonably be expected to have been realized. 
 The subject of gross profits on sales is treated in further detail 
 under the caption of "Retail Merchants." 
 
 RETAIL MERCHANTS 
 
 The volume of detail in a retail business of any size, partic- 
 ularly if credit is extended to customers, is so great that it is 
 difficult to make a satisfactory audit for a moderate-sized fee. 
 It is obvious that a complete audit of all the details is out of the 
 question, but the tests of the correctness of the different sections 
 of the accounts should be sufficiently varied and comprehensive 
 to disclose any systematic manipulation of the accounts. 
 
 If the business is a large one, some system of internal sales 
 audit will probably be in use. The auditor should trace the daily 
 totals into the general books and also test the make-up of the 
 daily totals. It may also be possible for him to suggest addi- 
 tional safeguards for the prevention of irregularities in the hand- 
 ling of cash sales. 
 
 If the work in connection with the customers' charge ac- 
 counts is properly systematized, the auditor can verify the ac- 
 counts receivable with some degree of assurance. The sales, 
 returns, and allowances and cash totals should all be traced into 
 the controlling accounts and the trial balances of the customers' 
 ledger verified. A good verification of the outstanding balances 
 is for the auditor to compare the monthly statements at the close 
 of the period, either with the trial balance, or if that has not yet 
 been prepared, then with the ledger itself, before the statements 
 are sent out. 
 
RETAIL MERCHANTS 409 
 
 It is customary to allow employees of the store a special dis- 
 count on their purchases and also to permit their accounts to 
 run until pay day, when settlement is made. If these accounts 
 are numerous, they should be segregated either in a separate 
 ledger or in a section of one of the customers' ledgers. The 
 auditor should see that none of these accounts has been per- 
 mitted to run past pay day without settlement being made, and 
 particularly that no balances are standing against persons who 
 have left the employ of the store. 
 
 In some businesses, particularly those handling small articles 
 broken from original packages, it is not feasible to keep complete 
 stock accounts and some other check on the accounting, for the 
 wares handled must be used. This is found to some extent in a 
 comparison of the rate of gross profit earned in one period as 
 compared with prior periods. Decided variations should be sus- 
 ceptible of definite explanation as being due to specific causes ; a 
 decrease in the percentage of gross profit which cannot be satis- 
 factorily explained raises at least a presumption that the pro- 
 ceeds of sales are not being fully accounted for, or that payments 
 are being made for goods which are not actually being received 
 by the house. 
 
 Percentages of gross profit are by almost all merchants cal- 
 culated on the sales, and not on the cost of the goods sold. 
 
 In some lines of retail trade, such as cigars, men's furnishing 
 goods, etc., it is possible to apply a check on the accounting for 
 sales which is also used in some department stores. The plan 
 is to charge all goods purchased to a stock account at their sell- 
 ing values; credits are made on the account for any changes in 
 selling prices ; the inventories at beginning and end of the period 
 are priced at both cost and selling value, and the latter values 
 applied in stock account mentioned. The crediting of the actual 
 sales of the period should balance the account. There will natu- 
 rally be some differences, but if they are not very large, the sales 
 can be considered to have been fully accounted for. 
 
 Some method of determining the approximate stock on hand, 
 even if calculated only on the basis of an estimated rate of gross 
 profits on sales, is needed by all merchants for the purpose of 
 determining the proper amount of insurance to be carried on the 
 stock, as well as to prevent overbuying. 
 
4IO AUDITING 
 
 Whenever several different lines of goods are handled, both 
 sales and purchases should, as far as possible, be kept separate 
 for each line. The rates of gross profits on the different lines will 
 probably vary, and the information as to the results of the busi- 
 ness done in each class of goods will be valuable to the manager. 
 
 In a business conducted entirely on a cash basis the number 
 of customers' accounts is greatly reduced, but they are not in all 
 cases entirely eliminated, as regular customers often leave de- 
 posits to avoid the inconvenience of paying separately for each 
 purchase. The auditor should see that deposit accounts are not 
 overdrawn, and that if interest is credited, it is at the proper rate. 
 
 A quite general practice is to issue a credit memorandum to 
 customers returning goods, which memorandum may be either 
 applied in payment of subsequent purchases or cashed on presen- 
 tation to the cashier. It is desirable that these credit memoranda 
 be controlled by an account on the general ledger. If this is 
 done, it is possible for the auditor to satisfy himself by testing 
 entries for credit memoranda issued and paid, and by reconciling 
 the aggregate of the outstanding memoranda with the balance 
 of the controlling account, that the credit memoranda have been 
 properly handled. 
 
 DEPARTMENT STORES 
 
 A department store is really a group of retail stores in dif- 
 ferent lines of business with one general management and with 
 the accounting centralized in one department. 
 
 Practically all department stores have a more or less efficient 
 staff auditing department. This department pays particular at- 
 tention to the continuous auditing of the sales. The volume- of 
 detail in connection with the cash and charge sales is so great 
 that the professional auditor is not expected to go back of the 
 summaries prepared by the auditing department. He should, 
 however, see that the various totals on the summaries are prop- 
 erly carried into the general books. 
 
 The auditor should also satisfy himself by careful investiga- 
 tion that the system of internal audit is such as to insure an 
 accounting for all sales. It is particularly important to see that 
 the system of handling C. O. D.'s and "will calls" (similar to 
 C. O. D.'s, excepting that the customer will pay for the goods on 
 
DEPARTMENT STORES 411 
 
 calling for them at the store, instead of having them delivered) 
 is such as to reduce the possibility of fraud or error to a minimum. 
 ControlUng accounts for these classes of transient items are of 
 decided assistance in this respect. 
 
 The volume of merchandise purchases in a department store 
 is very large, and it is out of the question under ordinary circum- 
 stances for the auditor to examine all or even a considerable part 
 of the purchase invoices. Tests should be made, however, and 
 especial care should be given to see that a proper plan of verify- 
 ing and approving each invoice is in use and that it is actually 
 carried out. It is important that the plan be such as will guard 
 against the failure to deduct freight when the goods are bought 
 on a deHvered basis, shortages in weight or count, and allow- 
 ances for defects or inferior quality. Frequently goods are paid 
 for before they are actually received in order to obtain the cash 
 discount obtainable for early payment. The system of approv- 
 ing invoices should insure such purchases being verified on re- 
 ceipt of the purchased goods and insure that claims, if any be in 
 order, are made. 
 
 As discounts on purchases form no small part of the net 
 income of department stores, it is desirable that this subject re- 
 ceive attention during the course of the audit. Almost all de- 
 partment stores are wide-awake to the importance of having all 
 invoices approved as quickly after receipt thereof as possible, so 
 that the discount day may not pass before the approved invoice 
 reaches the treasurer's department for payment. Should the 
 auditor, however, discover any deficiency or weakness in this 
 respect, he may rest assured that his client will very much appre- 
 ciate having his attention called to the matter. 
 
 Salaries and wages form the largest single item in the ex- 
 penses, and the verification of the expenditure therefor is of 
 prime importance. The padding of pay rolls as far as sales clerks 
 are concerned can usually be detected by comparing the pay roll 
 with the auditing department's analysis of sales by sales clerks. 
 Vice versa, this is also somewhat of a check on the statements of 
 sales. The payments for expenses will be found to be very 
 voluminous, and it would not be practicable to vouch them with 
 any approach to completeness. A study of the comparisons 
 shown by the departmental accounts for different periods will, 
 
412 
 
 AUDITING 
 
 however, indicate such of the expenses as should be specially 
 investigated. 
 
 Almost without exception, some form of departmental ac- 
 counts, i. e., accounts showing the operations of each department 
 separately, will be found to be in use in every store. Their ac- 
 curacy and completeness vary : in some cases they are very com- 
 plete and are controlled by accounts in the general ledger; in 
 other stores they are on a single-entry basis, arbitrary charges 
 for rent, interest on stock, and similar items are made of which 
 no cognizance is taken in the general books, and no attempt is 
 made to bring the aggregate of the results shown in the depart- 
 mental accounts into agreement with the final results shown on 
 the general books. It is certainly most desirable that the depart- 
 mental accounts be controlled by the general ledger, and if the 
 system of accounts be well laid out, it is entirely feasible. 
 
 While daily statements of sales and weekly or monthly state- 
 ments of profits (based on estimated inventories) are furnished 
 to the management, most stores close their books and state the 
 final results of their business operations twice a year, the closing 
 dates being either the end of January and July or of June and 
 December. The first half of the year is called the spring season 
 and the latter half the fall season. In comparing the operations 
 of a department for different periods, the comparison should 
 always be made between the same season in different years and 
 not between the two seasons in the one year. The volume and 
 character of the business done in the spring season varies con- 
 siderably from that of the fall season. 
 
 In studying the operations of the various departments, one of 
 the most important things to be considered is the rate of gross 
 profit on sales. Any undue fluctuation therein from one year to 
 another should be thoroughly investigated. Fluctuations in the 
 ratio of selling expenses to sales should also receive careful at- 
 tention. The volume of business done exerts, of course, a more 
 noticeable influence on the percentage which the expenses are 
 of the gross sales than should be the case with the gross profit. 
 
 The basis of the apportionment among the various depart- 
 ments of such expenses as delivery service, wrapping desks, in- 
 surance, general administration, etc., ought to be investigated. 
 A rough and ready way of distributing such general charges may 
 
AUTOMOBILE DEALERS 413 
 
 work serious injustice to some departments, undue advantage to 
 others, and result in misleading showings generally. 
 
 In verifying the assets and liabilities, no unusual questions 
 of principle are encountered. The principal assets are accounts 
 receivable and merchandise inventory. Customers' accounts re- 
 ceivable should be analyzed as to date ; this will furnish a basis 
 for the determination of a proper amount to be reserved for un- 
 collectible accounts. Notes receivable held by a department 
 store may ordinarily be viewed with some suspicion as to the 
 financial strength of the makers. Goods sold at retail are usu- 
 ally purchased by the customer for consumption and not for re- 
 sale; consequently the account should be paid at maturity and 
 the giving of a note therefor is a confession of the customer's 
 having purchased in excess of his ability to pay. 
 
 The important questions in connection with the inventory 
 are the correctness of quantities, prices, arithmetical work, and 
 salability of the stock. For the correctness of the quantities the 
 auditor will be dependent largely on the certification of those 
 who took the inventory and of the "buyer" (department man- 
 ager). The investigation of large increases or decreases in the 
 inventory as compared with prior dates will sometimes result in 
 the detection of errors in quantities. Prices may be tested by 
 reference to the purchase invoices. Goods which are still in orig- 
 inal packages should be inventoried by reference to the purchase 
 invoice therefor, and verification thereof is comparatively simple. 
 Sufficient tests of the extensions and footings should be made to 
 assure the correctness of this element. Goods should be so indi- 
 cated on the inventory that those purchased prior to the current 
 season can be readily identified and allowance made for eventual 
 loss thereon owing to the necessity for price reductions to close 
 them out. (See page 104, "Inventories.") 
 
 Some department stores, in fact quite a number of them, also 
 have a wholesale department. Whenever this is the case, the 
 audit of the accounts pertaining to the wholesale department will 
 follow the lines laid down under "Wholesale Merchants." 
 
 AUTOMOBILE DEALERS 
 
 It is important that the auditor thoroughly familiarize him- 
 self with the terms of the dealer's contract with the manufactur- 
 
414 AUDITING 
 
 ers. Deposits with the latter are not accounts receivable, but 
 payments on account of cars to be purchased during the contract 
 period, and the amounts so deposited may be deducted pro rata 
 from the price to be paid for each car or from the last shipments. 
 The unapplied balance of such deposits should be confirmed by 
 correspondence with the manufacturers. Interest on these de- 
 posits is sometimes paid by the manufacturers, and where this is 
 the case its collection should be verified. 
 
 Deposits by customers with the dealer should appear in 
 separate accounts, as they are not current accounts payable. If 
 any interest is to be allowed on such deposits, the auditor should 
 ascertain that proper entries for the accrued portion thereof have 
 been made. 
 
 Cars on hand should be physically examined and their 
 numbers compared with the daily car record. The ownership of 
 cars in the possession of others for alterations or other pur- 
 poses should be confirmed by correspondence. The invoices for 
 unsold new cars should be used to verify the prices at which they 
 are taken into the inventory and the second-hand cars should be 
 appraised, but in no case should the appraised values exceed the 
 allowances made to the customers for the cars plus the cost of 
 overhauling them. Usually the dealer incurs a loss on the sale of 
 second-hand cars, and this fact must be considered in passing 
 upon their value for balance-sheet purposes. 
 
 Statements of accounts receivable balances, after being 
 stamped with request to communicate directly with the auditors 
 if not correct, should be sent to all customers. Liberal allowance 
 should be made for the probable loss on any old or disputed 
 accounts. 
 
 All accounts with manufacturers should be checked against 
 statements received from them. This is important, as allow- 
 ances are often made to satisfy customers and charged to the 
 manufacturers, but for which the latter will not pass credit to the 
 dealer. 
 
 The inventories should be carefully examined, all obsolete 
 parts eliminated, and allowance made for probable loss by fall- 
 ing off in demand for parts of cars manufactured prior to the 
 audit year. In some cases manufacturers agree .to keep a certain 
 quantity of parts on hand at the dealers' repair shops. The value 
 
BRANCH ACCOUNTS 415 
 
 of such consignments should either be deducted from the inven- 
 tory or be shown in a separate ledger account. 
 
 The correctness of the cost of work in progress in the dealer's 
 repair shop should be tested by examination of the shop cards. 
 All of the cars, both new and second-hand, on hand at the begin- 
 ning of and purchased during the audit period should be ac- 
 counted for as charged against some customer or as still on hand 
 at the close of the period. 
 
 Tests should be made of the deliveries from stock to ascer- 
 tain that parts and supplies are paid for in cash, charged to 
 customers either directly or on shop or road repair cards, or are 
 properly used to repair demonstrating cars and second-hand cars 
 taken in exchange. Charges for shop and road repair work 
 should also be checked. 
 
 Time reports of workmen in repair shop and the preparation 
 of pay rolls should be investigated to ascertain that actual work 
 only is paid for, and that it is charged on shop or road repair 
 cards. Office, demonstrating, and general expenses should be 
 vouched and compared with prior periods. Contracts with sales- 
 men should be examined and commissions paid to them verified. 
 
 A liberal reserve should be made for free repairs to sold cars, 
 which are usually necessary during the year subsequent to car 
 sales in order to retain the good will of customers, but the cost of 
 which will probably not be collected from the manufacturers. 
 
 BRANCH ACCOUNTS 
 
 The close relation which. exists between a branch house and 
 the parent concern presupposes the existence of complete records 
 or reports at the head office; but it will be necessary for the 
 auditor to ascertain definitely how complete the branch records 
 are and by what system they are reflected in the general books. 
 
 Some branches keep a full set of books and furnish regular 
 returns as required by the home office. In such case the latter 
 will have but a current account with the branch in the general 
 books, which will be a controlling account, and will represent the 
 branch's capital, composed of the assets at the branch less the 
 liabilities. Usually such assets will be represented by cash, stock 
 on hand, and accounts receivable, and in preparing the final or 
 consolidated balance sheet, the branch balances must be divided 
 
4i6 AUDITING 
 
 into the various classes of assets of which they are made up. 
 They should never be treated simply as an account receivable. 
 Where a branch is not visited by the auditor, complete reports or 
 returns should be furnished him, properly certified, and so far as 
 may be necessary he should check them into the head ofifice 
 books. All cash remittances included in the branch report, as 
 well as all cash sent from the head office, should be vouched in 
 the general books. A reconciliation of the account between the 
 branch and the head office should be made, either at a particular 
 date during the audit or as of some date within the period under 
 review. The only items affecting such reconciliation will be the 
 cash or invoices in transit, and these should subsequently be 
 vouched to determine the absolute harmony between the two 
 sets of books. 
 
 Some concerns allot a permanent cash fund to each branch, 
 and require that all receipts be deposited to the credit of the 
 home office. In such cases it will be necessary to see that the 
 moneys received at the branch appear on the bank statement or 
 pass books as deposited. 
 
 When an auditor accepts the certificate of officials or other 
 persons for the verification of assets at branches, he should limit 
 his responsibility by a statement to that effect in his report. He 
 should, however, satisfy himself that all questions of principle, 
 such as valuation of stocks, depreciation, reserve for bad debts, 
 etc., have been properly considered. 
 
 Some head offices now have on file duplicates of all records 
 prepared by the branch houses. The latter are able to furnish 
 these by the use of typewriters or other mechanical bookkeeping 
 devices adapted for the purpose. By one operation customers' 
 ledgers are posted, customers' monthly statements are written, 
 and duplicate ledger sheets are prepared for the head office, while 
 duplicate records of cash receipts and disbursements form a cash 
 book with which it is possible to keep in close touch. The facil- 
 ities thus afforded, whereby instant reference can be had to 
 branch transactions, make possible a most satisfactory branch- 
 house internal audit at the home office. 
 
 Goods billed to retail branches by the head office are charged 
 either at cost price, at cost price plus a percentage, or at selling 
 price, inventories in each case being taken on a similar basis. For 
 
BRANCH ACCOUNTS 417 
 
 balance-sheet purposes the auditor should see that the values of 
 the stocks in the last two cases have been reduced to cost or 
 market price. 
 
 Schedules of debtors at the branch should be submitted duly- 
 certified and the auditor should make certain that all branch 
 liabilities not already shown in the head office books have been 
 taken into account. 
 
 In making up a balance sheet of the concern as a whole, the 
 auditor must not overlook the fact that accounts between 
 branches and the home office included in controlling accounts 
 with the ordinary receivables and payables are to be eliminated. 
 
 In addition to the points mentioned above, the audit of 
 foreign branches involves the question of exchange, and this re- 
 quires that the conversion of the various items into domestic cur- 
 rency should be checked and that the difference in exchange as- 
 certained to have been properly handled. In the case of English 
 or French currency, the rate of exchange is sufficiently stable to 
 warrant the accounts being converted on a fixed basis, and the 
 only difference will then be in connection with remittances. 
 Where exchange fluctuates, the value of the fixed assets should be 
 converted into domestic currency at the rate at which actually 
 purchased, the current assets and liabilities at the rate prevailing 
 at the close of the fiscal period, and remittances during the period 
 at the actual rate at which made. If the conversion results in a 
 loss, it should be charged off ; if a profit, it is proper and is some- 
 times considered desirable to carry it forward as a reserve against 
 possible losses in a succeeding period. 
 
CHAPTER XXV 
 
 SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS 
 
 (Continued) 
 
 PUBLIC UTILITIES 
 
 For a number of years there has been a growing tendency 
 toward strict regulation of public service corporations. Wiscon- 
 sin, the pioneer State in this movement, has for some years had a 
 commission which has done very effective and progressive work 
 in this respect, and New York's Public Service Commissions 
 (there being two, one for the counties of New York, Kings, 
 Queens, and Richmond, and the other for the other counties in 
 the State), which were created in 1907, have also performed good 
 service. Some other States have also created similar commis- 
 sions or have conferred real power on formerly ineffective gov- 
 ernmental bodies which were nominally charged with the duty of 
 regulation, but which were without authority in law to enforce 
 their mandates. 
 
 The powers of the various commissions vary. In some States 
 they have large powers, such as the right to grant or deny 
 franchises, to regulate the issue of stocks, bonds, and other evi- 
 dences of corporate indebtedness, to regulate rates, to issue man- 
 datory orders with reference to operation, etc. One of the 
 powers with which practically all these newer commissions are 
 vested is that of prescribing uniform systems of accounts for the 
 various classes of public service corporations coming under their 
 jurisdiction. This is rightly regarded as an important element 
 in the proper regulation of the conduct of public utilities. Classi- 
 fications of accounts have been promulgated by the commissions 
 of a number of States for electric railways, gas companies, and 
 electric light, heat, and power companies. These classifications 
 have frequently been prepared after consultation with represen- 
 tatives of such bodies as the American Street and Interurban 
 Railway Accountants' Association and with prominent public 
 accountants and conferences between the commissioners of vari- 
 ous States, so that the variations between the classifications pre- 
 
 418 
 
PUBLIC UTILITIES 419 
 
 scribed by different States and by the Interstate Commerce Com- 
 mission (which also exercises jurisdiction over certain classes of 
 public service corporations other than steam railroads) are not 
 material. The principal feature of these classifications which 
 might call for criticism is a tendency toward too minute a sub- 
 division of the operating expenses. To relieve small companies 
 of the burden which would be imposed by requiring them to use 
 in complete detail the prescribed classifications, the classifications 
 have been condensed somewhat for moderate-sized companies, 
 only the very large companies being required to use the classifi- 
 cations in their entirety. The distinction is drawn by making 
 each grade of classification obligatory on companies having gross 
 annual revenues within certain limits. 
 
 The earliest, and still most important, instance of govern- 
 mental regulation of public utilities was the creation of the Inter- 
 state Commerce Commission in 1887 to supervise steam railroads 
 transacting an interstate business. The Commission early in its 
 existence began to require the submission by the railroads of 
 annual reports prepared on uniform lines. In 1906, a number of 
 very important amendments were made to the Interstate Com- 
 merce Act. The jurisdiction and powers of the Commission were 
 greatly extended. In addition to steam railroads, all electric rail- 
 ways, express companies, sleeping-car companies, carriers by 
 water (as described in the act), pipe lines (excepting water and 
 gas), and telephone companies whose business activities are not 
 confined within the limits of one State, are subject to the Com- 
 mission's authority. The Commission now has the power to fix 
 maximum rates, a power most far-reaching in its effects, not 
 only on the corporations subject to its authority, but also on the 
 communities whose ability to maintain their commercial suprem- 
 acy or equality of advantage is dependent on the fixing of fair 
 rates as compared with those enjoyed by competitive points. 
 Another notable broadening of its powers was the conferring of 
 the right to prescribe a uniform system of accounts for each class 
 of corporations subject to its authority, and the enforcement 
 thereof by making deviation therefrom a penal offense. This 
 was an important development of the limited power formerly en- 
 joyed of calling for uniform reports. 
 
 A most important feature of the new classification of ac- 
 
420 AUDITING 
 
 counts for steam railroads promulgated after the enactment of 
 the amendments of 1906 is the requirement that periodically 
 entries be made for depreciation of equipment. It may well 
 be expected that in time depreciation charges will also be 
 required to be made for all other parts of the physical property 
 which are subject to depreciation or gradual exhaustion. This 
 recognition by a governmental body of a fundamental account- 
 ing principle is gratifying to accountants, who stood for years 
 practically alone in their advocacy of the need for depreciation 
 charges in the accounts of railroads and all other public utilities. 
 
 State Legislatures can, and in some cases already have, en- 
 acted laws delegating to commissions or municipalities the power 
 to fix the rates to be charged by public service corporations oper- 
 ating within the State. Under these circumstances the auditor 
 has responsibilities additional to those which simply consider the 
 stockholders. In a sense he stands between the company and the 
 public. Should depreciation allowances and other necessary re- 
 serves be omitted from the accounts, the apparent profits shown 
 will be larger than is actually the case and may result in an agi- 
 tation for a reduction in rates charged to consumers which the 
 real facts in the case do not justify. In the ensuing litigation it 
 will probably be very difficult to convince either judge or jury 
 that depreciation charges, etc., which were not made at the 
 proper time should now be allowed as an element in the cost of 
 operation. On the other hand, if the reserves for depreciation 
 and the like are excessive, the profits will be shown at less than 
 their real figures and the public will be deceived. 
 
 The importance of this subject was recognized at a national 
 gathering of public accountants as long ago as 1904, when a 
 paper on the subject was read and a special committee was ap- 
 pointed to consider the matter. This committee later reported 
 as follows : 
 
 The committee appointed at the Congress of Accountants, held at 
 St. Louis, U. S. A., in September, 1904, to review the paper by Robert 
 H. Montgomery, C. P. A., upon "The Importance of Uniform Practice in 
 Determining the Profits of Public Service Corporations Where Municipalities 
 Have the Power to Regulate Rates," having taken the paper into considera- 
 tion, have come to the following conclusions, and now beg to state the 
 same as their opinion upon the questions raised: 
 
 I. A distinction must be made between the profits of an undertaking 
 
PUBLIC UTILITIES 421 
 
 from the point of view of the general community and the profits available 
 for dividends from the point of view of a corporation owning such under- 
 taking. The former would be the net earnings from the operation of the 
 undertaking, after providing for all waste or depreciation of capital assets 
 arising directly out of such operation; while the latter would be arrived 
 at only after providing also for any possible loss on capital assets arising 
 from causes not directly incident to such operation and for interest on 
 borrowed money. 
 
 II. The net earnings of a public utility with which the general com- 
 munity is concerned are determined by the excess of gross earnings over 
 expenses, defining the latter terms as follows: Gross earnings consist 
 of the charges for all services rendered during the period as distinguished 
 from mere receipts, but would exclude incidental earnings not arising out 
 of the operation of the utility, such as interest on investments. 
 
 Expenses consist of: (i) The direct cost of operation and of main- 
 tenance (ordinary repairs), expenses of management and provisions for 
 bad debts, damage claims and rebates, as well as extraordinary expenses 
 incurred during the period, such as legal charges, etc., but they should not 
 include interest on borrowed money, discounts on bonds issued, or other 
 charges in connection with the promotion or financing of the undertaking. 
 (2) Depreciation : (a) On plant — physical — covering wear and tear, in- 
 cluding direct requirements for renewals, etc., arising both from known 
 and probable causes, such as electrolysis, etc. (b) On plant — indirect — 
 due to obsolescence and the like, but not that due to a fall in value from 
 general causes, (c) On other capital, assets which are diminishing in 
 value as a direct result of the operation of the property, such as moneys 
 properly expended in acquiring from the local authorities the franchise under 
 which the utility is operated where such franchise is, as is usually the case, 
 terminable after a certain number of years; or cost of mines, quarries, 
 or other similar properties which are being used up continuously for the 
 purpose of operating the utility. But there should not be included any 
 provision for recouping promoters' profit or other watered capital, or for 
 possible loss by reason of a general fall in values, etc., on the purchase 
 at the end of the franchise of the whole undertaking by the public au- 
 thorities, i. e., the State or municipality. 
 
 III. In dealing with the private accounts of a corporation operating 
 the utility, earnings will also embrace miscellaneous receipts, if any, not 
 connected with the actual operations of the undertaking, and the following 
 additional expenses should be allowed for before arriving at a balance 
 available for distribution: 
 
 (i) Depreciation: An additional amount to cover any excess of the 
 book value of good will, franchise, and plant over that provided for under 
 section 2, subsection (c) above, or over the sum it may be expected to 
 realize on the expiry of the franchise. 
 
 (2) Interest: On bonds or other funded or floating debt. 
 
 IV. In determining the rates which should be charged to the public, 
 
422 
 
 AUDITING 
 
 regard must be had (a) to the profit ascertainable under section II, and 
 (b) to further charges specified under section III, which would have to 
 be borne by the corporation out of such profits. For instance, if eight 
 per cent per annum on the capital invested is considered a reasonable rate 
 for a corporation to earn, taking into consideration the risks in section III, 
 then the rates should be fixed so as to allow of a profit of eight per cent 
 calculated as laid down in section II, and out of this profit the corporation 
 would have to provide for the risks and expenses stated in section III. 
 
 A. Lowes Dickinson, Ernest Reckitt, 
 
 Elijah W. Sells, John B. Niven, 
 
 Harvey S. Chase, Robert H. Montgomery, Chairman. 
 
 One of the most vital questions confronting the auditor of 
 pubHc utiHty accounts is the separation of all expenditures into 
 the two classes of capital and revenue, or — as they are more often 
 termed in practice — construction and maintenance. Frequently 
 expenditures are of such a nature that it is open to debate as to 
 whether they belong in the one class or the other. 
 
 A factor which contributes to make the distinction difficult is 
 that most public service corporations, particularly railways and 
 light and power plants, do not have any but very extensive addi- 
 tions to plant made by outside contractors. The work is done, 
 under the direction of their own engineers, by their own work- 
 men. As these same forces also do the current maintenance 
 work and use the same kinds of materials for construction as for 
 maintenance purposes, it is practically impossible to determine 
 merely from the nature of the labor and material expenditures 
 whether they are capital or revenue charges. 
 
 The only satisfactory solution of the problem is for the com- 
 pany to keep such cost accounts of its construction work as will 
 relate the expenditures to the thing done or accomplished. It is 
 then possible for the auditor to satisfy himself by conference 
 with the company's engineer, as well as by his experience with 
 other engagements in the same field, whether or not the capital 
 charges are proper. Unfortunately, many companies do not 
 keep such construction cost records, though all should. Where 
 they are lacking, one of the best things for the auditor to do is 
 to have the engineering department submit a statement of the 
 construction work done during the period under review and the 
 legitimate cost of each part thereof. Such a statement will usu- 
 ally be of material assistance in passing on expenditures which 
 
PUBLIC UTILITIES 423 
 
 have been charged to capital account. The best managed com- 
 panies have a system of "Construction Authorizations" which 
 are prepared by the engineering staff and approved by the board 
 of directors or executive committee. These authorizations form 
 the best basis for construction cost accounts. 
 
 Charges for additional equipment are usually more easily 
 traced, and there is not, as a rule, much difficulty in coming to a 
 conclusion as to whether the charges should go to capital or 
 revenue. 
 
 Whide it is advisable that in cases of doubt the decision be 
 in favor of the conservative policy of charging the items in doubt 
 to maintenance, yet excessively conservative practice must also 
 be avoided, as it increases the apparent cost of service rendered 
 and consequently is unjust to the consumers. 
 
 There is no question but that the cost of the original plant 
 and all extensions and additions are proper capital charges. Re- 
 construction expenditures frequently give occasion to much 
 doubt as to their proper apportionment. If the reconstruction 
 has resulted in increased capacity, some portion thereof is prop- 
 erly chargeable to capital. The most equitable plan is to 
 charge to capital the reconstruction cost and eliminate therefrom 
 the cost of the construction work or equipment which has been 
 replaced. The result is that the plant always stands on the 
 books at the last cost, i. e., the cost of the plant as it stands at the 
 present time. In cases involving the determination of rates 
 which are equitable to the consumers and yet at the same 
 time yield a fair return on the actual investment, it is certainly 
 most satisfactory to have the investment in plant appearing at 
 the cost of the present plant, and not at the cost of the plant as it 
 was at some earlier date. 
 
 In considering the question of a proper charge for deprecia- 
 tion of plant, which is an element in the cost of service rendered 
 (see Section II, subsection 2 (a) of the report supra), it would 
 seem that it should be based on the cost of the plant in operation. 
 This would necessarily include the last cost of any parts of the 
 plant which might have been reconstructed or replaced since its 
 original construction. 
 
 While there is necessarily a different classification of ac- 
 counts for each of the various classes of public utilities, the 
 
424 AUDITING 
 
 general principles underlying all of them are the same. A 
 committee of the American Association of Public Accountants 
 submitted to the 1907 convention of the Association the follow- 
 ing: 
 
 STANDARD SCHEDULE OF REVENUE AND EXPENSE 
 (Income and Expenditure) 
 
 For Municipal Industries and Public Service Corporations 
 
 Hetenue from Operatinq 
 
 Gross Earnings from PubUc Services S 
 
 Gross Earnings from Private Consumers 
 
 Gross EarmngB from By-Products, etc 
 
 Total i 
 
 Deduct Rebates, Refunds, Discounts, etc 
 
 Total Revenue from Operating % 
 
 Expense op Operatinq 
 
 1. Expense of Manufacture: 
 
 Operation ) 
 
 Maintenance 
 
 Product Purchased (Gas, etc.) ' . . 
 
 2. Expense of Distribution: 
 
 Operation . ... 
 
 Maintenance 
 
 3. General Expense (Salaries, Office Supplies and Expenses) . . . 
 
 Total (1, 2, and 3) 
 
 4. Taxes (Real Estate and Other) 
 
 5. Franchise Tax^ (paid or accrued annually or otherwise) .... 
 
 6. Rentals (Leaseholds, etc.) 
 
 7. Insurance (Fire, Accident, and Fiduciary) 
 
 8. Damages (including Extraordinary Legal and Other Expenses and Losses) . 
 
 9. Guaranty (Bad Debts Written Off and Reserve for Doubtful Accounts) 
 10. Depreciation (Deterioration Written 0£E and Reserve for Estimated 
 
 Depreciation) . . 
 
 Total Expense of Operatmg 
 
 a. Net Revenue from Operating (or Deficiency) 
 
 b. Other Revenue or Income, net (from Sources Other Than Operating) .... 
 0. Appropriations for Operating, Provided by the Municipality from General Funds 
 
 Total Available Income . 
 
 Disposition of Available Incoub 
 
 11. Interest on Funded and Floating Debts 
 
 Remainder of Available Income . . . . 
 
 12. Reserved for Sinking Funds . ... S 
 
 13. Reserved for Amortization Funds 
 
 14. Reserved for Other Funds . 
 
 Total Reserves 
 
 15. Dividends (Private Plants) 
 
 16. Appropriation to General City Funds (Public Plants) . 
 
 Total disposition of Available Income . . . 
 Credit (or Debit) balance transferable to "Surplus" 
 
 Note.— The various items in this condensed statement (pardcularly expense items 1, 2, and 3) should be 
 supported by detailed schedules. 
 
 This is a condensed form suitable for any form of public 
 utility — railway, gas, electric light and power, water works, or 
 telephone — and would be accompanied by schedules giving the 
 
PUBLIC UTILITIES 425 
 
 details pertaining to the particular utility for which used. It 
 would be especially useful in comparing the operations of differ- 
 ent undertakings, as it brings out quite distinctly those items 
 whose treatment is a matter of judgment, such as depreciation, 
 or which for any other reason may be considered as "variables." 
 
 The exhaustive report of the National Civic Federation on 
 "Municipal and Private Operation of Public Utilities," issued in 
 1907, will be of both interest and value to the accountant who 
 wishes to devote especial attention to the accounts of public serv- 
 ice corporations. 
 
 The tendency of legislation for the regulation of rates to be 
 charged by public service corporations is to limit them to such 
 rates as will not yield more than a moderate return on the capital 
 actually invested. As the accounts of but very few companies 
 have been kept in such a way as to exhibit clearly or conclusively 
 the cost of the plant, not to mention proper allowances for depre- 
 ciation, one of the first steps when fixing of rates, renewal of 
 franchises, or similar negotiations are under consideration, is to 
 have the property appraised. The following suggestions for the 
 making of such an appraisal are quoted from Mr. Henry Floy's 
 recent book on "The Valuation of Public Utility Properties." 
 
 APPRAISALS OF PUBLIC UTILITIES 
 
 Suggested Procedure: A valuation, to be complete in the fullest 
 sense, must take into consideration not alone the original cost, present 
 value, or cost of reproduction of the physical plant, but also the intangible 
 and non-physical values, the limitations of franchise, as well as the market 
 quotation of securities. To complete a valuation of such broad scope, the 
 following method of procedure is suggested : 
 
 (a) Obtain from the proper officials of the company data, drawings, and 
 specifications covering original construction as well as later additions, also 
 lists of material and supplies, and if available, a complete inventory of all 
 existing physical property. Where inventories are incomplete, as is usually 
 the case, they must be completed by field inspection, and in every case 
 verified and checked. How thoroughly and with what detail inspection 
 may be necessary depends on the thoroughness of the appraisal being made. 
 For example, test holes may have to be sunk in order to verify information 
 as to excavation, foundations, buried pipes, duct lines, or other subsurface 
 structures. The size, quantity, and condition of all physical property must 
 be determined. 
 
 (6) Obtain available data as to costs and prices by examination of 
 corporation vouchers, not only for the period in which the appraisal is 
 
426 AUDITING 
 
 being made, but covering also original cost. Classify the cost of different 
 materials and labor, in accordance with that method which will enable a 
 convenient and easy comparison for the appraisal work in hand. Particular 
 attention should be given to expenditures during the early history of the 
 company covering items that may properly be qualified as "Development 
 Expenses," such as interest, taxes, and similar expenses during construction, 
 checking the cost as ascertained from vouchers with the book cost. The 
 two are not likely to agree, due to destruction of old records, accidentally 
 or otherwise, and the fact that expenditures may have been made and no 
 vouchers received therefor. 
 
 (c) Examine the record books of the corporation, ascertaining there- 
 from all information as to the issuance of stocks, botids, or other forms 
 of indebtedness, the cash received therefrom, records of transactions of 
 the officials in authorizing contracts, and the prices thereof. 
 
 (rf) A personal inspection and examination must be made of a physical 
 property by the individual in charge of the appraisal work, and a more or 
 less detailed acquaintance had with the plant and the conditions under 
 which it is operating, even though the working out of detailed information 
 is left to one's subordinates. 
 
 (e) Determine the unit prices to be used and the percentages to be 
 allowed in connection therewith; the fixing of unit prices and percentages 
 to be added depends upon the basis adopted for the prices themselves. 
 
 (f) Using the completed inventory, the unit prices determined upon 
 are to be applied and the work carefully checked to avoid errors. Two 
 inventories and two sets of unit prices may be necessary if both the original 
 cost and the cost of reproduction are being determined. To the totals 
 obtained from applying the unit prices to the inventory should be added 
 the percentages for engineering, contingencies, and administration or super- 
 intendence during construction, etc., in order to obtain the cost of the 
 physical plant. 
 
 (g) If the depreciated or present value is desired, the amount of 
 depreciation must be determined in accordance with the principles laid 
 down in the chapter on "Depreciation" and this sum deducted from the 
 cost, giving the present value of the physical plant. 
 
 (h) Investigate the actual operating conditions, method of serving 
 the public, rates charged, system of providing for depreciation, and main- 
 tenance of the property. 
 
 (j) Ascertain the limiting conditions in the Articles of Incorporation, 
 charters, franchises, municipal contracts, or other governing obligations, 
 determine whether local conditions are such as to promise fair treatment 
 and a bright future for the corporation, or whether its business is likely 
 to be interfered with, either through competition or popular opposition. 
 
 (;■) Development expenses are determined from a consideration of the 
 time necessarily consumed in building the plant under consideration, the 
 rate of interest, taxes, and other such expenses, with proper allowance for re- 
 muneration to the original promoters of the enterprise. 
 
STEAM RAILROADS 
 
 427 
 
 (k) Consideration should be had as to whether good will, franchise, 
 or going value should be allowed for, and if so, the amount may be 
 determined from a consideration of the matters set forth in another chapter. 
 
 (/) The sum of the physical plant value plus the development expenses, 
 plus the value of franchise, good will, going value, or contracts, if any, 
 will result in a sum representing one fair value. 
 
 The items to be determined in making a valuation to ascertain the total fair 
 value of a utility property may be diagrammatically summarized as follows : 
 
 Net coat of physical plant. 
 Contractor's profit. 
 
 Contingencies, etc. 
 
 Expenses preUminaiy to beginning iilant construction. 
 Overhead expenses during construction. 
 Working capital. 
 Superseded phint. 
 
 Franchises. 
 Goodwill. 
 Going value. 
 Contracts. 
 
 Structural value. 
 
 Development expenses. 
 
 Intangible value 
 
 Total value. 
 
 STEAM RAILROADS 
 Taken as a whole, railroad accounting has probably reached 
 a higher degree of standardization of accounting than any other 
 branch of industry or commerce. The uniform reports called for 
 by the Interstate Commerce Commission for the past twenty- 
 five years, and the authority which the Commission has exercised 
 for the past five years of not only prescribing uniform reports, 
 but the accounts to be kept, and forbidding any deviation from 
 the prescribed classifications, have undoubtedly contributed to a 
 considerable extent to this result. On the other hand, it is to be 
 noted that some of the Commission's instructions have not been 
 based on sound accounting principles. For instance, the classifi- 
 cation of construction expenditures which was in efifect for many 
 years permitted bond discount to be capitahzed and charged to 
 construction. The latest classification, however, recognizes the 
 force of the accountant's contention that discount is nothing else 
 than interest paid in advance and consequently cannot properly 
 be permanently capitalized, and the present classification forbids 
 the capitalizing of discount on bonds. It is generally admitted 
 that the classifications now in force are based on sound account- 
 ing principles. 
 
428 AUDITING 
 
 In England one requirement of the Railways Act is that be- 
 fore a dividend can be paid auditors must certify the semiannual 
 accounts. In recent years the number of American railroads 
 having their accounts audited by public accountants has consid- 
 erably increased. In time, no doubt, stockholders will insist 
 more firmly on an independent verification of the accounts sub- 
 mitted by the management. 
 
 As with all public service corporations, one of the most vital 
 points in auditing railroad accounts is to establish the correct- 
 ness, or otherwise, of the apportionment of expenditures as be- 
 tween capital and income, or, as it is also termed, construction 
 and maintenance. The true condition of a company's operations 
 and finances has probably been more often concealed by either 
 manipulation or lack of good judgment in making charges to 
 capital accounts than in any other one way. In the case of many 
 large railroads the auditor's problem of satisfying himself that 
 the apportionment of expenditures as between construction and 
 maintenance has been correctly made, while by no means entirely 
 solved, is somewhat simplified by the fact that construction work 
 is usually done under a department other than the one charged 
 with ordinary maintenance work. 
 
 The prime consideration in connection with the verification 
 of income, and the one in which an audit of railroad accounts 
 differs from an ordinary audit, is the audit of the traffic earnings. 
 These fall into two general classes, viz., freight and passenger. 
 The principal data from which the traffic earning accounts are 
 built up are the periodical reports from station agents of freight 
 received and forwarded, tickets sold, etc. Also of importance 
 are reports from "foreign" (other) roads, train conductors' re- 
 ports of cash fares collected, car records showing the movement 
 of cars out on foreign lines or foreign cars on the company's own 
 lines. From the last-nam'ed records are calculated the charge 
 against or credits accruing to foreign roads for equipment "away 
 from home." An important item of indirect income, i. e., a re- 
 fund of expenses paid out, consists of the charges to other roads 
 for repairs made to their cars while in temporary use by the com- 
 pany whose accounts are being audited. Shop reports are the 
 usual basis for these charges. 
 
 In the case of large railroad systems it is manifestly impos- 
 
STEAM RAILROADS 429 
 
 sible for the professional auditor to examine in any reasonable 
 length of time all the original reports and other data which form 
 the basis of the traffic earning accounts. Also in view of the fact 
 that almost every road has a highly organized auditing depart- 
 ment whose duty it is to conduct a continuous internal audit, it 
 is not necessary or even desirable that he should attempt to do 
 so. The system in force should be carefully studied to make 
 sure that by its use an effective check on the station agents, ticket 
 offices, and others handling funds for the company's account is 
 maintained. Sufficient tests should also be made by comparison 
 of original reports with the summaries into which their various 
 totals are carried, etc., to assure the auditor that the system is 
 being faithfully carried out. 
 
 Reports from station agents, in addition to forming the basis 
 of the traffic earning accounts, are of service in certifying that 
 asset appearing in the balance sheet as "Due from Agents." 
 Every agent makes a report, at least monthly, of the account be- 
 tween the company and himself, showing thereon inter alia the 
 uncollected freight bills and the balance due the company for 
 collections made, but not yet remitted. The balance due from 
 each agent per the company's books should be verified by refer- 
 ence to the agent's last report. Frequently the two will not be 
 in exact agreement owing to remittances in transit, suspense 
 items, etc. A reconcilement of the book balance with the report 
 should, however, be in evidence. 
 
 The importance of verifying the balances purporting to be 
 due from agents cannot be better emphasized than by referring 
 to a case which received wide attention in the newspapers a few 
 years ago. The treasurer of a constituent company of one of the 
 largest systems in the country confessed to having embezzled 
 over $500,000. While a full explanation of the manner in which 
 the funds were abstracted and the defalcation concealed for a 
 period of years was never made public, it was stated in general 
 terms that the treasurer had tampered with the agents' accounts. 
 It would certainly seem that if the internal audit of the agents' 
 accounts had been intelHgently and faithfully conducted, the 
 theft could not have been concealed for any considerable length 
 of time. Had the accounts been periodically audited by profes- 
 sional accountants, the embezzlement would in all likelihood 
 
430 AUDITING 
 
 either never have begun or would have been detected before the 
 amount had reached large proportions. 
 
 With reference to depreciation charges, it may be stated that 
 the Interstate Commerce Commission has made them compul- 
 sory for equipment, but not for track or structures. It is still 
 optional with the railroad management whether or not any de- 
 preciation at all shall be charged for accruing renewals or 
 obsolesence of track and structures. 
 
 While the railroad audit includes many other points, some 
 of them of extreme importance, they are not sufficiently different 
 from those obtaining in other lines of business to call for special 
 treatment at this time. 
 
 Valuable papers on steam railroad accounts were presented 
 by Professor Henry C. Adams (connected with the Interstate 
 Commerce Commission) and Arthur W. Teele, C. P. A., to the 
 Atlantic City convention of the American Association of Public 
 Accountants. They are to be found in the Association's 1908 
 "Year Book." 
 
 The following extract from' an article in a financial paper 
 summarizes a number of the important points to be covered in 
 auditing railroad accounts : 
 
 No one doubts that the Baltimore and Ohio of to-day is a magnificent 
 property. But that is all the more reason why it should seem very strange . 
 that some of those who are still in the board should apparently have for- 
 gotten the experience of sixteen years ago. Early in September of 1896, 
 despite the profit and loss surplus of $23,737,000 then existing, Stephen 
 Little was employed to go over the old Baltimore and Ohio's books. Before 
 the end of that month the announcement that a receiver had been appointed 
 for the company came like a bolt out of the blue. In his report Mr. Little 
 gave the following causes for the Baltimore and Ohio's trouble: 
 
 1. The inflation or overstatement of net income. 
 
 2. The mischarge of worn-out equipment to profit and loss. 
 
 3. The capitalization of charges to income. 
 
 4. The capitalization of so-called improvements and betterments of leased 
 lines. 
 
 5. The payment of unearned dividends. 
 
 6. The understatement of liabilities, etc. 
 
 SHIPPING COMPANIES 
 
 Previous to 191 1 there was no recognized uniform classifica- 
 tion of accounts for shipping companies. The Interstate Com- 
 
SHIPPING COMPANIES 431 
 
 merce Comrnission now provides very comprehensive classifica- 
 tions of accounts for carriers by water under its jurisdiction. 
 
 Shipping-company accounts do not differ materially from 
 those used in ordinary commercial undertakings. However, 
 there are some points in connection with shipping accounts 
 which are of interest. It is customary to arrange them so that 
 the income and expenses of each trip can be stated separately. 
 To each voyage, therefore, its fair share of shore expenses must 
 be allocated besides a proportion of such expenses applying 
 directly to specific vessels, but which cover periods longer than 
 a single voyage. The ascertainment of such amounts often in- 
 volves considerable detail. 
 
 Some shipping companies do business entirely with vessels 
 chartered from their owners. The many forms of these hire- 
 agreements, or "charter-parties," as they are called, make it im- 
 perative that the auditor should carefully examine such agree- 
 ments as may still be in force at the time of the audit. 
 
 The auditor should ascertain that all revenues from freight 
 traffic and passenger service have been accounted for, also all 
 moneys due from the government for mail service and from ex- 
 press companies; that all maintenance expenses have been 
 charged as such, and not included in the cost of vessels; that 
 proper provision has been made for depreciation; that all liabil- 
 ities have been provided for, also any unearned income; that re- 
 turns of insurance premiums due on account of the "laying up" 
 of any vessel have been obtained. 
 
 The Interstate Commerce Commission regulations distinctly 
 require that provisions for depreciation of vessels shall be made. 
 In many cases in the past it was customary not to make provision 
 for depreciation. This was especially so with owners of single 
 ships. 
 
 Another custom which has become quite general is that of a 
 company's providing its own insurance fund instead of placing all 
 its insurance with underwriting companies. In such cases the 
 amounts which would be paid to the insurance companies are 
 set aside and a fund created to take care of losses and damages. 
 It is advisable that these amounts should be segregated from 
 other funds and invested in securities which have a ready market. 
 All repairs and replacements which were the result of perils of 
 
432 AUDITING 
 
 the sea and the vessels' proportion of general averages would be 
 paid from this fund. 
 
 It is quite obvious that only such companies as own a large 
 number of vessels, and can consequently distribute the risk, are 
 really warranted in carrying any part of their own insurance. 
 Even in such cases it is universally recognized that at least a 
 part of each risk should be placed with outside underwriters. 
 
 Even when the risk is well distributed, it sometimes happens 
 that the total loss of a large vessel in excess of the outside insur- 
 ance carried will be greater than the amount accumulated in the 
 company's own insurance fund. In such cases the question 
 arises whether it is proper to carry the debit balance of the insur- 
 ance fund into the balance sheet as an asset. It is sometimes 
 argued that this is legitimate, especially if the amount is not so 
 large as to preclude the possibility of its being eliminated by 
 future credits within a reasonably short period of time. Such 
 an argument is fallacious, however, as the overdraft on the insur- 
 ance fund has absolutely no value at the date of the balance sheet 
 and in no way benefits future operations, which would be the 
 only justification for entering among the assets an item which 
 has no present value. If it is desired to preserve the identity of 
 the insurance fund, even though it has been exhausted, the 
 proper procedure would be to show the debit balance thereof in 
 the balance sheet as a distinct item, but deducting it "in short" 
 from the surplus or profit and loss account with an appropriate 
 explanation. 
 
 ELECTRIC RAILWAYS 
 
 One of the earliest attempts by an unofficial organization to 
 secure the adoption of a uniform system of accounts for any in- 
 dustry was made in 1898, when a committee of the Street Rail- 
 way Accountants' Association of America (now known as the 
 American Electric Railway Accountants' Association) prepared a 
 standard classification of accounts for street railways. Many 
 street railway companies adopted this classification, and it was 
 also prescribed by the railroad commissioners of a number of 
 States for use in preparing reports submitted by railways under 
 their jurisdiction. 
 
 Several years ago the Interstate Commerce Commission 
 
ELECTRIC RAILWAYS 433 
 
 issued a more elaborate classification. As this classification was 
 devised in consultation with the Railway Accountants' Associa- 
 tion, and has since also been made the basis of classifications 
 promulgated by State commissions, it is largely taking the place 
 of the earlier classification, which had done good service. It 
 should be borne in mind that, excepting in those States in which 
 commissions having authority to prescribe accounting systems 
 for public utilities have adopted the Interstate Commerce Com- 
 mission's classification, adoption of the latter's classification is 
 obligatory only on such railways as do an interstate business. 
 
 Even in those classifications which differ from that of the 
 Interstate Commerce Commission, it will be found that the differ- 
 ences are more frequently in details than in any essentials. The 
 grouping of the detailed accounts is well nigh universal into the 
 general classes of 
 
 Maintenance: Way and Structures. 
 
 Equipment. 
 Conducting Transportation: 
 
 Power. 
 
 Operation of Cars. 
 General and Miscellaneous. 
 
 The auditor will naturally familiarize himself with the 
 classification in use before beginning his audit. 
 
 The revenue of an electric railway is largely on a cash basis, 
 the principal exceptions being sales of tickets to city depart- 
 ments or the Post Office Department or isolated cases of very 
 large ticket users having recognized financial standing, adver- 
 tising in cars, sales of scrap and other old material, and, in the 
 case of railways carrying freight, accounts with large shippers 
 having good credit. Traffic sheets are made up for each day 
 showing the different runs and the amount of cash fares, tickets, 
 and passes turned in by each conductor. The totals of these 
 sheets should be traced into the cash book. The traffic sheets 
 themselves should be tested by comparing therewith conductors' 
 reports for days in different parts of the period under review. A 
 further test, which is of a reciprocal nature, is to compare the 
 names of conductors on the pay roll with the names on the traffic 
 sheets to see that some amount is entered on the latter for each 
 conductor appearing on the pay roll. While this comparis'on 
 
434 AUDITING 
 
 does not establish the correctness of the amounts entered on the 
 traffic sheets, it would result in the detection of the total omis- 
 sion of the receipts of any conductor. On the other hand, it 
 would reveal any padding of the pay roll as far as conductors 
 are concerned. Indirectly, it also places a check on the number 
 of motormen on the pay roll, as these two classes of carmen 
 should, of course, be in a proper proportion to each other. Traffic 
 receipts should be in evidence for every day in the year. 
 
 Receipts from ticket sales can frequently be verified in total 
 by reference to the serial numbers of the first and last tickets 
 sold during the period. Complications in the shape of tickets in 
 the hands of conductors at beginning and end of the period will 
 sometimes be encountered, but these will usually not interfere 
 with verifying the ticket sales, at least approximately. 
 
 The earnings from advertising in cars and waiting-rooms are 
 to be verified. Usually this is not a difficult matter. More often 
 than not, a contract for the entire advertising space is made with 
 an agency for a fixed sum per annum. Under such circumstances 
 the verification of the income from this source is exceedingly 
 simple. 
 
 Miscellaneous receipts from sales of scrap and similar sources 
 will need to receive careful attention. As they are received at 
 irregular times, failure to account for them could more easily 
 escape attention than in the case of regular traffic receipts. All 
 receipts of whatsoever nature should be deposited in bank. No 
 railway with a well-devised accounting system permits pay- 
 ments to be made from traffic or other receipts. 
 
 The treatment of ticket sales in the accounts should receive 
 attention. Theoretically the proceeds of tickets sold may prop- 
 erly be included among the traffic earnings only when the tickets 
 have been collected. Until that time they should appear to the 
 credit of an unearned or deferred income account, which is to be 
 included among the liabilities in stating the balance sheets. As 
 the tickets are sold, the receipts therefrom are credited to the 
 liability account referred to, and at regular intervals, say, 
 monthly, transfers are made therefrom to the credit of earnings 
 for the value of the tickets collected. 
 
 In cases where the ticket sales form a very small proportion 
 of the total traffic receipts, the outstanding tickets would be a 
 
ELECTRIC RAILWAYS 435 
 
 negligible quantity and no great harm will be done if tickets are 
 treated as earnings when sold. With many companies, however, 
 the outstanding tickets aggregate large amounts, and it is cer- 
 tainly not correct accounting to include among the earnings cash 
 received for service which has not yet been rendered to the com- 
 pany's patrons. Attention is also called to the fact that inaccu- 
 racies in the gross earnings, due to the inclusion therein of ticket 
 sales before the tickets have been used, are greatest for some 
 time after forms of tickets or methods of selling them have been 
 changed or when special tickets are sold for a limited period. 
 
 As is naturally to be expected, the most important single 
 feature of the audit of the expenditures is the verification of the 
 apportionment between capital and income. This is frequently 
 a most difficult matter, owing to the fact that the nature of m,any 
 of the expenditures is identical, whether they be for extensions or 
 for maintenance, i. e., they will be for materials and labor, and 
 the items on their face do not indicate conclusively in which cate- 
 gory they properly fall. 
 
 If a system of recording construction and equipment costs is 
 in use, the auditor will be able to satisfy himself as to the pro- 
 priety of the construction charges much more readily than when 
 such records are lacking. Unfortunately many companies — 
 probably a majority — do not have such records. The keeping of 
 them does not, as a rule, entail an undue amount of work, and, 
 where not already in use, the auditor should recommend their 
 installation. The essentials are that a separate account, usually 
 in a subsidiary ledger, be opened for each distinctive piece of con- 
 struction work undertaken and for each addition made to the 
 equipment. All construction charges should find their way into 
 this ledger. In the general ledger the expenditures, storeroom 
 charges, etc., would be debited to a controlling account called, 
 say. Construction in Progress. As a specific piece of construc- 
 tion work is completed, the total shown in the account therefor 
 in the subsidiary ledger would be transferred by journal entry 
 from the Construction in Progress account to the appropriate 
 account or accounts in the classification of construction accounts 
 in the general books. Under this plan the entries for charges to 
 construction accounts show what they are really for and what 
 additions to the company's roadway, structures, or equipment 
 
436 AUDITING 
 
 have really been made. The total of the expenditures made on 
 uncompleted construction work appears on the general ledger in 
 the Construction in Progress account, and the details may be 
 referred to in the construction cost ledger. 
 
 Where construction records have not been kept, the auditor 
 will find it necessary to consult with the company's engineer and 
 use such other means as are available to get definite information 
 as to just what has been accomplished by the expenditures 
 charged to capital accounts. Having supplemented in this way 
 the data furnished by the books, he will then have to decide 
 whether the company was warranted in charging the expend- 
 itures against capital rather than against earnings. 
 
 Depreciation of plant — or, if the word "depreciation" has 
 an unpleasant sound, the term "accruing renewals and replace- 
 ments" may be substituted — is a most important subject in con- 
 nection with electric railways. Up to a few years ago railway 
 operators, and especially promoters, would not admit that there 
 was any necessity whatever for the inclusion of depreciation 
 charges in the operating accounts. Their stock argument was 
 that the franchises increased in value more rapidly than the phys- 
 ical property deteriorated, and consequently there was no depre- 
 ciation in the property as a whole. The fact that the increase in 
 franchise values would not produce funds wherewith to make 
 replacements when they were finally needed was ignored. Since 
 the repeated puncturing of this fallacy by the bankruptcy of 
 companies which proceeded on such an unsound basis, railway 
 operators have reluctantly come to admit the necessity for tak- 
 ing account of depreciation, until at the present time practically 
 all engineers of high standing consider it as an item of operating 
 expense. It is a satisfaction that the correctness of a principle 
 for which at one time almost no one but accountants contended 
 has at last been recognized. In cases where companies have not 
 made any allowance for accruing depreciation, the auditor is not 
 warranted in giving a certificate unless it contains a qualification 
 plainly calling attention to the omission of depreciation allow- 
 ances. 
 
 So-called reconstruction expenditures, when no depreciation 
 reserve has been provided against which they can be charged, 
 sometimes present a perplexing problem. Frequently they are 
 
ELECTRIC RAILWAYS 437 
 
 the result of the omission over a period of years to make re- 
 newals as they are needed, and thus, when extensive expenditures 
 for the rehabilitation of the property are finally imperative, they 
 really represent an accumulation of long-deferred maintenance 
 charges. It is manifestly unfair to charge the entire amount of 
 the expenditures against the operations of the particular year in 
 which they happen to be made. On the other hand, if they are 
 but accumulated maintenance charges, the mere size thereof does 
 not justify capitalizing them. Then, too, the problem is usually 
 complicated by the fact that the expenditures usually result in 
 some increase in the carrying capacity of the road. The worn- 
 out rolling stock is replaced with larger units, heavier rails are 
 laid, and power-plant equipment of increased capacity is in- 
 stalled. 
 
 The proper treatment of reconstruction charges is to charge 
 to capital such part thereof as represents an increased' value in 
 the reconstructed part of the property over the original cost of 
 the property replaced; such part of the expenditure as represents 
 a fair or normal annual maintenance charge should be debited to 
 operating; and such part as represents the making good of 
 neglected maintenance applying to prior years should be treated 
 as a special charge against profit and loss. 
 
 When such reconstruction expenditures are made by a com- 
 pany after the purchase of a dilapidated property, it is assumed 
 that in fixing the purchase price allowance was made for the 
 expenditures required to be made to place the property in good 
 operating condition. Consequently, under such circumstances 
 the entire amount of the reconstruction expenditures are consid- 
 ered to be a proper capital charge. It is to be borne in mind that 
 especially under such circumstances it is essential that deprecia- 
 tion allowances be included in the accounts. Otherwise, with 
 the abnormally low maintenance expenditures which will natu- 
 rally follow during the first few years after extensive reconstruc- 
 tion, the showing of net earnings will be misleading. 
 
 It should be borne in mind that there is danger in capitaliz- 
 ing charges for betterments which do not increase earnings nor 
 decrease operating expenses. On the other hand, in view of rate 
 regulation it is not safe to wipe off all such expenditures. The 
 situation can perhaps best be met by capitalizing the charges and 
 
438 AUDITING 
 
 segregating a liberal proportion of the surplus to prevent the 
 payment of unwarranted dividends. 
 
 The liability for unsettled damages to persons and property 
 always needs to be thoroughly investigated. In practically all 
 cases some suits will be found to be under way or threatened, 
 and in addition, consideration should be given to all accidents 
 for which releases have not yet been obtained, even though suit 
 has not been entered. Large companies have a special claim 
 department, from which the desired information can be obtained, 
 and for smaller companies a letter from the company's attorney 
 should be obtained stating all unadjusted claims and the prob- 
 able cost of settlement. 
 
 Many companies create an accident reserve by crediting to 
 such an account and charging to operating expenses a certain 
 percentage of the gross earnings. Payments in settlement of 
 claims are charged against the reserve. This plan is preferable 
 to that of charging accident payments directly to operating ex- 
 penses, as it equalizes the charge to successive fiscal periods and, 
 if the charge is ample, creates a reserve for those claims which 
 are unsettled at the end of each period. The plan must be intel- 
 ligently used. Some companies use too low a percentage and 
 carry the resulting debit balance in the reserve account along 
 from one period to another as a deferred charge to operations. 
 Obviously, payments for accidents occurring in one period are not 
 of the slightest benefit to the operations of a future period, and 
 if a debit balance develops in an accident reserve account, it 
 should be forthwith written off. Such a condition is sometimes 
 due to an unusually serious and costly accident, which is not 
 likely to occur again soon, and it may not be necessary to raise 
 the percentage of gross earnings credited to the accident reserve. 
 As already stated, however, the overdraft in the reserve account 
 should be immediately written off, as it is not an asset in any 
 sense of the word. 
 
 The extensive development of the interurban electric railway 
 field during the past decade has resulted in conditions which in 
 some respects are perhaps even more analogous to those of steam 
 railroads than to those of the city electric railway. With con- 
 siderable mileage, a large freight and express business, grad- 
 uated rates of fare for passenger trafific, etc., an efficient auditing 
 
TRANSPORTATION COMPANIES 439 
 
 department as a part of the company's organization is a neces- 
 sity. This department will naturally audit the details of the 
 company's operations, and the professional auditor's duty with 
 respect to this part of the work will ordinarily be limited to such 
 tests and investigation as will satisfy him that the prescribed 
 system is being followed and that the client's interests are safe- 
 guarded in every way possible. 
 
 TAXICAB COMPANIES 
 
 In auditing a taxicab company, the procedure would be much 
 the same as for an ordinary manufacturing company, excepting 
 the verification of its chief source of income — the charges for 
 service rendered. 
 
 The taxicabs, as the name indicates, are equipped with taxi- 
 meters. These show both the total mileage and the revenue 
 miles, i. e., the mileage run during the time the cab is carrying 
 passengers. 
 
 Most companies keep what is called a master's sheet or some 
 record showing the car number, the time out and in, and the 
 reading of the meter, both as to revenue and total miles. When 
 the cab leaves the garage, the reading is entered on the sheet, 
 and on its return, the reading is again taken and entered along- 
 side of the first or "out" reading. The difference in the revenue 
 miles reading represents the revenue miles run and has to be 
 accounted for by the driver of the cab, either in cash or by proper 
 evidence of having carried a charge customer. With the larger 
 companies most of the calls originate at some hotel or at a stand 
 where there is a starter employed by the company. It is the 
 starter's duty to determine whether or not the customer has an 
 account, and if so, he signs a ticket which is given to the driver, 
 so that the driver turns in either cash or tickets for all fares. By 
 most companies any shortages are deducted from the drivers' 
 wages. 
 
 Each driver is provided with a daily card, which should show 
 the same mileage as the master's sheet, but in addition gives the 
 details of the call. The cash received from this source is entered 
 in a cash-fares column in the cash book and the charges are 
 posted from the tickets to the customers' ledgers, the total being 
 posted through a journal to the general ledger. In some cases 
 
440 AUDITING 
 
 these charges are written up on sheets, or a journal, and posted 
 to the ledgers therefrom. 
 
 It would not be practicable for the auditor to check the ac- 
 curacy of all of the entries, but a thorough test should be m^de 
 for a certain period. The total cash fares and charges should be 
 checked with the drivers' cards. The mileage shown by the driv- 
 ers' cards should be checked with the master's sheets, and the 
 "out" readings of the mileage should be compared with the "in" 
 readings of the previous day. The latter is important, as it would 
 be an easy matter, if collusion existed, for the starter at the 
 garage to add several miles to the "out" readings or to deduct 
 several miles from the "in" readings, which, if the driver used 
 the same figures on his card, would give him less mileage to 
 account for. 
 
 Many companies keep mileage records. Where this is not 
 done, it would be well, in connection with the checking of the 
 master's sheets, to make a list of the mileage, both revenue and 
 total, and compare the ratio of the one to the other for the period 
 investigated. There are many expenses which should vary di- 
 rectly as the mileage. Tires sometimes are rented on a mileage 
 basis. Using the mile as the unit and stating the earnings and 
 expenses per mile, especially when such results can be compared 
 with the results of another period, enables the auditor to uncover 
 many discrepancies. 
 
 In the verification of the pay rolls, disbursements, purchases, 
 sundry sales of gasoline and supplies, storage, etc., the procedure 
 should be the same as in any other business. 
 
 Depreciation is an important item, but it should be borne in 
 mind that a good taxicab can be renewed in large part, and where 
 tires and motors and other repairs are being charged against 
 operations, a reserve of only fifteen to twenty per cent is suffi- 
 cient to cover all depreciation in a going concern. 
 
 As an illustration of the accounts to be found in a taxicab 
 company, the following form of balance sheet and statement of 
 earnings and expenses is presented : 
 
TRANSPORTATION COMPANIES 
 
 441 
 
 THE TAXICAB COMPANY 
 
 STATEMENT OF EARNINGS AND EXPENSES 
 
 For the Month of June, 1912, and for the Six Months ended June 30, 1912 
 
 Eabhinos 
 
 Six Months 
 Month of Ended 
 
 June, 1912 June 30, 
 
 1912 
 
 Motor Car Earnings . , 
 Mbcellaneoua Eanungs 
 
 Dedtjctions: 
 
 Refunds and Allowancea 
 
 Net Earnings . 
 
 Vehicle OpCTation 
 Garage Operation 
 Muntenance 
 Rent and Insuruice 
 Taximeters . . 
 Hired Equipment 
 Licenses . . ■ 
 Commissions . 
 Free Riding 
 General Expenses. 
 
 Resbbves: 
 
 Motor Cars . . . 
 Equipment . . . 
 Repair Stock . . . 
 Injuries and Damages 
 Bad Debts . . 
 
 ChaufEeurs' Clothing 
 
 Total Expenses . 
 
 Current Operating Profit: 
 Motor Department . . 
 
 Additions to Income: 
 Interest on Deposits . . 
 Discoimts Earned 
 
 Total Income 
 
 Deductions from Income: 
 Interest on Bonds 
 Interest on Notes . . 
 Discount on Bonds . . 
 Organization Expenses . 
 
 Total Deductions 
 
 Net Profit . . 
 
n 
 
 
 g d-g 
 
 gofc 
 
 c3 
 
 5 
 
 33 
 
 ■"■ 9 H 2 9 
 
 •t.ill«" 
 
 
 II 
 
 442 
 
TRANSPORTATION COMPANIES 
 
 DETAILS OF STATEMEHT OF EARNINGS AND EXPENSES 
 For the month of June, 1912, and for the six months ended June 30, 
 
 VxmcLS Ofxratioh: 
 
 Salaries, Operating Office 
 Chauffeurs Wages 
 Starters' Wages . 
 Gasoline . . . 
 Lubricants . . 
 Tires .... 
 
 443 
 
 igi2 
 
 
 Six Months 
 
 Month of 
 
 Ended 
 
 June, 1912 
 
 June 30, 
 
 
 1912 
 
 Gaiugb Opebition: 
 
 Salaries, Garage Office . 
 Wages, Garage . 
 light, Heat, and Power . 
 Garage Supplies . . . 
 
 Maihtenahce: 
 • BodyRepaiiB, Labor .... 
 
 Do Materials . . . 
 
 ChasEos Repairs, Labor .... 
 
 Do Materials . . . 
 
 Damages Collected from Chauffeurs 
 Stock Room Wages .... 
 Motor Car Accessories .... 
 Chauffeurs' Clothing .... 
 Rep^rs to Equipment .... 
 
 Rent and Insubange: 
 Rent: 
 
 Rent Proportion .... 
 Repairs do .... 
 Taxes do .... 
 
 Insurance on Buildings . . 
 
 Total Rent . . . 
 Insurance other than on buildings 
 
444 AUDITING 
 
 DETAILS OF STATEMENT OF EARNINGS AND EXPENSES— Continued 
 
 Six Months 
 Month of Ended 
 
 June. 1912 June 30, 
 
 1912 
 
 General Expenses: 
 Salaries of Officers . 
 Do General Office 
 Telephone 
 Office Expense 
 Stationery 
 Postage . . 
 Adverting 
 Freight and Expreaaage 
 Miscellaneoua . . 
 
 Results pek Unit 
 
 Six Months 
 Month of Ended 
 
 June, 1912 June 30, 
 
 1912 
 
 Cabs Used 
 
 Live Miles run .... 
 Dead Miles run .... 
 
 Total Miles run . 
 Ferc^t^e of Live mileage . 
 
 Miles run per cab for period 
 
 Drivers* Wages per live mile 
 Gasoline per gcosa mile . . 
 Lubricants do do . . 
 Tires do do . . 
 
 Chassis Repairs do . . 
 Garage Wages per cab used 
 Gajage Supplies do 
 Body Repairs do 
 
 Net Revenue per live mile 
 
 Total Expenses per live mile 
 Do Reserve do do 
 
 Total Cost per li\e mile . 
 Current Profit per live mile 
 
LIGHT AND POWER COMPANIES 445 
 
 ELECTRIC LIGHT AND POWER COMPANIES 
 
 Classifications of accounts for electric light and power com- 
 panies have been prescribed by a number of States. The Inter- 
 state Commerce Commission has also issued a classification for 
 use by the electric companies in the District of Columbia, which 
 are under its jurisdiction. This classification is quite similar to 
 that issued by the New York Public Service Commissions. 
 
 The accounting systems of public service corporations of 
 different kinds have much in common. The elements of income 
 from service rendered to the public, the cost of performing such 
 service (made up in turn of the cost of maintaining the physical 
 property and the direct cost of performing the service), and the 
 almost continuous expansion of the plant to keep pace with the 
 growth of the community, are alike met with in the case of street 
 railways, electric light and power companies, gas corporations, 
 water works and telephone companies. Consequently much of 
 what is said under each of these classes of companies applies, 
 sometimes with very slight modification, to all classes. The re- 
 marks under the general heading of public service corporations 
 are also to be considered in connection with any one class of such 
 corporations. 
 
 Conditions dififer somewhat, however, between the various 
 classes. For instance, while the earnings of an urban street rail- 
 way accrue largely in cash from day to day, the earnings of an 
 electric light and power company are based on monthly charges 
 to consumers who have anywhere from five days to a month in 
 which to make payment, and comparatively little of the revenue 
 is on a cash sale basis. 
 
 The consumers' register is the initial record of the gross earn- 
 ings from electric current sold. This record is usually so de- 
 signed that it contains not only the original charge to the con- 
 sumer, but collections and credits for abatements are also posted 
 thereto, and it is in reality a ledger of consumers' accounts, and 
 is in fact called the consumers' ledger in many offices. 
 
 Two forms of consumers' register are widely used. One is a 
 wide columnar book, usually with one or two short leaves, with 
 a group of columns for each month, there being separate columns 
 for balances, charges, cash, and credits under each month. One 
 or more lines are allotted to each customer's name or to a loca- 
 
446 AUDITING 
 
 tion; the months progress horizontally across the page. The 
 respective totals of balances, charges, cash, and credits (rebates, 
 allowances, etc.) which appear in the controlling accounts receiv- 
 able or consumers' account in the general ledger are ascertained 
 (for charges) or proven (for cash collections, credits, and bal- 
 ances) by footing the column set apart for each. 
 
 The other form of ledger has but one consumer's account on 
 a page. This also is a book of original entry as far as the charges 
 are concerned. The totals of charges made, collections posted, 
 etc., are ascertained by scheduling on the adding machine items 
 of a given class from all the consumers' accounts. The advan- 
 tages claimed for the latter form are that it eliminates the neces- 
 sity for carrying forward, or to a recapitulation, the totals of hun- 
 dreds of pages, that a new register does not need to be written 
 up anew each year (as companies of even moderate size will have 
 some thousands of names, this is no small task), and that it per- 
 mits of a more convenient-sized book than the cumbersome 
 columnar record. The individual account form, as the last-men- 
 tioned of the two forms described may be termed, is like a sharp 
 tool. In the hands of a competent workman, it is very useful, 
 but in the hands of any other, its use may produce any but satis- 
 factory results. 
 
 The meter-reader's books or cards are the data from which 
 the charges are made in the consumers' register. In the case of 
 flat rates the contract is the basis of the memorandum of the 
 charge to be made monthly, which is noted in the register. 
 The best forms of registers provide columns for showing meter 
 readings. In the wide columnar register, however, the readings 
 are not entered for lack of space. While the auditor is not usu- 
 ally expected to go back of the charges in the consumers' register, 
 it is well for him to avoid getting into a rut by occasionally com- 
 paring some of the entries in the meter-reader's books with the 
 register, also seeing that there are no consumers recorded in the 
 meter-reader's books for whom there are no accounts in the reg- 
 ister. The monthly totals of charges for current, cash collected, 
 etc., per the consumers' register, will, of course, need to be com- 
 pared with the entries therefor in the general books. 
 
 Sales of appliances, such as electrical irons, stoves, motors, 
 high efficiency lamps, etc., have become a large item in the busi- 
 
LIGHT AND POWER COMPANIES 447 
 
 ness of many companies. The profit thereon is usually small. 
 The method of recording such sales should be carefully ex- 
 amined, as the misappropriation of the proceeds of such sales 
 could be more easily concealed than the theft of ordinary collec- 
 tions for the consumption of current. Sales of appliances are 
 frequently made on the installment plan. The accounts receiv- 
 able for uncollected balances will necessarily require thorough 
 scrutiny. The net profit only from sales of appliances should be 
 included among the gross earnings in stating the company's 
 operations. 
 
 The audit of the expenditures involves no features which are 
 not common to practically all public utilities. The distinction 
 between capital and revenue is of first importance. The remarks 
 made on this subject under the head of electric railways are also 
 very pertinent to electric light and power companies. 
 
 An unusually low ratio of operating expenses to gross earn- 
 ings should be the subject of investigation. In the absence of 
 unusual operating advantages, it is frequently due to insufficient 
 expenditures for maintenance, which will sooner or later result 
 in a rundown property. 
 
 In the case of machinery which has a tendency to become 
 obsolete as quickly as electrical equipment does, depreciation 
 allowances should be very liberal. 
 
 GAS COMPANIES 
 
 In many respects the audit of a gas company will be similar 
 to that of an electric light and power company, which has al- 
 ready been considered. Sales of gas are, however, almost invari- 
 ably made on a metered basis, whereas flat rates for electricity 
 furnished have been and are yet, although to a lesser extent than 
 formerly, quite common. 
 
 An item of importance is the sale of residuals, particularly in 
 the case of companies manufacturing coal gas ; the residuals re- 
 covered in the manufacture of water gas are less in both quan- 
 tity and value. The quantities of residuals recovered in different 
 fiscal periods should be compared with the quantities of materials 
 "charged," i. e., placed in the retorts, and explanation of varia- 
 tions in the ratio of one to the other should be sought. The 
 system of recording and reporting sales of residuals should also 
 
448 AUDITING 
 
 be investigated, so as to be certain that failure to report deliv- 
 eries to customers will not escape detection. 
 
 Another important item of income which needs to be verified 
 is the sale of appliances. With the largely increased use of gas 
 for cooking and heating purposes which has come about in recent 
 years, and the energetic endeavors of the gas companies to en- 
 courage such use to the utmost, it has become customary for the 
 company to sell stoves and other appliances on the installment 
 plan, the payments covering a period of one to two years. The 
 business handled in the appliance department is frequently very 
 large, the company not only selling the appliances, but also in- 
 stalling them. All this means that if no loss is to be sustained, 
 careless methods must be avoided and suitable records be kept 
 of the transactions in connection with the sales of appliances and 
 fittings and the diligent prosecution of the collection of the 
 accounts or installments as they fall due. It is preferable to take 
 into the statement of operations only the net profit or loss on 
 sales of appliances, rather than to include the sales among the 
 gross earnings and the cost among the operating expenses. 
 
 There are no unusual features involved in the verification of 
 the expenditures. For the ordinary operation of the plant the 
 wages do not usually fluctuate very much. The quantity of coal 
 carbonized, i. e., used in making gas, should within certain limits 
 bear a definite ratio to the quantity of gas produced. 
 
 Depreciation of plant is an especially important considera- 
 tion in the case of gas companies. Some parts of the plant, par- 
 ticularly the retorts or benches, need to be renewed at compar- 
 atively short intervals. Hence full provision should be made for 
 such accruing renewals. 
 
 At the 1902 Annual Meeting of the American Gas Light 
 Association, a committee appointed for the purpose of devising a 
 uniform system of accounts for gas works submitted a report 
 on "Classification of Operating Expense Accounts ; Classification 
 of Betterments on Property Accounts; Forms of Monthly 
 Journal Entries and Rules for Closing." This furnished a work- 
 ing basis for the classifications of accounts for gas companies 
 which have since been issued by the Public Service Commissions 
 of the State of New York and the Interstate Commerce Commis- 
 sion. 
 
WATER WORKS COMPANIES 449 
 
 WATER COMPANIES 
 
 The audit of water companies is very similar to that of gas 
 and electric companies. In many companies a very large part of 
 the charges to consumers is based on contracts for fixed annual 
 rates. These rates are based on a certain charge for each kind 
 of plumbing fixture. The use of water meters is, however, in- 
 creasing, especially by private companies as distinguished from 
 municipally owned water works. Charges to consumers based 
 on meter readings are naturally treated in the same manner as in 
 the case of gas and electric companies. 
 
 Flat rate charges to consumers are most often made quar- 
 terly, though in some few cases they are made monthly, and in 
 still other instances semiannually, and — particularly in the case 
 of municipalities — annually. In contradistinction from metered 
 charges, flat rates are ordinarily payable in advance, and it is 
 important to see that in closing the accounts such part of the flat 
 charges as have not yet been earned are treated as a liability, 
 being carried forward as deferred or unearned income. 
 
 The consumers' ledger accounts are usually arranged by 
 location, and as most cities and towns are supplied by a single 
 system, the accounts of buildings for which no water rent is 
 charged should be examined to see that the water was off during 
 the entire period. The dates on which the water is turned on or 
 off are usually noted directly on the consumers' ledger. 
 
 In addition to vacancies, attention should be given to arrear- 
 ages and uncollectible accounts. The bad debts should be very 
 small in the case of a well-managed water company. Unpaid 
 water rents due a municipaHty are, in some States, a Hen on the 
 real estate where the water was used. 
 
 Municipal ownership of water works is far more general than 
 is the case with any other class of public utilities. Probably less 
 attention has been given to the systematic regulation of water 
 companies by the States than of other public service corpora- 
 tions. This may possibly be due to the fact that so many water 
 works are municipally owned and operated. On the other hand, 
 it is to be noted that there has been much litigation in attempts 
 to regulate the rates charged by water companies. Much of this 
 litigation has been the result of hasty and ill-considered efforts, 
 superinduced by the heat of political campaigns. 
 
450 AUDITING 
 
 None of the State public service commissions have pre- 
 scribed uniform classifications of accounts for water companies. 
 The New England Water Works Association has for years, 
 however, had a form for uniform reports which has been used 
 by a considerable number of publicly and privately owned water 
 works. In recent years the American Water Works Association 
 has given considerable study to the subject of uniform accounts 
 for water works, and in 1907 the United States Bureau of the 
 Census began a study of the subject. As the result of a confer- 
 ence held at Washington in 191 1, at which representatives of the 
 Census Bureau, American Association of Public Accountants, 
 American Water Works Association, New England Water 
 Works Association, and others were present, a suggested scheme 
 of accounts, together with comprehensive instructions for its use, 
 was published by the Census Bureau. The pamphlet, bearing the 
 title "Uniform Accounts for Systems of Water Supply," may be 
 had on application to the Bureau of the Census, Washington, 
 D. C. The scheme of accounts has been so arranged as to make 
 it sufficiently feasible to permit of its, adaptation to the account- 
 ing needs of both the largest and the smallest water works. 
 
 TELEPHONE COMPANIES 
 
 A telephone company's main product is service. To a large 
 extent the expense of operation varies but little with fluctuations 
 in the volume of business done. 
 
 The largest single item of expense is that of salaries and 
 wages. In the largest company this amounts to about fifty per 
 cent of the total income. Next is supplies, rent, etc., i. e., ordi- 
 nary operating expense outside of labor. 
 
 The disposition of the gross revenue of the Bell System for 
 the year of 191 1, as reported by the company, was as follows: 
 
 Salaries and Wages 50% 
 
 Materials, Rents, Traveling, etc 20% 
 
 Taxes 5% 
 
 Interest and Dividends 19% 
 
 Surplus 6% 
 
 100% 
 In many States some form of jurisdiction over telephone 
 
TELEPHONE COMPANIES 451 
 
 companies has been given the local Public Service Commission. 
 On January i, 1912, there were twenty-eight States whose Com- 
 missions had been given power to regulate rates and service. 
 This fact plays an important part in the modus operandi of the 
 auditor. 
 
 The assets of a telephone company consist of its telephone 
 plant, its contracts and licenses, supplies and tools, accounts 
 receivable, cash and investments. Its liabilities consist of its out- 
 standing bonded indebtedness, accounts and notes payable, and 
 the contingent liability based upon the numerous contracts with 
 subscribers and others. 
 
 The income is derived mainly from local telephone traffic, 
 long-distance tolls, and revenue from investments. There is 
 often other income in the shape of rental derived from property 
 owned or leased, the sale of scrap supplies, the charges for private 
 lines and special temporary installations, and income derived 
 from advertisements in the directories. 
 
 The telephone plant is subdivided into numerous accounts, 
 including Buildings, Central Office Equipment, Wire Plant, Con- 
 struction and Equipment, Substation Equipment, General Office 
 Equipment, Stores Department Equipment, Utility Equipment, 
 etc. 
 
 The toll (long distance) and exchange (local) business 
 must' be kept separate, and all expenses and income properly 
 apportioned. 
 
 Taxes constitute an important item of expense, and should 
 be watched closely. The auditor should see that some adequate 
 means of verifying tax bills, and providing for taxes payable, 
 but unpaid, is in force. 
 
 The directories furnish opportunities for considerable pecula- 
 tions if not watched closely. The auditor conducting a thorough 
 audit of a telephone company cannot consistently certify to the 
 accuracy of the income without examining into the management 
 of the directory. 
 
 The proper provision for depreciation, for the creation of a 
 sinking fund and an amortization reserve, when necessary, are 
 questions that must be settled in each case according to the rules 
 laid down by the local commission, if one exists, otherwise ap- 
 proved accounting principles should be observed. 
 
452 AUDITING 
 
 The commercial department has charge of public pay sta- 
 tions, and to that account are chargeable the salaries and commis- 
 sions paid at public pay stations, the cost of labor and other ex- 
 penses incurred in collecting from such stations, the cost of 
 advertising, and other expenses relating to this branch of the 
 service. The credit to the account consists of the toll received 
 from public pay stations. 
 
 The subscribers' ledger records the revenue of the company, 
 and should be kept with great care. It is in the form of a journal 
 ledger, i. e., the original charges are made in this book and the 
 totals thus shown are transferred to the general books. The 
 book is ruled so that it will last for one year without rewriting 
 the names. Short leaves may be used tp reduce the size of the 
 book. The columns are headed as follows : 
 
 Telephone Number. 
 
 Name. 
 
 Location. 
 
 Date Installed. 
 
 Kind of Service. 
 
 Rate per Month. 
 
 Date Transferred or Discontinued. 
 
 Each month's headings follow : 
 
 Balance. 
 
 Rental. 
 
 Toll and Messenger. 
 
 Total Debit. 
 
 Date Paid. 
 
 Amount Paid. 
 
 Rental. 
 
 Toll and Messenger. 
 
 Rebate. 
 
 The toll and messenger charges should be divided at the end 
 of the month, as well as the rebate for poor service and the bad 
 debts written off. Two colors of ink are usually employed to 
 mark the distinction in the items. 
 
 Depreciation: The Railroad Commission of Wisconsin has 
 issued a textbook on a system of accounting for telephone com- 
 panies which should be consulted by those interested in tele- 
 phone accounting. Depreciation is covered by the following 
 instructions : 
 
TELEPHONE COMPANIES 453 
 
 Depreciation Reserve: This account shows the balance set aside for 
 depreciation available for the replacing and rebuilding of the plant. There is 
 a certain wear and tear taking place in a plant which cannot be made good by- 
 ordinary current repair, and it is against this that the reserve for deprecia- 
 tion is made. The reserve should be made at such a rate as will entirely 
 wipe out the asset over the period of its probable life. It has been held 
 that in a moderately large exchange an allowance of seven per cent per 
 annum is sufficient to take care of all depreciations, but in a small exchange 
 an allowance of from eight to ten per cent should be made. If deprecia- 
 tion is not taken care of by means of a reserve fund, then the cost of re- 
 newing or reconstructing must be charged to operating expense as that 
 work is done, which has the effect of not providing proper comparisons 
 of one year with another. The years in which little reconstruction work 
 is done show profits in excess of the actual profit, since no provision has 
 been made for the depreciation or deterioration of the plant which actually 
 took place during these years, and, on the other hand, the years in which 
 a great amount of reconstruction work is required to be done show profits 
 greatly short of the actual profits, since the depreciation and deteriora- 
 tion of the plant which took place in earning the profits shown in previ- 
 ous years has been burdened on to them. It is thus to show the accurate 
 result of the operations that this account is established, and its operation 
 is as follows : 
 
 At the close of each month this account is credited and Account No. 
 76 debited with one-twelfth of the yearly amount of depreciation, which 
 is based upon a fixed percentage of the amount invested in the plant. 
 
 This account now being set up so that it will exactly represent the 
 amount of the investment in the plant when the plant has been worn out, 
 it is proper to charge against it the net cost of such renewals, replace- 
 ments, and extraordinary repairs as will increase the life of the plant. 
 The net cost of any such item is arrived at as follows : 
 
 The original cost of labor and material in the part replaced. 
 
 The cost of removing same. 
 
 Less the scrap value of the parts removed, 
 
 this amount being charged to Depreciation Reserve Account No. 42 and 
 
 credited to the relative accounts as explained under Account No. 6. The 
 
 cost of the new work is charged directly to the appropriate plant account. 
 
 Such ordinary current repairs as do not necessarily increase the life 
 of the plant should be charged to Maintenance. 
 
 The depreciation account is not designed to take care of such con- 
 tingencies as extraordinary destruction by storms, and the cost of repairing 
 such damages is chargeable as follows: 
 
 All charges in connection with repairing the damage may be charged 
 to Account No. 31 and the scrap value of all salvage will be credited to 
 
 this account. . 
 
 When completed, an inventory of the actual value of the new Ime 
 should be made, together with the original value of the line rebuilt. 
 
 Then Account No. 31 should be debited with the amount by which the 
 
454 AUDITING 
 
 original value exceeds the rebuilt value and Plant Account credited, or if 
 the rebuilt value is greater than the original value, then Plant Account 
 should be debited and Account No. 31 credited with the amount of the 
 increase. 
 
 An examination should then be made of the Depreciation Reserve 
 Account and such sum as may have been set aside as depreciation on the 
 line rebuilt, after deducting any amounts which may have been charged to 
 Depreciation Reserve Account for renewals on the rebuilt line, should be 
 charged to Depreciation Reserve Account and credited to Account No. 31. 
 
 When this has been done. Account No. 31 will show the exact loss 
 from the storm and this amount can then be charged off to Account No. 77, 
 either in one sum or in equal monthly installments, covering such period 
 as may be decided upon. 
 
CHAPTER XXVI 
 
 SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS 
 
 (Continued) 
 
 MUNICIPAL 
 
 Before outlining the procedure which an auditor should 
 follow in auditing the accounts of a municipality, it will be well 
 to outline briefly the methods by which cities are financed and to 
 say a word about municipal organization. 
 
 Preparation of Budget : A time-honored custom of municipal- 
 ities and other governmental bodies is that no money can be 
 spent for any purpose whatsoever unless the expenditure has 
 been first authorized. This means that revenues or other funds 
 must be appropriated for specific purposes by the proper author- 
 ities.. The method of authorizing expenditures and appropriat- 
 ing funds is usually provided for in the city's charter or by State 
 laws. The usual procedure in appropriating revenues is some- 
 what as follows: Some time before the beginning of the fiscal 
 year the mayor or chief financial officer requests the head of each 
 department, bureau, or office to prepare a detailed estimate of 
 the amounts of money that he will require to meet the expend- 
 iture of his department for the ensuing year. These estimates 
 are usually collated by the chief financial officer. In some cities 
 they are examined by comparison with departmental records, as 
 they should be, but in most cases they are not. The financial 
 officer also prepares an estimate of the. revenues from sources 
 other than general taxes that will probably be received during 
 the ensuing year, basing the estimate on the experience of pre- 
 vious years. These estimates of expenditures and revenues 
 which constitute what is coming to be called the "tentative 
 budget" are then submitted to the council, board of commission- 
 ers, or other authorizing body for action. 
 
 Fixing the Tax Rate : After the amount which is to be author- 
 ized for expenditure has been determined upon, the amount of 
 estimated revenues is deducted therefrom in order to ascertain 
 what amount must be raised by general taxation. This amount, 
 
 455 
 
4s6 AUDITING 
 
 divided by the total assessed valuation of property, gives the tax 
 rate. 
 
 Authorization of Expenditures : These facts having been de- 
 termined, they are embodied in an ordinance, usually called 
 the budget ordinance or appropriation bill, which is voted by the 
 appropriating body. The charters of most cities provide that the 
 ordinance shall be approved by the mayor. 
 
 The funds thus appropriated usually provide only for meet- 
 ing the current operating and maintenance expenses of .the city. 
 Funds for permanent improvements and other property which 
 has a continuing value are generally raised by selling bonds 
 which in most cases run for a long term of years. These bond 
 issues must be authorized by the appropriating body, and some- 
 times action by the State Legislature is necessary. Funds so 
 raised must also be appropriated for specific purposes. 
 
 All amounts appropriated are represented by accounts in the 
 books of account and all amounts payable therefrom are charged 
 to them. The auditor should have a copy of the city charter at 
 hand, and before proceeding with the audit should acquaint him- 
 self with the provisions relating to finances and accounts. 
 
 Business Departments of a City: All cities except the very 
 small ones have a finance department and a treasury department, 
 which together handle the general financial business of the city as 
 a whole. The most important of these is the finance department. 
 This is, or should be, the central office of financial and account- 
 ing control. The official in charge is sometimes called comp- 
 troller, sometimes auditor. In commission cities he is called the 
 commissioner of finance, and in the very small cities the func- 
 tions of the office are performed by the city clerk. He keeps all 
 the general accounts of the city, audits all claims against the city 
 for payment, and performs such other duties pertaining to the 
 finances of the city as may be specified in the city charter. He 
 is usually an elected officer. 
 
 The treasurer is sometimes elected, but more frequently he is 
 appointed by the mayor or the council. He is custodian of the 
 city funds, receives all revenues, and pays all claims against the 
 city on the order or warrant of the chief financial officer. His 
 accounts should be under the accounting control of the finance 
 officer, although in some instances this control exists in name 
 
MUNICIPAL 457 
 
 only. In very small municipalities the treasurer frequently keeps 
 all of the books. 
 
 The various operating departments are managed by officers, 
 usually called either commissioners or directors, appointed in 
 most cities by the mayor. Those common to nearly all cities 
 are the health, public safety, public works, and public charities 
 departments. There are frequently departments for other func- 
 tions according to circumstances." The bulk of expenditures is 
 incurred by these departments. Usually each has its own pur- 
 chasing agent, although a few cities have central purchasing 
 departments. Most cities endeavor to make their purchases 
 chiefly by letting contracts, though in practice it is found neces- 
 sary to make many purchases in the open market. 
 
 Invoices and pay rolls are usually prepared for payment on 
 vouchers which are certified by department heads and their sub- 
 ordinates and submitted to the financial officer for audit and pay- 
 ment. 
 
 Sources of Revenue: The chief sources of revenue of cities 
 are the general taxes levied annually on the taxable real and per- 
 sonal property within the city. There are many other sources of 
 revenue, among which may be mentioned the following : 
 
 Water rates. 
 
 Excise taxes and liquor licenses. 
 
 Franchises. 
 
 Licenses. 
 
 Permits. 
 
 Privileges. 
 
 Rents. 
 
 Market fees. 
 
 Market rents. 
 
 Tolls. 
 
 Fees. 
 
 Court fines and penalties. 
 
 Court costs and fees. 
 
 Sale of old material. 
 
 Interest. 
 Control of Receipts and Expenditures: The general theory 
 of control over city revenue is that for all moneys paid into the 
 city treasury there shall be an independent report made by the 
 
458 AUDITING 
 
 collecting office to the financial officer from which he can build 
 up a record of cash receipts for the purpose of establishing a con- 
 trolling account against the treasurer. The means of control 
 over cash payments made by the treasurer originate with the 
 financial officer, since it is only upon the order or warrant of the 
 latter that the treasurer can pay out money. The treasurer's 
 cash account can be reconciled with the comptroller's cash ac- 
 count by taking account of the warrants not yet paid by the 
 treasurer's cheques. In many cases, however, the treasurer 
 draws cheques on the same day on which the warrants are 
 drawn, so that his cash account is, or should be, always in agree- 
 ment with the financial officer's account. 
 
 Few cities have adopted methods by which control may be 
 established over the amount of revenues that should accrue. 
 This can be done absolutely only by the use of controlled finan- 
 cial stationery^ issued to collecting offices by the chief financial 
 officer. This stationery should be so manufactured as to be diffi- 
 cult to imitate, and should be numbered and charged to the col- 
 lecting agents, who must account for it either in money or un- 
 used forms. 
 
 A system should provide for daily and monthly reports of 
 collection, the daily reports to the financial officer to be accom- 
 panied by skeleton carbon copies prepared at the time the orig- 
 inal document is issued. At the same time daily reports of col- 
 lections are made to the treasurer, who, after making the neces- 
 sary entries in his books, acknowledges the receipt of the cash 
 on the reports and transmits them to the finance officer. The 
 latter audits the treasurer's reports by mean^ of the collecting 
 agents' reports and the carbon copies above referred to, thus 
 establishing a current control over the accuracy and complete- 
 ness of revenue returns. 
 
 The accounting methods of most municipalities are crude and 
 archaic, few of them having kept pace with the modern improve- 
 ments in accounting practice. Their bookkeeping consists 
 mainly of accounts showing the condition of appropriation ac- 
 counts and the inflow and outgo of cash. Accounts on the basis 
 
 'This is similar in form to the money orders used by the Post Office Department. The 
 cutting of the dollars and cents on the margin controls the amount to be accounted for by 
 the receiving clerk. The unused portion of each piece of stationery is preserved as a voucher. 
 
MUNICIPAL 
 
 459 
 
 of revenue accrued and expenses incurred are the exception, and 
 accounts showing assets such as taxes and other revenue receiv- 
 able, stores, equipment, and other permanent properties, are 
 either not understood or considered wholly superfluous by all but 
 a few cities. 
 
 Periodical Examinations: The following extract from "Short 
 Talks on Municipal Accounting and Reporting," issued by the 
 Metz Fund, August 15, 1912, is of interest: 
 
 As a means of insuring continuous conformity to the authorized proce- 
 dure, it is a good plan to have the accounts audited and the procedure in- 
 spected periodically, once or twice a year, by a competent representative of 
 the comptroller's office, or, if necessary, by an outside accountant. In ad- 
 dition to establishing the integrity of the accounts (if they are correct), such 
 an inspection will determine not only whether the procedure is being scru- 
 pulously followed, but will afford the examining accountant an opportunity 
 to suggest modifications or improvements which may be needed as conditions 
 change with the lapse of time. 
 
 In this relation it may be of interest to quote from a letter received by 
 the Metz Fund from the comptroller of a large New England city. He 
 writes: "We are having an audit conducted in this city of the comptroller's 
 records and of other department records in so far as they relate to the comp- 
 troller's records. Some criticism has arisen as to the need of such a step, 
 some maintaining that it is an audit of the auditor and that there should be 
 no need for such a proceeding. While I do not expect you to decide a con- 
 troversy, yet I consider that a talk on such a subject would be of interest to 
 citizens and officials throughout the country." 
 
 It is true that many persons not concerned with the active management 
 of business do not see the necessity of an independent audit made by an 
 outsider. But the experience of thousands of enterprises has so conclusively 
 demonstrated the wisdom of such a procedure that the subject is no longer 
 debatable. A large proportion of well-conducted private concerns, even 
 though their regular office staff includes an auditor or a comptroller, have 
 periodical examinations of their accounts made by professional auditors, and 
 the proportion is constantly increasing. They have learned that the moral 
 effect of an audit on the office staff is salutary ; that many a man who, if left 
 to his own devices, might misappropriate funds and falsify the accounts to 
 conceal the misappropriation, would absolutely be deterred from so doing 
 if he knew that an audit of the accounts would be made which would mean 
 exposure. Even the employee who does not have the handling of funds will 
 do his work better if he knows that he may be criticised by an outsider. 
 
 The inside auditor, from too close contact, loses his ability as well as his 
 disposition to criticise, hence the outside auditor is needed to supply this 
 deficiency. The professional accountant, moreover, by reason of his contact 
 with the affairs and problems of many widely different concerns, is in a posi- 
 tion to make valuable suggestions as to the accounting methods, organization. 
 
46o AUDITING 
 
 and business policies of his client, and such service has frequently bridged 
 the gap between failure and success. The need for independent audits is 
 even greater in public business, where tenures of office are frequently of short 
 duration and where there are not the same influences at work which make 
 for strict accountability in private business. There is no reason why system- 
 atic audits of municipal accounts should not be made by a properly equipped 
 State department. 
 
 Audit of Revenue : The auditor should carefully examine the 
 method of control over revenues, and if it is adequate in principle, 
 he should make tests to satisfy himself that all the revenue to 
 which the city is entitled has been accounted for. If the method 
 of internal check does not sufficiently safeguard the city's inter- 
 ests, his judgment must be guided by circumstances. He must 
 adopt such a procedure as will be necessary to satisfy himself 
 that the cash turned in is the amount collected, and that the 
 amount collected is the amount to which the city is entitled. 
 
 Taxes: As general taxes constitute the major portion of the 
 revenues, he should pay particular attention to the method of 
 accounting for them. He should ascertain whether the uncol- 
 lected taxes recorded on the tax rolls agree with the summary or 
 controlling account in the general ledger. He should see that 
 abatements made are authorized and should make tests to ascer- 
 tain that the proper amount of interest and penalties has been 
 collected on past-due taxes. He should notice whether altera- 
 tions have been made in tax assessments in the tax roll and 
 should make sure that all alterations are authorized. 
 
 The laws of most States provide that when taxes are in 
 arrears a certain length of time, the tax liens (in some cases the 
 property itself) shall be sold by the city to indemnify it for the 
 taxes unpaid. The auditor should make a note of all taxes in 
 arrears in respect of which the city has not availed itself of its 
 prerogative thus to indemnify itself. 
 
 Assessments: Assessments due the city for improvements, 
 such as sewers, grading and paving streets, etc., benefiting par- 
 ticular properties, should also receive attention. In most cases 
 the city undertakes these improvements, financing them by bor- 
 rowing on public improvement or assessment bonds and then 
 assessing the property benefited to recover the amount spent. 
 Frequently the city bears a percentage of the cost. The auditor 
 should look into the condition of assessments levied to see that 
 
MUNICIPAL 461 
 
 they are accounted for in cash or accounts due, and whether the 
 conditions attaching to the assessments are being compUed with, 
 such as the payment of principal within a stated period, interest, 
 penalties, etc. 
 
 Rents and Franchises: The auditor should see that rents for 
 all properties of which the city is lessor are accounted for and 
 that the income from all franchises granted by the city has been 
 accounted for. 
 
 Audit of Outstanding Accounts : The general theory of veri- 
 fying accounts receivable by sending confirmatory statements to 
 debtors may properly be appHed in the audit of municipal ac- 
 counts. Such a plan would be particularly useful in verifying 
 unpaid taxes, and in many cases would probably be fruitful of 
 results, although there will probably be somewhat more difficulty 
 in reaching persons so indebted than ordinary trade debtors. 
 
 Audit of Expenditures: The method of internal audit of 
 claims against the city should be carefully inspected. All 
 vouchers should be approved by the heads of departments in 
 which they originate and should be certified by the subordinates 
 who have knowledge of the facts as to delivery of goods or per- 
 formance of services, quality, prices, correctness of calculations, 
 etc. If vouchers are by law required to be approved by the 
 council or a council committee, the auditor should see that this 
 rule has been complied with. Payments of an unusual character, 
 such as judgments, damage claims, etc., should be carefully 
 scrutinized. Particular attention should be paid to pay-roll 
 vouchers to see that they are not "padded." Usually the salaries 
 and number of incumbents of all positions other than those of 
 laborers are fixed by the council. Tests may be made by refer- 
 ence to the council's resolutions relating to these matters. Pay- 
 ments of bonds and bond interest should be carefully scrutinized 
 and audited by reference to canceled coupons and bonds, or, in 
 the case of interest on registered bonds, to the record of bonds 
 outstanding. 
 
 Tests of prices paid for supplies, particularly those used 
 in large quantities, such as coal, forage, etc., will often reveal 
 improper methods of administration. For example, it will some- 
 times be found that one department buys coal at one price and 
 that another department pays the same contractor consider- 
 
462 AUDITING 
 
 ably more for the same kind of coal at the same season of the 
 year. The charters or ordinances of most cities fix the max- 
 imum amount which may be purchased on open order, requiring 
 that purchases exceeding this limit be made by public letting of 
 contracts. This rule is frequently violated by "splitting" orders 
 among favored dealers, keeping each order within the lawful 
 limit, the result of which is that the city pays very much higher 
 prices than it would have to pay if it obtained competitive bids. 
 
 Since expenditures can be made only from appropriated 
 funds, the auditor should see that claims have been charged to 
 the proper appropriation accounts. He should report all appro- 
 priations which have been overdrawn. 
 
 Sinking Funds: The adequacy of sinking fund provisions 
 should have careful consideration. It is astonishing how many 
 cities fail to lay aside regularly money which will accumulate 
 and be sufficient and available to pay off bond obligations at 
 maturity. In order that the burdens growing out of the acquire- 
 ment of properties of a more or less permanent character may 
 be to some extent distributed over a period of years, cities finance 
 these acquisitions by issuing long-term bonds, the plan being to 
 raise by taxation and set aside each year in a sinking fund an 
 amount which, with interest accretions, will be sufficient to retire 
 the bonds at maturity. Rarely are these yearly sinking fund 
 installments computed correctly; indeed, in some instances they 
 are not raised at all. 
 
 In some States the amounts which cities are required to pay 
 into sinking funds yearly are fixed by law, a certain percentage 
 of the total issue of bonds being specified, while the charters of 
 some cities provide that revenues from certain sources shall be 
 turned into the sinking fund. Sometimes this causes the sink- 
 ing funds to be in excess of requirements, which means that tax- 
 payers are bearing a heavier burden than is necessary. Sink- 
 ing fund requirements should be computed on the basis of 
 actuarial tables, and a reserve should be built up by additions 
 each year, which will at all times show what should be in the 
 sinking funds to date. The auditor should ascertain whether the 
 amounts in the sinking funds in cash and securities equal the 
 actuarial reserve. If there is a deficit he should call particular 
 attention to the fact. 
 
MUNICIPAL 463 
 
 Financial Statements: The financial condition of a municipal- 
 ity is more easily understood if its transactions are summarized 
 according to the several groups into which they naturally fall 
 and financial statements prepared accordingly. 
 
 The accounts growing out of the raising of current revenues 
 and the incurring of liabilities to meet current operating and 
 maintenance expenses constitute the general account, or the gen- 
 eral fund, as it is frequently called. At the end of the fiscal 
 period these transactions are reflected in a balance sheet of the 
 general account and a statement of revenues and expenses. The 
 assets and liabilities of the general account may thus be related 
 to a statement of revenues and expenses as in any private busi- 
 ness. The principal items of assets are cash, taxes, and miscel- 
 laneous revenues receivable, stores, work in progress, and pre- 
 paid expenses. The principal liabilities are invoices and pay rolls 
 payable, vouchers and warrants payable, and temporary loans 
 made in anticipation of the collection of taxes and other revenues. 
 
 The second natural division or group has to do with the per- 
 manent properties and equipment of a city, construction and im- 
 provements in progress, including assessments levied against 
 property owners who are benefited by improvements. The lia- 
 bilities relating to this group are invoices and pay rolls payable, 
 assessment or special improvement bonds, and funded debt. 
 These constitute the capital account balance sheet. 
 
 The third natural division has to do with the funds and prop- 
 erties held in trust by the city, such as intestate estates, bequests, 
 security deposits, pension funds, etc. The condition of these 
 trusts is shown in a trust fund balance sheet. 
 
 The fourth group comprises the appropriation fund accounts, 
 which are set forth in a fund balance sheet. These show the con- 
 dition of appropriated funds and the contingent liabilities of the 
 city on contracts and open orders, the latter being charges or en- 
 cumbrances against appropriated funds which have not yet be- 
 come actual liabilities. Opposed to these items are shown the 
 resources, present and prospective, which are looked to for the 
 liquidation of the liabilities. 
 
 These several detail balance sheets are brought together in a 
 summary consolidated balance sheet in order to give in a single 
 statement a complete view of the city's finances. 
 
464 AUDITING 
 
 GENERAL ACCOUNT BALANCE SHEET 
 
 (Exhibit 2, page 472.) 
 
 Accounts Receivable — Unpaid Taxes: This is supported by 
 the uncollected items in the tax rolls, or tax duplicate, as it is 
 sometimes called. Provision for uncollectible taxes should be 
 made currently by including in the annual budget of expenses a 
 percentage of the tax levy sufficient to cover the estimated loss 
 in collection. The product of taxes levied in the year will thus 
 be sufficient to meet all expenses authorized for the year. 
 
 Miscellaneous Revenues Receivable: This account is sup- 
 ported by the revenues receivable ledger and includes various 
 uncollected charges. 
 
 Due From Other Funds : This account is charged with cash 
 temporarily loaned to the capital account or to trust funds. It is 
 credited when cash is returned or when cash is borrowed from 
 these funds. 
 
 Stores (which should be supported by stores ledgers) : Are 
 shown in the general account balance sheet and not in the capital 
 account balance sheet, since in the main they are used for meet- 
 ing current operating and maintenance expenses. If any stores 
 are used for construction purposes, a charge for them is made to 
 the capital account the same as if cash were advanced. 
 
 The reserve for stores among the liabilities is merely a device 
 to keep them from being represented in the surplus. Stores and 
 other prepaid items are not available for meeting contingent lia- 
 bilities which may exist or which may be incurred against appro- 
 priated funds, and hence, to find the balance of assets available 
 for further appropriation, they are excluded from the surplus. 
 
 Temporary Loans in Anticipation of Taxes : Many cities are 
 obliged to borrow money for short periods pending the collec- 
 tion of taxes and other revenues. In consequence, temporary 
 loans are made which are a lien against these revenues. They 
 should be paid off when the collections are made. 
 
 CAPITAL ACCOUNT BALANCE SHEET 
 
 (Exhibit 4, page 473.) 
 
 Cash: Is held exclusively for meeting liabilities incurred in 
 the acquisition of property having a continuing value, such as 
 
MUNICIPAL 465 
 
 lands, buildings, equipment, and improvements. It is obtained 
 by issuing long-term bonds and by the collection of assessments. 
 
 Assessments Receivable: Are amounts due from property 
 owners whose property has been benefited by local improve- 
 ments, such as the paving of streets, the building of new sewers, 
 etc. They are frequently made payable in installments. This 
 item is supported by individual accounts in the assessment rolls 
 or assessment ledger. 
 
 Local Improvements in Progress : Represent current expend- 
 itures for grading and paving new streets, building sewers, etc., 
 the cost thereof being assessable against property deemed bene- 
 fited when the improvements are completed, at which time this 
 account is credited and assessments receivable debited. Coinci- 
 dent with this entry, permanent improvements account is 
 charged and capital account surplus is credited. It frequently 
 happens that the city is obliged to stand some portion of the cost 
 of the improvements. This is the case when city property is 
 benefited by them or when the city at the outset agrees to bear a 
 percentage of the cost. When the city's share is determined, 
 long-term bonds are usually issued to meet it. At the time per- 
 manent improvements account is charged as noted above, capital 
 surplus is credited for the amount assessed against taxpayers 
 only, local improvements in progress being credited with the 
 amount to be borne by the city. 
 
 Other Accounts: When among the assets, will be readily 
 understood by their titles. These items should be supported by 
 detail ledgers showing the various individual properties owned 
 by the city. 
 
 The rule in regard to depreciation of assets may be applied 
 in municipal accounts as in the accounts of private concerns, 
 with one exception. The best authorities suggest that instead of 
 creating a depreciation reserve by a mere bookkeeping entry, the 
 depreciation charges should be included in the annual budget of 
 expenses and the cash raised and invested in a fund. At the end 
 of the period estimated to be the life of the property this fund 
 would contain an amount sufficient to replace it, and the prop- 
 erty would thus be automatically perpetuated. 
 
 The argument advanced against this practice is that it 
 entails a double charge against taxpayers, namely, the annual 
 
466 AUDITING 
 
 depreciation charge and the annual sinking fund installments 
 provided for the retirement of the bonds sold to purchase the 
 properties. In some cases at least, it is a question whether, 
 when a public work has outlived its usefulness and an entire 
 reconstruction is in order, there should not be a new issue of 
 bonds for the rebuilding. In this way the cost, of the improve- 
 ment may be spread over its life, and each generation of tax- 
 payers made to bear the burden of the improvements it enjoys 
 by a single charge for the annual sinking fund installments. As 
 a matter of actual practice, however, depreciation of municipal 
 properties is seldom provided for. 
 
 Assessment or Special Improvement Bonds: Represent the 
 bonds issued to finance assessable improvements. They are 
 shown under a separate head so that they may be contrasted 
 with assessments receivable which are available for meeting 
 them. 
 
 Bonded Debt: Instead of showing sinking fund cash and 
 investments among the assets of the capital account, they are 
 shown as a deduction from bonded debt. This admits of stating 
 them in a supplementary statement (sinking fund balance sheet. 
 Exhibit 5, page 473) in relation to the reserve required to meet 
 bonded debt at maturity. As has been previously pointed out, the 
 most important fact to be set forth in connection with sinking 
 funds is the amount that should be on hand in cash and invest- 
 ments at any given date. This can be dope only by building up 
 a reserve on an actuarial basis, adding to it each year an amount 
 equivalent to the amount of cash that should be provided each 
 year, which, accumulated to the maturity date of the bonds, plus 
 interest accretions, will yield an amount equal to the amount of 
 bonds to be paid off. If an amount of cash commensurate with 
 the yearly reserve (allowing for interest accretions) is not pro- 
 vided each year, the inadequacy of the sinking funds will be dis- 
 closed by the excess of the reserve account. In other words, 
 there will be a deficit in the sinking funds. 
 
 TRUST FUND BALANCE SHEET 
 
 (Exhibit 8, page 474.) 
 
 Cash, Securities, and Investments: Are supported by detail 
 ledger accounts showing how the trust funds are invested. The 
 
MUNICIPAL 467 
 
 assets are not necessarily ear-marked according to the several 
 trusts represented, though they may be. 
 
 Invoices Payable, Vouchers and Pay Rolls Payable, Warrants 
 Payable: Are the current liabilities of the trust accounts. The 
 number of separate general ledger accounts to be kept will de- 
 pend somewhat upon the precise methods employed for handling 
 transactions. 
 
 Reserve for Public and Private Trusts: Under this head are 
 summarized the various trusts assumed by the city. Each indi- 
 vidual trust is represented by an account, and if there are many 
 of them, as is usually the case in large cities, these accounts 
 should be carried in a subsidiary trust fund ledger. 
 
 CURRENT OPERATION AND SURPLUS ACCOUNT 
 
 (Exhibit 3, page 472.) 
 
 As an adjunct of the general account balance sheet it is 
 necessary to show (i) the revenues and expenses for the fiscal 
 period, and (2) the present condition of the surplus of the gen- 
 eral account. Revenues should be summarized according to 
 sources, and expenses according to purposes. For the latter, 
 it is suggested that the functional classification adopted by the 
 United States Census Bureau be employed. This classification 
 divides the expenditures of a city under the following significant 
 headings, viz., general government, protection to persons and 
 property, conservation of health, sanitation, highways, charities, 
 correction, education, recreation, interest, and miscellaneous. 
 
 The financial statements thus far discussed represent what 
 may be called the proprietary relations of a city, that is, what 
 the city owns and what it owes and the results of current opera- 
 tion. These statements are in every respect analogous to those 
 employed in private business. We shall now discuss the state- 
 ments that show the funding relations of a city, namely, those 
 which have to do with the restrictions placed upon public officers 
 in the expenditure of funds. There are two main categories of 
 funds — those derived from taxation and those obtained from the 
 sale of long-term bonds. A statement of the former is an ad- 
 junct of the general account balance sheet, whereas a statement 
 of the latter is an adjunct of the capital account balance sheet. 
 
468 AUDITING 
 
 FUND BALANCE SHEET— GENERAL ACCOUNT 
 
 (Exhibit 6, page 474.) 
 
 An analysis of the items appearing on the credit side of this 
 statement will facilitate the understanding of it. When the ap- 
 propriating body authorizes the amounts which may be expended 
 (budget), it is necessary to establish accounts in the books 
 so that officers may know at any time the amount of author- 
 ized funds available for expenditure and so that they may 
 know when they have reached the limit of expenditure. An 
 entry is therefore made in the general ledger crediting appropria- 
 tions or authorisations to incur liabilities for the amount authorized. 
 Detailed accounts showing the various purposes of expenditure 
 are opened in a subsidiary ledger. Under the rules of double- 
 entry bookkeeping some account must be charged, and since the 
 appropriations are predicated upon revenues which are expected 
 to accrue, an account is established on the debit side entitled esti- 
 mated revenues from taxes and miscellaneous receipts needed to 
 meet budget authorizations. This gives not only a proper equa- 
 tion, but lays the foundation for currently obtaining two distinct 
 items of information, as will presently be shown. 
 
 Some accountants attempt to treat appropriations as liabil- 
 ities and include them among the liabilities in the balance sheet. 
 This is obviously improper, since the act of appropriating money 
 for expenditures does not make the city a debtor. The argu- 
 ment in favor of treating appropriations as a liability is, that 
 while a mere appropriation is not a liability, yet if taxes have 
 been levied to provide for payment of the municipality's ex- 
 penses for a whole year and the uncollected part of such levy 
 is included in its entirety among the assets, the oniission from 
 the liabilities of the appropriations for which the levy was made 
 shows a surplus which is likely to mislead (at least during the 
 early part of the year) as to the municipality's financial condi- 
 tion. It is quite feasible, however, by means of the fund balance 
 sheet to show the exact condition of affairs without thus doing 
 violence to the accepted meaning of terms. 
 
 When contracts are awarded and orders are issued, con-; 
 tingent liabilities are created and appropriations are encum- 
 
MUNICIPAL 469 
 
 bered. These must be recognized in any statement of a city's 
 financial condition. The details relating to unencumbered ap- 
 propriations and contingent liabilities on contracts and orders 
 are shown by the appropriation ledger over which these general 
 ledger accounts operate as a control. The details of contracts in 
 the appropriation ledger are further supported by the contract 
 ledger. 
 
 In order to maintain a distinct accounting action within the 
 fund group of accounts, it is necessary to introduce two other 
 debit accounts, namely, available balance and unapplied balance. 
 In doing this, valuable information is currently produced which 
 otherwise could not be obtained without analysis. The unapplied bal- 
 ance is identical with cash less demand liabilities shown in the 
 general account balance sheet, and as such it shows what amount 
 of cash is available for meeting contingent liabilities on contracts 
 and orders already incurred, or to be incurred, against available 
 appropriations. It appears only in the general ledger and is not 
 supported by subsidiary accounts. Available balance is identical 
 with accounts receivable in the assets. It is built up by credits 
 to the account estimated revenues from taxes and miscellaneous 
 receipts needed to meet budget authorizations. It is likewise not 
 supported by subsidiary accounts. Action in both of these ac- 
 counts is produced by entries secondary or collateral to those 
 which affect assets, liabilities, revenues, and expenses. For 
 example, when cash is received in payment of taxes, cash is 
 debited and taxes receivable is credited. At the time this entry 
 is made a secondary entry must be made in the fund group 
 of accounts debiting unapplied balance and crediting available 
 balance. 
 
 The item on the credit side entitled reserve for retirement of 
 loans in anticipation of collection of taxes represents the item in 
 the general account balance sheet entitled temporary loans in 
 anticipation of taxes. It is not supported by any subsidiary ac- 
 counts. 
 
 For further information regarding the bookkeeping proced- 
 ure relating to the treatment of these accounts, the reader is re- 
 ferred to "Handbook of Municipal Accounting," prepared by 
 the Metz Fund for Promoting Efficient Municipal Accounting 
 and Reporting. 
 
470 AUDITING 
 
 FUND BALANCE SHEET— CAPITAL ACCOUNT 
 
 (Exhibit 7, page 474.) 
 
 A similar group of accounts is kept to show the condition of 
 funds raised by issuing bonds, and the condition of these funds 
 is shown in a fund balance sheet of the capital account (Exhibit 
 7). One of the items on the credit side of this statement needs 
 to be explained, namely, reserve for retirement of assessment bonds. 
 As assessments are collected assessments receivable is credited 
 and cash is debited. At the same time a secondary entry must 
 be made in the fund accounts debiting unapplied balance and cred- 
 iting this reserve. The latter serves to show the cash that should 
 be held available for paying off the assessment bonds by which 
 the assessable improvements were financed. 
 
 SUMMARY CONSOLIDATED BALANCE SHEET 
 
 (Exhibit I, page 471.) 
 
 We come now to the summary consolidated balance sheet, 
 which comprises the several detail balance sheets and fund state- 
 ments already described and gives in a single statement a com- 
 prehensive view of a city's financial condition. It is in two sec- 
 tions, the first dealing with assets, liabilities, and surplus, the 
 second section showing estimated revenues, appropriations, and 
 reserves. It will be noted that the accounts available balance and 
 unapplied balance are eliminated from this consolidated balance 
 sheet, the assets, which they represent in a detached statement, 
 taking their place. In the second section the excess of assets is 
 added to the balance of estimated revenues from taxes and miscel- 
 laneous receipts for the reason that appropriations which were 
 predicated on such estimated revenues are stated against them. 
 As any balance of the estimated revenues not accrued (or col- 
 lected) at the end of the fiscal year will have to be provided for 
 in the following year, it must be regarded as at least a potential 
 asset. The excess of assets and estimated revenues over liabil- 
 ities, appropriations, and reserves is the amount which is avail- 
 able for further appropriations ; in other words, the free surplus. 
 

 
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CHAPTER XXVII 
 
 SPECIAL POINTS IN DIFFERENT CLASSES OF 
 AUDITS (Continued) 
 
 EXECUTORS AND TRUSTEES 
 
 An audit of the accounts of executors or trustees properly 
 begins with a careful reading of the will or deed of trust, as the 
 provisions of these documents will have an important bearing on 
 the actions of the executors or trustees as reflected in their ac- 
 counts. While the apportionment of receipts and payments be- 
 tween capital and income should always receive attention in the 
 auditing of trusts, it becomes extremely important under some 
 wills and trust deeds. 
 
 Having examined the documents from which the trustees 
 derive their power, the auditor should next compare a certified 
 copy of the inventory of the estate, which was filed with a court 
 of probate, with the trustees' books, to see that all the assets 
 scheduled in the inventory have been entered in the books and 
 at the appraised values. Should the trust have already been in 
 existence for a considerable time and the audit not go back to its 
 inception, it is desirable that the examination start with the date 
 with -vvhich the most recent account approved by the court 
 closed. 
 
 The income from securities should be verified in detail. This 
 can usually be very satisfactorily done ; even if the securities are 
 not listed on a stock exchange, information as to dividends or 
 interest paid thereon can in almost all cases be obtained without 
 much difficulty. Overdue interest on mortgages should be in- 
 vestigated. 
 
 When examining the securities, which work is an important 
 feature of the audit, the auditor should see that they are regis- 
 tered in the names of all the trustees, if there are more than one. 
 
 If real estate has been committed to the care of the trustees, 
 or if the will gives the executors the custody and disposition of 
 
 475 
 
476 AUDITING 
 
 the testator's real estate, the rentals therefrom will need to be 
 verified and taxes and other realty expenses vouched. 
 
 Vouchers should be submitted to the auditor for all pay- 
 ments. In verifying the correctness of the credits taken by the 
 executors or trustees, the commissions paid or claimed should be 
 carefully scrutinized. Their arithmetical correctness can usually 
 be verified in total, but it is also important to see that the basis 
 on which they were calculated is a proper one. Particularly must 
 duplications of commissions be guarded against. If an executor 
 becomes trustee of an estate after being discharged as executor, 
 he will receive but one commission on the principal of the estate. 
 Furthermore, a commission is not ordinarily allowed on changes 
 of investments, though it is usually allowed on the net increase, 
 if any, in the principal caused by such changes. The average 
 rates of commission allowed executors and trustees of decedents' 
 estates are two and one-half or three per cent on the principal 
 and five per cent on the income handled, but rates vary, and in 
 some States a sliding scale of commissions is in force. In the 
 case of large estates, however, a different rate or a fixed amount 
 of compensation is sometimes named in the will (frequently, no 
 doubt, in pursuance of an agreement between the executor to be 
 and the testator during the latter's lifetime), and by accepting 
 the trust the executor binds himself to limit his commission in 
 accordance with the stipulation in the will. Presumably, how- 
 ever, if the executor declined to serve and no one could be found 
 who would be willing to accept the trust for the stipulated com- 
 pensation, the probate court could appoint an administrator who 
 would not be bound by this stipulation of the will, but would be 
 allowed the ordinary rate of commission. 
 
 In a complete audit of the accounts of a trust estate, the in- 
 vestments made by the trustees should also be reviewed from 
 the standpoint of whether they were legitimate at the time they 
 were made. The character of investments which are legal for 
 trust funds vary in different States ; generally they are first mort- 
 gages on real estate, Government (Federal, State, county, and 
 municipal) bonds, and the first mortgage bonds of railroads hav- 
 ing an established dividend record. 
 
 The importance of a correct apportionment of all receipts 
 and payments between principal and income has already been 
 
EXECUTORS AND TRUSTEES 477 
 
 mentioned. In this connection it should be borne in mind that 
 interest and rents accrued to the date of the testator's decease are 
 part of the corpus or principal of the estate ; that profits realized 
 or losses sustained on the liquidation of legitimate investments 
 are added to or deducted from the principal; that expenses dur- 
 ing the period of the executorship are paid out of principal and 
 not from income, excepting expenses connected with improved 
 real estate which are chargeable against the income derived 
 therefrom ; that losses on unauthorized or illegal investments are 
 chargeable to the trustees personally with such interest (usually 
 at the rate of six per cent per annum without compounding) as 
 may be directed by the court ; that a trustee is similarly charge- 
 able with interest on funds actively applied to his own use or 
 indirectly so applied by merging them with his own funds, even 
 though he may have balances on deposit to his personal credit in 
 excess of the trust funds for which he is responsible ; that, even 
 when investments of a wasting nature are specifically author- 
 ized, or form the original principal of the estate, a life tenant 
 does not necessarily receive the entire gross income. When the 
 instrument creating the trust provides that the life tenant and 
 the remainderman shall benefit equally from such investments, it 
 is usual to treat such part of the receipts from the investment as 
 equals, say, five per cent on the appraised value of the invest- 
 ment at the time the trust was created as income for the life 
 tenant and to capitalize the amount received in excess thereof. 
 
 The terms of the will or trust deed may, however, modify any 
 of the foregoing rules, and hence the importance of the auditor 
 studying carefully the conditions of the trust. 
 
 With regard to premiums paid on securities purchased by 
 the estate, the usual rule is that they come out of the principal of 
 the estate. Discounts on bonds purchased inure to the benefit 
 of the principal. As probably the great majority of investments 
 which are legal for trust funds sell at a premium rather than at a 
 discount, one does not oilfset the other. From an accounting 
 standpoint, premiums paid on bonds purchased should be amor- 
 tized over the life of the bonds, and a portion of each interest 
 payment retained to refund the premium advanced from the prin- 
 cipal of the estate, and only the actual income yield on the in- 
 vestment paid over to the life tenant. The accountant must. 
 
478 AUDITING 
 
 however, in this, as in all matters pertaining to trust estates, be 
 guided by the rules laid down by the court, which are not uni- 
 form in the different states. It is to be hoped that the courts 
 will in time give effect to a more logical treatment of premiums 
 on bonds than they have in the past. 
 
 The division or partition of an estate is frequently quite a 
 complex proceeding. An estate is sometimes left in trust for the 
 children of a family, each to receive his or her respective share of 
 the principal on attaining a specified age. Until such time each 
 beneficiary receives only his or her share of the income. As the 
 specified event would not occur simultaneously in the case of all 
 the beneficiaries, they would not all become entitled to their re- 
 spective shares at the same time. As soon, however, as any one 
 became entitled to receive his share, he could demand it without 
 having to wait for such time as all the heirs could receive their 
 respective shares of the principal, and, excepting by consent, the 
 estate would have to be forthwith divided. Should the estate 
 consist of securities which are readily divisible, no serious diffi- 
 culty is encountered, as the beneficiary may then be given 
 his proportion of each of the estate's investments. Should the 
 estate, however, consist of real estate or other nondivisible 
 assets, resort must be had to some other method of determining 
 the beneficiary's share and delivering it to him. 
 
 Were all the beneficiaries of age, a mutual agreement could 
 be made, but if any one of the beneficiaries is a minor, he or she 
 cannot give binding consent to such an agreement. The only 
 course left open is to apply to the courts for an order to "par- 
 tition" the estate; the final order of the court confirming the 
 share determined to be payable to the beneficiary entitled to the 
 partition will be a protection to all parties interested. The pay- 
 ment of his share to the retiring beneficiary forthwith terminates 
 his interest in the estate, and he is not concerned in any fluctua- 
 tions in the value of the trust investments which may subse- 
 quently take place. Such fluctuations would affect only the re- 
 maining beneficiaries, for whose benefit the balance of the estate 
 would be administered. 
 
 A principle of law which should not be overlooked is that no 
 beneficiary who is under age has power to consent to any 
 changes in the terms of a trust. 
 
INSTITUTIONAL 479 
 
 EDUCATIONAL INSTITUTIONS 
 
 As the greater portion of the income of educational institu- 
 tions is usually derived from tuition fees, dormitory rents, and 
 board, any failure of the records to control adequately the col- 
 lection of such income should be reported, and detailed tests 
 should be made (if these records are kept by single entry) to 
 ascertain that all such income is being received and accounted 
 for. Particular attention should be given to cases where no tui- 
 tion fees, or fees at reduced rates, are received, to ascertain that 
 proper authority therefor has been granted. The collection of 
 extra charges for diplomas, special examinations, laboratory or 
 school supplies, etc., should be given careful attention. 
 
 The examination of securities and the verification of the in- 
 come therefrom are important. The records should show clearly 
 the total amounts of all special funds, the invested and unin- 
 vested portion thereof, and, in addition, should enable the auditor 
 to ascertain that the income therefrom has been applied to the 
 purpose designated by the donors. 
 
 The annual report will be of material assistance to the 
 auditor in the verification of income from tuition and donations, 
 as the names of students and donors (and the nature and amount 
 of donations) are usually detailed therein. If the report is not 
 published until after the audit, it is desirable for the auditor to 
 verify the proof sheets of the annual report prior to the final 
 printing thereof. 
 
 The accounts of most educational institutions are kept only 
 on a cash basis, and uncollected income and outstanding liabil- 
 ities are usually ignored in stating their financial operations. It 
 would be well for the auditor to recommend changes in the ac- 
 counting records which will enable accurate statements of opera- 
 tions, as well as of assets and liabilities, to be prepared period- 
 ically. These statements will be valuable to the executive offi- 
 cers and trustees and should form part of the annual report. 
 
 CHARITABLE ORGANIZATIONS 
 
 This class of institutions includes hospitals, asylums, orphan- 
 ages, relief societies, and all organizations whose aim is to relieve 
 suffering and distress. That respect in which the accounts of 
 
48o AUDITING 
 
 charitable organizations especially differ from ordinary commer- 
 cial accounts is the receipt of voluntary subscriptions and con- 
 tributions. The receipts or acknowledgments sent to contrib- 
 utors should be consecutively numbered, and preferably so de- 
 signed that a carbon copy will remain on file. Entries should 
 be found in the cash book for all donations appearing on the 
 copies of acknowledgments to contributors. The only practical 
 way of insuring an accounting for all contributions received is 
 to include in the annual report a list showing both the names of 
 contributors and the amounts of their donations; then if any 
 donations have not been accounted for, the donors may call at- 
 tention to the omission thereof from the published list. 
 
 In hospitals, asylums, and like institutions considerable in- 
 come is received from pay patients. This should be thoroughly 
 verified. Keeping a controlling account in the general ledger 
 for the patients' accounts will aid materially in verifying the cor- 
 rectness of the income from patients. 
 
 Patients' accounts are similar in theory to those of hotel 
 guests. There is a patients' register in which are recorded the 
 arrival and departure of patients, and the books can be so 
 arranged as to permit of a conclusive audit. 
 
 Another item of income is from appropriations made by the 
 State. These are sometimes in round sums and in other cases 
 are based on the number of patients cared for at a fixed amount 
 per patient. 
 
 In some States the accounts of charitable institutions receiv- 
 ing State aid are subject to audit by representatives of a State 
 bureau. These official audits are usually restricted to an inquiry 
 into the expenditure of the State appropriation and do not em- 
 brace the verification of other items of income and expenditure. 
 Some States also prescribe a classification of expenses which in- 
 stitutions receiving State aid must follow, but these classifica- 
 tions have not as a rule been planned with the thoroughness 
 characteristic of the classifications prescribed for public service 
 corporations. 
 
 In the great majority of cases the accounts of charitable insti- 
 tutions are kept on a purely cash basis. The need for keeping 
 and stating the accounts on a true income and expense basis so 
 that actual results of operations may be seen is just as great in 
 
INSTITUTIONAL 481 
 
 the case of charitable institutions as in business houses. As 
 every accountant knows, a cash statement does not necessarily 
 show the real cost of conducting an institution, and a large de- 
 ficit may be accruing of which the published reports give no inti- 
 mation. 
 
 In auditing the disbursements, the actual cost of operation 
 should be ascertained as closely as feasible and the per capita 
 cost determined. This will furnish data for comparison with the 
 operations of other institutions of like nature ; such comparisons 
 make for increased efficiency. 
 
 The use made of trust funds devised to an institution for 
 specific purposes should receive the auditor's attention. If the 
 income from the funds is not being applied to the objects desig- 
 nated by the donors, or if the principal of funds has been en- 
 croached upon, when only the income was to have been used, it 
 is clearly the auditor's duty to call attention to the matter. 
 
 The comptroller of the city of New York requires charitable 
 institutions which receive public aid to keep uniform accounts, 
 and to submit to him periodical reports, using the following 
 forms : 
 
COMPARATIVE BALANCE SHEET AND SUMMARY OF INCOME AND 
 
 EXPENSES 
 
 Of. 
 
 For Six Months Periods Ending 19. . . 
 
 BALANCE SHEET 
 
 ^ MoDtha Six Months 
 
 Ended Ended Increase Decrease 
 
 Cash on hand and in bank , 
 Due from City of New York 
 Other accounta receivable 
 Investments .... 
 
 Accrued income on investments 
 Inventory of supplies . . . 
 
 Special funds 
 
 Real estate and bmldings, donated 
 Real estate and buildings, purchased 
 
 Equipment 
 
 Prepaid items ..... 
 
 Total Assets . . 
 
 Liabilities 
 
 Accounts payable . 
 Loans payable . . 
 Accrued items . . 
 Mortgages payable 
 Bonds outstanding. . 
 
 due. 
 
 Total Liabilities 
 
 Excras of Assets Over Liabilities 
 
 SxmPLus AND Resssrves 
 
 Surplus at be^ning . . . 
 Income 
 
 Total 
 
 Less: 
 
 Maintenance expenses 
 Non-maintenance expenses 
 
 Total . ... 
 
 Surplus at end 
 
 Rraerrra for special funds . . . 
 
 Surplus and Reserves . 
 
 482 
 
STATEMENT OF INCOME AND EXPENSES 
 
 Six Months 
 
 Ended.... 
 
 Six Months 
 Ended. . . . 
 
 Increase Decreaae 
 
 Incohb 
 New York City for maintenance . . 
 New York City for education . 
 Donations, gifts, etc., for Eeneral purposes 
 Donations, gifts, etc, for specif *' 
 
 Collections 
 
 Fairs, entert^mnenta, etc. . . 
 Sales of manufactured products . 
 Legacira, bequests, etc, — general 
 " " " — special 
 
 Income on investments . . . 
 Inter^t on trust funds . . . 
 
 Rents 
 
 Miscellaneous 
 
 Total Income . . , 
 
 M&INTBNANCE EXPENSES: 
 
 Repturs and renewals to plant and equipment 
 
 " " " " furniture and fixtures 
 FoodBtuffs 
 Supplies- 
 Clothes 
 
 Linen and bedding . . 
 
 Fuel 
 
 Light 
 
 Salaries and wages . . 
 Forage and care of animals 
 
 Telephone 
 
 Printing, stationery, and advertising 
 
 Postage, telegrams, magazine, md newspapers 
 
 Professional services 
 
 Miscellaneous . . 
 
 Expenses boarded-out children 
 
 Board of children . 
 
 Salaries .... 
 
 Traveling expensra 
 
 Clothes 
 
 Professional services 
 
 Miscellaneous . . 
 
 Total Msuntenance Expenses 
 
 Non-Maintbnahce Expenses: 
 Interest on mortgage 
 Interest on loans . 
 Kent .... 
 Insurance . . . 
 Taxes .... 
 
 Total Non-Mamtenance Expenses 
 
 Total Expenses . . 
 
 Weekly coat .... 
 
 Excess of income over expenses 
 Surplus brought forward 
 
 Surplus 
 
 483 
 
484 AUDITING 
 
 CHURCHES 
 
 In the majority of cases the audit of church accounts is un- 
 satisfactory to the auditor. One reason is that the church treas- 
 urer frequently is not only the custodian of all the church funds, 
 but is tacitly empowered to disburse the same at will. There is 
 usually a total lack of efifective internal supervision. At times 
 large sums pass through a treasurer's hands without any proper 
 check being kept upon his dealings. 
 
 It is the auditor's duty to check whatever he can, and at the 
 same time to urge upon his clients, judiciously but impressively, 
 the necessity for ordinary commercial caution. He should see 
 that all receipts are deposited in bank, and if a balance appears 
 to be on hand that also should be deposited. This is preferable 
 to an actual count of cash, as in the latter case the church ofiR- 
 cial might exhibit his own funds without any intention of having 
 them reach the church's bank account. A certificate from the 
 bank direct to the auditor should be obtained, this certificate 
 indicating the balance in bank belonging to the church at a stated 
 time. 
 
 In some churches a collection register is kept in which are 
 entered the collections as made, the aggregate amount subse- 
 quently being transferred to a cash book. The entries in the col- 
 lection register should, if possible, be verified and initialed by 
 some one other than the church treasurer. Special collections 
 should be vouched for in a similar manner. Where pews are 
 rented, the pew-rent register should be compared with the cash 
 book. If special funds have been devised to the church, the 
 securities held for such funds should be examined. Vouchers 
 should be in evidence for all payments ; these are to be compared 
 with the minutes of that board or committee of the church whose 
 duty it is to supervise its finances. 
 
 In at least one denomination the sentiment has been ex- 
 pressed that the accounts of a church whose treasurer handles 
 moneys in excess of a stated amount annually should be audited 
 by a Certified Public Accountant. When this sentiment becomes 
 general we shall see a decided improvement in the manner of 
 keeping church accounts, as well as added safety in the use and 
 care of church funds. 
 
INSTITUTIONAL 485 
 
 CLUBS 
 
 In auditing clubs, particular attention should be given to the 
 collection of income, and it will frequently be found that im- 
 provements can be made in this feature of their accounting sys- 
 tems. Since the m,embers are the club's proprietors, their co- 
 operation can usually be obtained, if necessary, in safeguarding 
 the clubs from being defrauded by their employees or others. 
 
 Members should be requested to pay by cheque to the order 
 of the club for all dues, house, restaurant, and other charges. 
 Where peculations have occurred they have usually been from 
 currency receipts, as the chance of detection is comparatively 
 small if there is no adequate system of check on those handling 
 the currency. 
 
 Consecutively numbered receipt forms, charge slips, and 
 bills should be used wherever practicable, as the ofifice copies 
 thereof are valuable for auditing purposes. 
 
 The collection of dues can usually be verified by examination 
 of the membership register. If necessary, the latter can, in turn, 
 be verified by comparing it with the membership record at the 
 close of the preceding audit and examining the minutes for 
 names of new members and of those resigned, suspended, or 
 expelled. 
 
 Wherever feasible, registers should be used as a basis for 
 room charges. A good additional check thereon, which is valu- 
 able for auditing purposes, is to have the housekeeper make a 
 daily record in a suitably ruled bound book of occupancies and 
 vacancies of rentable rooms. Consecutively numbered daily 
 reports to the office should form the basis of other house charges. 
 
 Members' signatures are usually required on orders received 
 in the restaurant and bar. In some clubs where it is the practice 
 to return such orders to the members monthly upon payment of 
 their accounts, duplicate orders are obtained by the use of carbon 
 sheets. If these orders are filed chronologically, they may be 
 used in connection with the verification of the deliveries from 
 stock of wines and liquors. If members can be induced to use 
 consecutively numbered ticket books, to be paid for either in 
 advance or charged for in total, the bookkeeping will be entirely 
 eliminated (in the first instance) or materially reduced (in the 
 
486 AUDITING 
 
 second) from that necessary when each order must be charged 
 to the personal account of some member. 
 
 There usually are, or ought to be, in hotels and clubs, mis- 
 cellaneous receipts from the sale of bones, fat, and other like 
 sources. The practice, which still exists in some clubs, of allow- 
 ing the chef to retain the proceeds from the sale of kitchen refuse, 
 should be discouraged, as the pay roll should show the entire 
 compensation of all employees. Under the best of conditions it 
 is difficult to be certain that all such receipts have been accounted 
 for, and comparisons should be made of the receipts during the 
 period audited with similar previous periods, and, in instances 
 where no such receipts are recorded, investigation as to the dis- 
 posal of the offal and scrap should be made. 
 
 Care should be taken to ascertain that proper allowance has 
 been made for depreciation of china, glass, silverware, linen, and 
 other furnishings. Either of two methods for doing this may be 
 used : charge original cost of furnishings to asset accounts and 
 all renewals to expense accounts, or reappraise the entire stock 
 at least once annually. Many clubrooms are from time to time 
 lavishly redecorated and refurnished, and it would be well, 
 instead of charging the entire usually heavy costs of this nature 
 to one year's operations, to distribute the expenditures equally 
 over a period of several years. 
 
 It is important that all expenses be properly apportioned 
 among the various activities of the club so that it may be defi- 
 nitely known whether those departments which are in the nature 
 of business activities are in fact yielding sufficient revenue to 
 defray all the expenses (including a proportion of the general 
 expenses) properly chargeable to such activities. Otherwise it 
 may be that departments which are supposed to be self-support- 
 ing, and which may on the face of the figures appear to be so, are, 
 if all expenses chargeable thereto are taken into consideration, 
 operating at a loss, which is being made up out of members' dues. 
 
 ARCHITECTS 
 
 The accounts of architects are not usually so voluminous as 
 to preclude making a detailed audit. Owing to the fact that men 
 who are professionally very able do not always have a keen busi- 
 
ARCHITECTS 487 
 
 ness sense it is important that the auditor exert every means 
 to safeguard the financial affairs of his client and protect him 
 from loss. 
 
 All payments should be carefully scrutinized. This is par- 
 ticularly necessary because some of the expenditures will be re- 
 coverable from clients and the auditor should see to it that all 
 such payments have been duly charged to accounts with the 
 clients. 
 
 A very important part of the audit is the verification of the 
 commissions and fees charged to clients. Fees of specified 
 amount are sometimes agreed upon, or are charged in the case 
 of preliminary work (such as sketches, etc.) done in cases where 
 the proposed undertaking is abandoned. Usually, however, the 
 architect's compensation is based on an agreed percentage on the 
 cost of the building and its equipment where the latter comes 
 under the architect's supervision. This makes it necessary for 
 the architect to keep a record of contracts let and payments made 
 thereon. The auditor should refer to this record as a means of 
 verifying the charges to cHents. Such a record of contracts is, of 
 course, also a necessary part of an architect's records for the pur- 
 pose of having a basis on which to issue certificates of the 
 amounts which are to be paid by the owners for work done by 
 contractors. 
 
 As there is almost invariably considerable work unfinished 
 at the end of a fiscal period, a basis of valuing it must be found. 
 The author's experience is that a quite satisfalctory basis is the 
 amount of contracts let, a part of the agreed rate of commission 
 being taken up on the amount of all contracts awarded and the 
 remaining part of the commission on the amount of payments 
 made on the contracts. There will be some engagements on 
 which the work has not yet advanced to the point of awarding 
 construction contracts. Valuations of such work will be made by the 
 architect himself, frequently in round sums, and the auditor 
 should see to it that the estimated valuations are, if anything, 
 ultra-conservative. When the work is only in the preliminary 
 stage there is frequently a possibility of the project being aban- 
 doned or indefinitely postponed, and in such cases the architect is 
 not always able to secure remuneration commensurate with the 
 work actually done. 
 
488 AUDITING 
 
 DOCTORS 
 
 The absence of a uniform system of bookkeeping on the part 
 of medical men, and their failure,, in most instances, to realize 
 the value or desirability of keeping accurate accounts with 
 patients, renders it difficult in the space here available to offer 
 definite useful hints as to the method of audit. Assuming, how- 
 ever, that there is a patients' ledger, it may be suggested that to 
 go behind the charges therein is not necessary. In fact, in many 
 instances it would not be possible to do so, as the charges may 
 or may not represent a stated number of visits, as frequently a 
 lump sum is .charged for a case. 
 
 The auditor should endeavor to introduce some efficient 
 system of recording yisits so that the client may have before him 
 all the facts when making his charges. It would be especially 
 satisfactory for purposes of subsequent reference if this record 
 gave in the case of a family the particular name of the patient 
 visited, though the ledger account might appear in the name of 
 the family head. 
 
 All credits on the patients' ledger should be carefully checked 
 by the auditor in order that all moneys credited to patients may 
 be properly accounted for. Any allowances that have been made 
 should be particularly noted. Many practitioners employ one or 
 more assistants who are authorized to receive money. Where 
 this is so, the importance of following ordinary commercial pre- 
 cautions against fraud is apparent. 
 
 Occasionally payments are made on account of patients for 
 medicines, consultation fees, or other objects. It is important 
 that the auditor determine that such charges have been charged 
 up and duly collected. Where practitioners supply their patients 
 with medicines and drugs it is necessary that the accounts of 
 druggists, etc., should be carefully checked, and at balancing 
 time an allowance will have to be made for the value of drugs in 
 stock. 
 
 Horses and carriages or automobiles that are the property 
 of the practitioner should be depreciated at the rate of fifteen to 
 thirty per cent per annum. If these are rented it is equally 
 important to include cost of hire to the date of balancing, or 
 
LAWYERS 489 
 
 in case of payment in advance, to carry a proportionate part for- 
 ward as a deferred asset. 
 
 LAWYERS 
 
 The nature of a lawyer's work, together with a general tend- 
 ency on the part of professional men toward laxity along book- 
 keeping lines, makes a complete, detailed audit a necessity if it 
 is to be effective. 
 
 A difficulty which frequently confronts an auditor going over 
 a lawyer's books is that they are the stock forms sold by law 
 stationers. These are designed with a view to saving time rather 
 than for any other purpose. 
 
 An important requirement is to make certain that the amount 
 included in the balance sheet for outstanding charges represents 
 the actual sum included in bills to clients. Every item of costs 
 charged a client might profitably be compared with a copy of the 
 bill rendered to make sure that all amounts chargeable have been 
 properly debited. Care should be taken to note amounts that 
 may have been paid on account. 
 
 A not uncommon practice among lawyers is a failure to dis- 
 tinguish between personal funds and those of a client. This very 
 condition emphasizes the necessity and importance of proper 
 accounts being kept by those attorneys who wish to avoid any 
 possible reflection upon their manner of dealing with moneys 
 intrusted to them by clients. This separation of money mate- 
 rially simplifies the keeping of accounts. Each large estate 
 should have its own bank account and separate books, entirely 
 independent of the books of the firm. 
 
 A "Clients' Accounts" in the cash book should show all 
 money received in trust for clients, and if there is but one bank 
 account, it would be advisable to recommend separate columns, 
 that the "clients' " accounts may be distinct from the "general" 
 bank account. 
 
 It is a common occurrence for a practitioner to make pay- 
 ments on behalf of a client who may not have a credit balance 
 upon the books. It is especially desirable, therefore, that pro- 
 vision be made for charges to be so entered that reference to any 
 account will reflect its true condition and lead to its settlement. 
 
 An important advantage in keeping large estates quite sep- 
 
490 AUDITING 
 
 arate from the general accounts is that the cost of keeping them, 
 and of having them audited, may then frequently be charged, to- 
 gether with other costs, against the estate. It will be possible, 
 also, to submit these accounts to clients or their representatives 
 without disclosing any other transaction. If they be so examined 
 at regular intervals, it may not be necessary to have them also 
 audited by the lawyer's auditors. In this way a further saving 
 of expense may be effected. 
 
 CONTRACTORS 
 
 The accounts of contracting companies, erectors, builders, 
 engineers, and others engaged mostly in work carried out under 
 contract may be included under this caption. 
 
 In nearly every instance separate accounts are kept for the 
 cost of each contract, or, if the work under one contract is very 
 large, for each of several sections of a contract, which are 
 later combined when each part is completed. Obviously, the 
 value of such a system of cost accounts to the client depends 
 upon the efficiency with which it is carried out. The auditor 
 should examine it carefully to ascertain that it is based upon 
 good accounting theory and that the results shown are in har- 
 mony with those shown on the general books. 
 
 The system of preparing the pay roll and of accounting for 
 materials purchased and handled through the storeroom should 
 be carefully investigated to ascertain that all reasonable safe- 
 guards against fraud and loss are provided. Wages should be 
 paid by qffice employees not connected with the preparation of 
 the pay roll. 
 
 The value of work done on uncompleted contracts is shown 
 on the balance sheet under the head of "Uncompleted Contracts" 
 or "Work in Progress." The auditor should request a certified 
 schedule of the expenditures on each of the contracts included 
 in this account. The schedule may readily be verified in cases 
 where correct cost accounts have been kept, but in other instances 
 the auditor may be obliged to accept the schedule upon the certi- 
 ficate of the engineers, superintendents, or other proper officials 
 after investigating unusual items and satisfying himself that 
 every effort has been made to prepare the schedule correctly. 
 
 As a matter of fact, there is almost always some check on 
 
CONTRACTORS 491 
 
 the amount of work completed. As the work progresses under 
 the supervision of architects or engineers, certificates are secured 
 from them testifying to the quantity and quality of work done 
 and authorizing partial payments on account. 
 
 The auditor may not see these certificates unless he asks for 
 them. Contractors are usually more optimistic about the pro- 
 portion completed than is the architect (unless the two are work- 
 ing together against the owner), so that his estimate as to the 
 part completed at a given time should be verified in every pos- 
 sible way. 
 
 The cash receipts are also a clue to the amounts certified to. 
 The stipulated payments are on a basis of ninety per cent of the 
 work completed, sometimes more and sometimes less. The con- 
 tracts themselves, which must always be open to the inspection 
 of the auditor, and which should be called for, will indicate the 
 percentage reserved until after completion and acceptance. 
 
 It is important to note whether or not any profit has been 
 taken on uncompleted contracts. The profit on each contract to 
 any date can readily be ascertained in instances where cost ac- 
 counts have been kept by preparing a memorandum profit and 
 loss account and making the following entries therein : 
 
 Debit: All Direct Contract Ossts. 
 
 Depreciation of Plant used on Contract Work. 
 Credit: Value of Work Certified to Date. 
 
 Value of Work Done, but not yet Certified. 
 
 Stores and Materials Charged to Contract, but still Unused. 
 
 The net credit balance of such a profit and loss account will 
 represent the estimated profit to date; a net debit balance will 
 represent the loss to date. 
 
 If a contract is nearly completed, the estimated profit upon 
 completion may be ascertained by deducting from the contract 
 price the combined cost of work to date and the estimated cost 
 of completion. 
 
 The most conservative method is to ignore entirely profits 
 which may have accrued on uncompleted contracts. It could, 
 however, hardly be claimed to be improper to take at least some 
 part of the profit on the work already done on, say, a large build- 
 ing contract extending over several fiscal periods, provided the 
 
492 AUDITING 
 
 percentage of the work completed has been estimated on a con- 
 servative basis and a liberal allovs^ance has been made f(*r con- 
 tingencies. Whenever such profits are taken, it is the auditor's 
 duty to satisfy himself that they have been conservatively cal- 
 culated. The accounts should show clearly the amounts of esti- 
 mated profits, if any, taken on uncompleted contracts, and the 
 auditor should show them separately in his statements and also 
 call attention thereto in his report, if deemed necessary. 
 
 Monthly statements should be requested from subcontract- 
 ors, as they may have large claims for work in excess of that 
 called for by their contracts, but for which credits do not appear 
 on the client's books. It may even be found that the client has 
 billed this extra work to the customer, and that credit therefor is 
 entered in the contract account. 
 
 At times subcontractors may do extra work under an agree- 
 ment with the general contractor providing for compensation 
 only in the event of collection therefor by the general contractor 
 from the customer; changes in specifications after subcontracts 
 have been let also furnish grounds for subcontractors' claims. 
 Sufficient reserve must be made to cover the probable amount to 
 be paid on such claims prior to carrying the gross profit from the 
 contract account to profit and loss. 
 
 REAL ESTATE 
 
 In auditing the accounts of a client engaged in buying, hold- 
 ing, renting, and selling real estate the leases should be examined, 
 and, in the case of office or loft buildings, should be compared 
 with loft plans, and all the rentals accounted for. Actual inspec- 
 tion should be made of properties, or rentable portions thereof, 
 which are recorded on the books as vacant at the time the audit 
 is begun. 
 
 Prepaid rents, or security deposited by tenants, should be 
 clearly shown, and changes in the latter during the audit period 
 carefully investigated. Balances due for unpaid rentals, power, 
 alterations, etc., can be verified by correspondence. 
 
 All expenses should be vouched and comparisons of the in- 
 come and expenses of each property and of administration should 
 be made with periods prior to that under review. Extraordinary 
 expenditures for alterations should be called to the attention of 
 
REAL ESTATE 493 
 
 the proprietors to ascertain if the tenants should perhaps have 
 been charged therewith. 
 
 If properties are managed by the client as agent of other 
 owners, the contracts with the latter should be examined and the 
 collection of the commissions verified. Balances due to or by- 
 owners may be verified by sending statements to the latter and 
 requesting confirmation thereof. 
 
 Care should be taken to ascertain that proper allowance has 
 been made for accrued taxes, interest on mortgages and ground 
 rents. The mortgage interest paid during a full year is a good 
 check on the principal of the mortgages, in addition to which the 
 amount of the latter, as well as the payments on account thereof 
 during the audit period, can be further verified by correspond- 
 ence with the mortgagees. 
 
 Prepaid insurance premiums should be verified by calcula- 
 tion. The charges to land, buildings, and equipment accounts 
 should be examined to ascertain that they are all for additional 
 land and construction work or improvements. 
 
 Accounts covering bonuses which may have been paid for 
 leases purchased, or the cost of improvements on leased ground 
 which will revert to the owners of the latter at the expiration of 
 the ground rent leases, should be reduced at regular intervals. 
 
 Settlement records may be used in connection with the veri- 
 fication of sales of real estate. 
 
 In the case of undertakings involving the development of 
 large tracts and the sale of lots therefrom, care should be taken 
 to ascertain (if any profits are calculated prior to the disposal of 
 the entire tract) that the costs of the lots sold have been cal- 
 culated on a conservative basis. 
 
 The following illustration of fraud discovered in the accounts 
 of a real estate agency will he of interest: Rent collections were 
 entered in detail in a cash receipt book, footings made each day, 
 and the total deposited to the company's bank account. The 
 footings were verified by the treasurer and agreed with the 
 amounts credited in the pass books each day. After this verifi- 
 cation, the cashier entered additional items covering amounts 
 which he had taken, in order that the collector, who checked up 
 the receipts, would see that all items had been collected. These 
 additional items were not, however, included in the totals. The 
 
494 AUDITING 
 
 cashier retained currency and cheques in his drawer, which he 
 juggled in order to make up the exact amount of the items he 
 was supposed to be depositing. 
 
 The main cash book or cash journal (the total of the day's 
 entries being journalized) included all of the items entered in the 
 cash receipt book, and fraudulent footings were made to agree 
 with the bank accounts. 
 
 All items were eventually posted in the ledger to the credit of 
 the various owners and the footings and balances, when inked in, 
 were as they should have been had there been no defalcation. 
 The postings were always from two to four months in arrears, 
 and, in order to prepare a trial balance, postings and footings 
 were falsified. Some months later these errors were corrected as 
 stated above. 
 
 The deficiency was partly concealed by depositing to the 
 company's credit cheques drawn to the order of clients which 
 had been properly charged to their accounts, but the cheques 
 were never sent to the clients. 
 
 The above-described fraud was practiced for about seven 
 years, and a total of some $26,000 obtained before the omission of 
 an entry for one item of receipt was questioned by the collector 
 and this led to the discovery of the fraud. 
 
 LAND AND DEVELOPMENT COMPANIES 
 
 The operations of a typical land development company 
 embrace the purchase of a tract of land, the platting of it into 
 streets and lots, the grading and paving of the streets, the lay- 
 ing of sewers and water mains, the laying of sidewalks and curbs, 
 the placing of telephone and light poles, and the selling of the 
 improved lots. Oftentimes there are other features of the plan, 
 such as the building of houses for purchasers, the extension of 
 railway or other transportation facilities to reach the property, 
 and possibly the temporary operation of one or more industries. 
 
 There are many fine points involved in the proper distinction 
 between expenses and additions to property. Unlike a railroad, 
 the entire cost and expenses up to the time the property is ready 
 to be marketed cannot be charged against the property. Only 
 such part of the expense as really adds to the value of the 
 property, such as the grading and paving of streets, the cost of 
 
LAND COMPANIES 495 
 
 the water and sewer installation, etc., is a proper addition to 
 the capital account. Administrative expenses and any prelim- 
 inary selling expenses, such as advance advertising, publicity 
 work, printing, and the preparation of maps, must be segregated 
 and shown on the balance sheet as deferred charges to future 
 operations until such time as revenue begins to come in. 
 The books peculiar to the' business are these : 
 
 "Real Estate Lot Ledger." 
 "Construction Ledger." 
 "Improved Real Estate Cost Ledger." 
 "Improved Real Estate Operating Ledger." 
 
 In the Lot Ledger the lots are carried at cost. Unimproved 
 tracts should be represented by an account with the tract until 
 such time as the tract is divided into lots, then the total cost of 
 the tract and improvements is spread over the number of lots, 
 the tract account is credited with the full amount, and an account 
 is opened with each lot. The basis of division of cost is not the 
 number of lots in the tract, but the relative value of each to the 
 whole, depending upon location, size, etc. 
 
 The Construction Ledger contains only the cost of buildings 
 and the carrying charges thereon, and does not include the cost 
 of land. Upon the completion of the building the cost of the 
 same and the cost of the lot are transferred from their respective 
 ledgers to an account in the Improved Real Estate Cost Ledger 
 representing the building and lot complete. 
 
 The details of the operation of the property are thereafter 
 carried in the Improved Real Estate Operating Ledger, from 
 which the credit or debit balance is carried at the end of the 
 fiscal period to proper profit and loss accounts. 
 
 Following are some of the points that should be covered in 
 the audit of a going concern engaged in the development and 
 sale of land : 
 
 Analyze the property account from the beginning of the development, 
 noting the nature of the charges against this account. 
 
 Ascertain if there is any record of the prices at which the lots are to 
 be sold and compare selling prices therewith. If no such record exists, 
 see that the sales contracts are approved by one of the principals before 
 being binding upon the client. 
 
 Obtain from the client the basis for the distribution of expenses be- 
 tween properties in case more than one property is being handled. Then 
 
496 AUDITING 
 
 see to it that the proper distribution is made for every expense incurred. 
 The distribution is usually made on the stub of the cheque or directly in 
 the cash book. There is no reason why the cheque stub cannot be dis- 
 pensed with, and the cheques entered and distributed directly in the cash 
 book. 
 
 Compare a considerable number of the cashier's contract cards with the 
 ledger, testing the correctness of the interest calculations. 
 
 Compare contracts entered into during the period under review with 
 the ledgers as to terms, name and address of purchaser, etc. 
 
 Compare the payments to salesmen for commissions with the card 
 record of contracts and with the ledgers, noting especially that commissions 
 have been charged back on canceled contracts. 
 
 Compare the sales of lots with map (retained by the auditor), noting 
 on the map the price obtained and investigating wide fluctuations. 
 
 Compare open items in the "lot book" with the lots unsold at the end 
 of the period per the map. 
 
 See contract terms regarding taxes, interest, etc. 
 
 Send out verifications of accounts to all customers. 
 
 HOTELS 
 
 The auditor should analyze the earnings and expense ac- 
 counts, if necessary, and prepare statements of the financial 
 results in each department, which should be carefully gone over 
 with the proprietors. Such departments as show unsatisfactory 
 returns should be especially investigated to the extent of verify- 
 ing the detail work for a part of the audit period. Hotels at 
 summer resorts usually have more departments than do city 
 hotels. Frequently the operations of the former include drug 
 stores, various amusements and excursions for guests, all of 
 which are sources of additional income. Stock accounts of 
 cigars, wines, liquors, etc., should be carefully examined in the 
 event of the results being unsatisfactory in departments where 
 they are handled. 
 
 The auditor should satisfy himself that all receipts are 
 accounted for, that expense payments are either covered by 
 vouchers or properly approved pay rolls, and that such as have 
 been made on behalf of guests have been charged to their 
 accounts and collected. The subsidiary guests' and purchase 
 ledgers should be proven with the balances in their controlling 
 accounts, and all of the entries in the general ledger should be 
 thoroughly checked. 
 
 Careful attention should be given to the question of depre- 
 
ADVERTISING AGENCIES 497 
 
 ciation of furnishings, such as china, glass, cutlery, silver, linens, 
 etc. These may be reappraised at periods when statements are 
 prepared or depreciated at such times at adequate rates. An- 
 other good method is to credit regularly a reserve account and 
 charge against the profit and loss account amounts sufficient to 
 cover the estimated actual renewals and depreciation over a 
 period of years, and then to charge all renewals to this reserve 
 account. 
 
 RESTAURANTS 
 
 The accounts of restaurants are somewhat similar to those 
 used in hotels and clubs, although, by reason of restaurants hav- 
 ing fewer departments, the records are not so complex. It is a 
 difficult matter to safeguard the proprietor against all possible 
 fraud and to discover if any has been perpetrated. The auditor 
 should, however, carefully investigate the manner of serving 
 meals and collecting therefor, and should ascertain that the earn- 
 ings and expense accounts in the general ledger are so classified 
 that the proprietor can form an opinion as to the efficiency of the 
 management. 
 
 In some restaurants the waiters do not issue checks to guests, 
 the checks being issued by a checker at the kitchen door, who 
 scrutinizes the food or drinks served, and who also charges the 
 waiter's account on a columnar checking sheet, which is used as 
 a check at the end of the meal periods against both the waiters 
 and the cashier. 
 
 ADVERTISING AGENCIES 
 
 It is important for the auditor of an advertising agency to 
 ascertain that the accounting system in use embraces a good 
 internal check on the actual advertising done, on the credits to 
 publishers therefor, and on the charges to the clients for the 
 advertising and commissions, and that the system is actually 
 being carried out in practice. 
 
 A good system will provide for the charges to the clients (for 
 the advertising and commissions), the credits to the publishers 
 (for the value of space occupied in their periodicals), and credit 
 to the agency's commission account to be made in one entry from 
 the same original data. If a "space" account is carried in the 
 agency's general ledger and is used as the medium through 
 
498 AUDITING 
 
 which the charges to the clients and the credits to the publishers 
 are made, the auditor should ascertain that the balance therein 
 consists of the aggregate value of specific advertising not yet 
 charged to the clients, but credited to the publishers, and of 
 specific advertising not yet credited to the publishers, but charged 
 to the clients. 
 
 The contracts of the agency with the publishers of period- 
 icals and with the clients should be examined, and the rates for 
 advertising and commissions should be compared with the 
 agency's records to ascertain that the credits to the publishers 
 for space and the charges to the clients for advertising and com- 
 missions are being correctly made. 
 
 THEATERS 
 
 The auditor of theatrical accounts must at once recognize 
 the fact that a cash system alone prevails and that all persons 
 connected with the financial part of the management necessarily 
 handle this currency. It is a matter of regret that managers 
 cannot be induced to make payments by cheque more generally, 
 but up to the present representations and arguments presenting 
 the advantages of such a system have not been favorably re- 
 ceived. However, the practice is increasing gradually, and in 
 time, it is to be hoped, may become general. 
 
 While nearly all receipts are in currency, it is not usual for 
 the auditor to be expected to verify such receipts ; this is a func- 
 tion for the treasurer, who is considered sufficiently responsible 
 for a service that demands integrity, but no great technical 
 knowledge or unusual ability. 
 
 The methods followed in keeping theater accounts are as fol- 
 lows : About half an hour after the beginning of each perform- 
 ance the treasurer of the theater counts his unsold coupon 
 tickets, making up a "rough" statement of the cash which should 
 be on hand ; to this he adds the proceeds of sales of "hard tickets" 
 (general admission and exchange), and then submits this state- 
 ment to the treasurer of the company. The two treasurers then 
 count the tickets contained in the doortenders' boxes, which, 
 except in stormy weather, agree very closely with the rough 
 statement. Following the count the theater treasurer makes out 
 a final statement, which is signed by both treasurers. 
 
THEATERS 499 
 
 A "settlement sheet" is made up at the end of each week by 
 the theater treasurer showing the gross receipts and the share 
 of same due to the theater. Any additional earnings are added 
 thereto, and after deducting the salaries and petty expenses, the 
 treasurer pays the remainder in currency to the manager. The 
 latter usually pays all advertising, bill-posting, light, etc., about 
 Tuesday of each week to cover the previous week. In some 
 theaters the treasurer pays all bills and settles with the manager 
 for the profit or loss shown by the weekly statements only, but 
 this is not a common practice. 
 
 The treasurer of the theater also prepares a complete weekly 
 statement for the company treasurer and settles therefor. After 
 making these two settlements he would have on hand only the 
 receipts of the "advance ticket" sales, which latter, as elsewhere 
 considered, should be verified. 
 
 It is well to remember that the object of theater bookkeeping 
 is to show the result of each week's business in a manner that 
 will determine which attraction pays best. Such items as annual 
 license fee, rent, repairs, etc., should, therefore, be apportioned 
 weekly on a basis of a season of thirty or thirty-five weeks. 
 
 The procedure in an audit of theater accounts should be 
 somewhat as follows: 
 
 Deduct the number of coupon tickets on hand from the total 
 capacity of the house; find how many "hard tickets" were fur- 
 nished the treasurer at the beginning of season, deduct number 
 on hand at time of balancing, and the remainder should be 
 accounted for in cash. The total result should then agree with 
 the cash and vouchers in the hands of the treasurer. 
 
 It is necessary to see that all nightly statements of the period 
 under review are signed by the treasurers of the companies. A 
 check on the proper division of receipts may be had by examina- 
 tion of the contracts. These will also enable the auditor to know 
 that the proper shares of extras have been collected from com- 
 panies. He should also inquire into the manner of preparing 
 pay rolls, in connection with which reference to an attendance 
 book will be necessary. This book records the names of persons 
 entering the premises by the stage door before a performance, 
 and from it fines for absence or lateness are determined. 
 
 As both the treasurer and his assistant have access to the 
 
500 AUDITING 
 
 same cash, it will readily be seen that a difficulty obtains in divid- 
 ing this responsibility; and a similar difficulty arises in connec- 
 tion with the weekly payments to the manager. After making 
 settlement with him, the cash remaining represents the advance 
 ticket sales, which needs to be verified at the time. However, 
 managers seldom count a large number of tickets, and just here 
 more than one defalcation has been covered up or carried along 
 by using advance sales to conceal shortages. 
 
 Strip tickets used largely by "vaudeville" or "continuous per- 
 formance" houses are, of course, easily counted. 
 
 THEATRICAL COMPANIES 
 
 A treasurer's cash book is the basis of the accounts of a 
 theatrical company; it should be balanced weekly, at least. 
 From it several accounts as here classified (known as "Produc- 
 tion" accounts) are built up. These include: 
 
 Preliminary Expenses: Incurred during rehearsals, such as 
 salaries of manager, musical director, and orchestra, hall rent, 
 typewriting parts, etc. 
 
 Properties: Including almost everything used in the stage 
 representation other than scenery, costumes, or electrical ap- 
 paratus, such as furniture, draperies, animals (either papier 
 mache or alive), flowers, etc. Perishable articles should, of 
 course, be absorbed in current expenses and not charged to prop- 
 erties. 
 
 Costumes: Covering clothing, shoes, wigs, etc. 
 
 Electrical Apparatus : In this item are included calcium lights 
 and special devices. If the electrical equipment is rented in- 
 stead of being owned, the rental is chargeable to current expenses. 
 
 Scenery : The work of building and painting is usually done 
 under contract. The scenery may be built by one firm and 
 painted by different artists. A difficult landscape would prob- 
 ably be done by a high-priced artist, but the painting of a simple 
 interior would be done by a cheaper man. 
 
 Vouchers representing expenditures for the foregoing items 
 should be examined. In addition, an audit would include the 
 verification of receipts by comparing them with the nightly state- 
 ments signed by the house treasurer; and also seeing that the 
 fines imposed by the stage manager are accounted for. The 
 
THEATRICAL COMPANIES 501 
 
 company's earnings statement is made up weekly to agree with 
 the theater accounts. 
 
 Owing to the uncertainty of the outcome of theatrical pro- 
 ductions, definite rules for the treatment of depreciation cannot 
 be stated. The whole cost of an unsuccessful production should 
 be written off forthwith ; on the contrary, the copyright of a suc- 
 cessful play does not depreciate rapidly in value. Ifi New York 
 the total cost of production is written off against the first year's 
 business. This is obviously the safest practice. 
 
CHAPTER XXVIII 
 INVESTIGATIONS 
 
 Part of the work of the professional auditor is designated, 
 not as an audit, but as an investigation. There is here an actual 
 distinction, just as the work of the accountant may be differen- 
 tiated from that of an auditor. 
 
 For the purposes of this book, audits and investigations are 
 separated only as to the special points to be observed in the 
 latter, it being assumed that in many investigations a complete 
 detailed audit will be required, and that in others a balance sheet 
 audit is essential. 
 
 Investigations are usually undertaken in connection with 
 the sale of a business to a corporation or other purchaser for the 
 purpose of obtaining special information relative to finances or 
 general affairs, or with respect to alleged fraudulent transactions, 
 or into the profits derived from the manufacture of infringing 
 articles, etc. 
 
 A curious feature connected with investigations, which rarely 
 arises with respect to audits, is the attempt on the part of 
 disreputable promoters, or of those with no reputation at all, to 
 retain the services of reputable auditors. Usually the enterprise 
 to be investigated lacks books of account and promises little in 
 this respect for the future, or a company has been formed with 
 a large capital stock on one side, and mining claims or some 
 equally uncertain asset on the other. A certificate is desired for 
 publication, or for private exhibition to prospective investors. 
 
 In the hands of an honest man, an auditor's certificate in the 
 ordinary form might be unobjectionable, but if the certificate is 
 in the possession of an unscrupulous promoter, it may be repre- 
 sented to be an unqualified indorsement of the enterprise and its 
 promoters, and there are enough ignorant investors to believe 
 these or stronger statements. The wise auditor will never per- 
 mit his certificate to be so used, for a single mistake of this kind 
 in sizing up a client may mean the loss of one's reputation. Suc- 
 
 502 
 
INVESTIGATIONS 503 
 
 cessful auditors can take no chances at all in this respect; they 
 must be more particular about their clients than a bank is about 
 its customers. 
 
 The various classes of investigations and the special features 
 of each will be discussed in the following order : 
 
 I. Upon the sale or purchase of a business. 
 II. To ascertain information required by: 
 
 (o) Creditors, prospective creditors, or stockholders, 
 (fc) Parties to litigation or disputes. 
 III. Investigation of suspected fraud. 
 
 SCOPE OF THE WORK 
 
 Instructions From Clients: The title of this chapter may- 
 convey the impression that the work to be done is more or less 
 restricted in its scope, and that the auditor who undertakes an 
 investigation for a special purpose may expect to receive special 
 instructions, differing from the circumstances under which he 
 would be willing to make an audit. It is not claimed that an 
 auditor would insist on proceeding with any professional work, 
 including audits, which appeared to be even remotely in opposi- 
 tion to his clients' wishes. He could withdraw, and this would 
 be the only proper course if he found himself unable to comply 
 with the directions of those for whom, his work was intended. 
 
 As a member of a profession with high ideals, he can insist, 
 or in the exercise of his full prerogatives he can demand, that 
 instructions outlining the scope of his work, or the form of his 
 certificate and report, shall accord with honorable motives and 
 straightforward dealing. Otherwise, he cannot proceed without 
 forfeiture of his self-respect. 
 
 If the instructions are incomplete and the auditor fails to 
 interpret them broadly, so as to include all of the results which 
 are called for by the nature of the case, he should not attempt 
 to excuse his deficient results by falling back on his instructions. 
 Therefore, at the commencement of an investigation it is most 
 important that specific instructions be issued by the client, or 
 prepared by the auditor and confirmed by the client. 
 
 Working Papers to be Preserved: Following up his instruc- 
 tions from the client, the auditor will issue special directions to 
 his own staff. The remarks on working papers (page yj) apply 
 
504 
 
 AUDITING 
 
 with full force, and, in addition, special care must be taken to 
 preserve all data bearing on the adjustment of the accounts. In 
 few investigations will the auditor's report show accounts and 
 amounts as they appear on the books. Even if net results are 
 not altered, an analysis will have been made resulting in a differ- 
 ent arrangement and presentation. 
 
 It is of the utmost importance that working sheets be pre- 
 pared and retained which will show in absolute detail the recon- 
 ciliation of the original book figures with those appearing in the 
 final report. Neglect of this precaution may subsequently result 
 in censure for neglect, coupled with the necessity of duplicate 
 work, for which a charge cannot, or should not, be made. 
 
 In some cases the working papers of an audit have to be 
 referred to after the report is submitted, but in nearly all inves- 
 tigations, questions arise after the work is completed which re- 
 quire reference to the data compiled during the progress of the 
 work. 
 
 Detail Which May Be Omitted: If "investigation" were 
 simply another name for an audit, this chapter would not have 
 been written. 
 
 In general -it may be stated that as an investigation is not 
 an audit, but an inquiry into specific matters, the routine require- 
 ments of an audit as outlined in this book may be omitted. Later 
 on, the features which must not be omitted will be discussed. 
 
 Previous Audits : It has also been mentioned that in an ordi- 
 nary engagement the auditor will often find himself to be the first 
 professional auditor who has been consulted. But with investi- 
 gations, which are frequently called for in connection with con- 
 solidations of prosperous enterprises, it will be found that many 
 of the latter have had their accounts audited. If the auditor can 
 secure the reports of such examinations, he will have a basis 
 upon which to determine what use he can make thereof. Obvi- 
 ously this basis will depend on the standing of the other auditors 
 and the nature of their reports. 
 
 If access to previous reports cannot be had, the auditor 
 should secure permission to consult with the previous auditors 
 for the purpose of securing any information possible. If this is 
 not feasible, he will have to proceed as if the accounts had never 
 been audited. 
 
INVESTIGATIONS 505 
 
 Where Assets are Appraised: It is becoming fairly general 
 in an investigation to employ appraisers as well as auditors. The 
 former must take the responsibility for physical valuations of 
 fixed assets items, and while this is of great assistance to the 
 auditor, he should never incorporate their valuations in his 
 accounts without considering their relation to the profit and loss 
 account. The auditor should steadfastly maintain that he can- 
 not state the net profits of a business irrespective of an exami- 
 nation of the assets and liabilities. If the book assets must 
 be adjusted to an appraisal, the profit and loss account may 
 require adjustment also. The word "may" is used advisedly, as 
 some appraisal companies are inclined to overvalue physical 
 assets. It is pleasing to proprietors (which may explain why it 
 is done), but it does not always afford a reasonable basis for a 
 writing up of book values and a consequent adjustment of the 
 profits. 
 
 On the other hand, in view of this tendency, any insufficiency 
 of assets shown by an appraisal should be reflected in the profit 
 and loss account. 
 
 Definite Report Wanted : In order that there may be no mis- 
 understanding, it should be understood that the author does not 
 advocate submitting suggestions and criticisms based on mere 
 hearsay, or on incomplete information. The point to be empha- 
 sized is that all facts pertinent to the inquiry are permissible 
 and may be of more value than a mass of figures. 
 
 Certain adjustments are necessary in practically all investi- 
 gations, but the auditor must be firm in arranging the results and 
 in wording his report, or it may be found that the final conclu- 
 sions are far from representing a well-thought-out opinion of the 
 standing of the business. 
 
 Auditors have been very properly warned that if there is 
 nothing definite for them to report, they should not be led into 
 stating that if the expectations of the promoter are realized his 
 estimates of the profits are correct. 
 
 ' Handling Books and Records: Before making a single mark 
 of any description in a record which is the property of another, 
 the auditor should ask himself the question : "Is there any possi- 
 bility of these records being falsified, and might it embarrass me 
 later if it were shown that I had made marks herein?" In every 
 
So6 AUDITING 
 
 case the question should act as a reminder that if marks 
 are warranted they should be small, neat, and so made as to 
 be readily and positively identified on any subsequent occa- 
 sion. 
 
 If fraud is suspected, it is always desirable, and sometimes 
 necessary, that no marks at all should be made. In such a case 
 the entries which are falsified should be rewritten on loose sheets, 
 paged the same as the original records, and the correct amounts 
 shown in an adjoining column. This will permit a summary of 
 the fictitious entries being made up at any time. 
 
 False Entries Sometimes Forgeries : The entry of an incorrect 
 amount in a book of record, if made with intent to defraud, is 
 forgery, and therefore a serious -crime. 
 
 Frequently false entries are found in books which indicate 
 that the one responsible therefor has misappropriated an equiv- 
 alent sum of money, but it may be difficult to produce satisfac- 
 tory evidence as to when and how the defaulter actually took 
 the cash. 
 
 It is well known that a verdict of guilty is difficult to secure 
 from a jury when the evidence consists largely of complicated 
 and manipulated accounts. The defaulter's plea that his books 
 were unfortunately mixed up, but that he never stole anything, 
 appeals to the sympathy of the average man. If it can be shown 
 conclusively, however, that certain entries are fraudulent on 
 their face, it may be possible to prove a charge of forgery. An 
 auditor should always be familiar with the law of his own State 
 on this subject. 
 
 Books as Evidence: Aside from the question of fraud, it is 
 always desirable that books and records be kept neatly and ac- 
 curately, and that they be complete and coordinate. In other 
 words, there can be no possible argument against accurate and 
 creditable books of account, but serious loss may result from 
 inaccurate and incomplete records. In the course of time a con- 
 siderable number of business enterprises are compelled to en- 
 gage in litigation, either as plaintiffs or defendants, in which the 
 books of account must be produced and ofifered in evidence and 
 many cases are lost through lack of evidence on some vital point 
 on account of insufficient or discreditable data. 
 
 The auditor will have many opportunities of dealing with 
 
INVESTIGATIONS 507 
 
 the wrong kind of books, which experiences will serve as 
 examples when he tells his clients what not to do. 
 
 Loose-Leaf Records: It was formerly held that loose-leaf 
 records were not proper and sufficient evidence, by reason of the 
 supposed danger of substitution, but business custom and con- 
 venience forced a change, so that to-day these records, when 
 bearing on their face all the signs of regularity, are admitted 
 without question. 
 
 The chief point to bear in mind in any event is the effect on 
 a jury. Carelessly kept bound books may have an adverse effect, 
 while neatly kept loose-leaf records, in binders, may impress the 
 jury as containing complete and dependable records of the trans- 
 actions in question. 
 
 Erasures : The matter of erasures is one to which the auditor 
 should give some attention. It directly affects the neat-looking 
 pages which some bookkeepers love, but it may be laid down as 
 a general rule that an incorrect figure ruled out, and with the 
 correct amount inserted above, always stands for itself, while an 
 erasure or alteration is sometimes hard to understand. If it 
 should develop at some later day that the altered figure is one 
 required to base an action or defense upon, the position of the 
 clerk responsible therefor is not an enviable one. 
 
 The one great factor is accuracy, and to this beauty must, if 
 there is need, be subordinated. 
 
 Original Records Necessary: The foregoing remarks lead up 
 to a consideration of the value of records which are merely tran- 
 scripts of others, or to which the entries in other books have been 
 posted. 
 
 In England it is customary to keep certain original records 
 in more or less "rough" form, and subsequently transfer the 
 entries to "fair" books. In such a case the moment it is shown 
 that a certain book is merely a copy of another, and was written 
 subsequently, it loses most of its value and the original record 
 is called for. If destroyed, the entire case might be lost. 
 
 This possibility contains a twofold lesson : it emphasizes the 
 desirability of making all original records part of the double 
 entry system of accounts without rewriting, and in addition 
 insures the preservation of records which may be called for when 
 least expected. 
 
5o8 AUDITING 
 
 (i) UPON THE SALE OR PURCHASE OF A BUSINESS 
 
 The professional auditor is now being consulted frequently 
 by the man who wishes to sell as well as the man who wishes to 
 buy. The former realizes that the services of an independent 
 auditor are of the utmost value to him in stating the ramifica- 
 tions of his business so clearly that he will not omit any favor- 
 able aspects in dealing with a prospective purchaser. Likewise, 
 the buyer feels that he cannot afford to depend on the represen- 
 tations of the seller nor on his own judgment. One may pay too 
 high a price and the other may sell at too low a price unless the 
 professional auditor passes upon the proposition. 
 
 It is generally recognized by leading accountants that when 
 an auditor represents a prospective purchaser, much that is 
 necessary in an ordinary audit may be omitted. It is safe and 
 legitimate to assume that the seller will not underestimate his 
 profits, nor his assets, and that he will not overstate his liabilities. 
 
 Briefly stated, if the auditor finds actual net earnings and 
 assets equaling the representations, and no more liabilities than 
 are claimed, he need not spend unnecessary time on an inspection 
 of the expense vouchers and similar work. 
 
 The chief points of difference which may arise between an 
 investigation of this kind and an audit, are the following : 
 
 (o) Something more than figures are wanted. 
 
 (6) Period covered. 
 
 (c) Analysis of earnings and expenses. 
 
 (d) Future requirements and economies. 
 
 (e) System of accounts. 
 
 (/) Elimination of unusual items. 
 (g) Adjustments and qualifications. 
 (h) Errors in the books. 
 
 (0 Investigation on behalf of a retiring partner when the business is 
 being sold to a continuing partner. 
 
 (;■) Investigation for those in charge of reorganizations. 
 
 (a) Something More Than Figures Wanted : The prospective 
 purchaser of a business wants to know as much of its past history 
 as a man does of his prospective bride. He usually contemplates 
 joining fortunes for an indefinite period, and his associations 
 must represent more than mere financial gain. Who is better 
 equipped to pass on the enterprise from almost every point of 
 view than an experienced auditor? 
 
INVESTIGATIONS 509 
 
 Most accountants feel that their full duty has been dis- 
 charged when they submit a balance sheet and a profit and loss 
 statement, together with such comments thereon as modify the 
 figures submitted. Outside of these figures, they will not go, on 
 the theory that to do so would mean a departure from facts into 
 the realm of theory. 
 
 Nothing could be more inconsistent! The figures shown 
 are, with very few exceptions, estimates only. The stock-in- 
 trade is always worth something more or less than the inventory 
 valuation. The fixed assets vary in value to such an extent that 
 book valuations are usually shown because actual values are un- 
 known. The accounts receivable are valued on past experience, 
 which may be deceptive. There may be contingent liabilities of 
 large amount unknown and not provided for. Therefore, certain 
 conclusions as to the conduct of the business, the trend of prices, 
 and other general information may be compiled by the auditor 
 and reported upon with about as much dependability as the 
 accounts. 
 
 What does a prospective purchaser want? It is not enough 
 that the report of the auditor, the appraiser, or the engineer show 
 that the assets, as represented, are in existence or that the earn- 
 ings equal the guaranteed estimates. It is of quite as much 
 importance to be assured that the management as it existed at 
 the time of the examination was all that could be desired. Assets 
 are sometimes accumulated and earnings realized through cumu- 
 lative circumstances which are no longer a factor, or under the 
 administration of men no longer connected with the enterprise. 
 
 In the United States, new industries or special and ingenious 
 processes may have been responsible for large profits which sub- 
 sequently become reduced through the natural economic law of 
 competition and imitation. Capital flows to unusually profitable 
 enterprises as surely as water finds its level. 
 
 Suppose the business under investigation has shown unusual 
 profits up to the date of the last balance sheet. Is the auditor 
 charged with the duty of forecasting a probable change? Per- 
 haps not, but many enterprises have failed to maintain past 
 profits, although the latter have been actual, and the auditor's 
 certificates thereto true in all respects. In some cases bank- 
 ruptcy has resulted within a year after the flotation of a stock or 
 
5IO AUDITING 
 
 bond issue, due entirely to a drop in gross profits, caused by com- 
 petition, the removal of tariff protection, compulsory reduc- 
 tion in rates by public authority or private demand, or reckless 
 or fraudulent practices. 
 
 The auditor is not and would not be held responsible for 
 losses arising out of these contingencies, but if the dov^rnward 
 movement were starting during the course of his examination, 
 should he not convey his impressions to his client? It may be 
 said that a prospective purchaser should think of these things 
 himself. Perhaps he should, but he doesn't. 
 
 The author has followed this line of suggestion more or less 
 for some years, and has found that the comments are well 
 received and always appreciated, even though his advice may not 
 always be followed. 
 
 An auditor who expects to perform a considerable amount of 
 investigating in the course of his practice will find it very use- 
 ful to compile statistics of various businesses. This may seem 
 to be a formidable undertaking, but it may not be. It so happens 
 that the proprietors of a business will hear that a certain auditor 
 has just completed an examination of the books of some one in 
 the same line as themselves. They feel that he has acquired spe- 
 cial knowledge relative to methods, etc., which may be beneficial 
 to them. It should be remarked in passing that only in the rarest 
 cases has an auditor been asked to reveal any confidential 
 information which he has secured from a competitor. 
 
 But the auditor may for his own information compile statis- 
 tics as to what a certain kind of business should earn, and what 
 its expenses and costs should be. Without revealing the source 
 of his information, he may be able to offer constructive sugges- 
 tions or in the case of a purchase or sale,, or other investigation, 
 he may be able to comment more intelligently on the accounts 
 than if he were dependent entirely on the data compiled in each 
 particular case. 
 
 There is another line of investigation which is not often 
 reflected in a report: are the accounts to which the auditor will 
 certify, prepared directly from the current books of account, or 
 are they the result of special compilation? If the latter, is the 
 actual state of the books an indication of neglect or ignorance? 
 Have the proprietors kept themselves informed as to the results 
 
INVESTIGATIONS 511 
 
 of operations through monthly or other frequent periodical state- 
 ments, or have they waited for definite results until the end of 
 their fiscal year, when an inventory is taken ? 
 
 Have they, therefore, been dependent entirely upon intuitive 
 knowledge, which is possessed more or less (chiefly less) by 
 executives who scorn theory and accounts, and who boast of the 
 value of practical experience? Are the departments coordinated, 
 or do they run independently to such an extent that one does not 
 know what the other is doing? Is it a fact that certain depart- 
 ments are a law unto themselves, that they run along and write 
 up copious records which are never used by those to whom they 
 might be supposed to be of value? 
 
 All of these queries and many more might be answered off- 
 hand by an auditor who had completed an investigation into 
 assets, liabilities, and earnings, but he could not properly report 
 thereon unless he had been in contact with every department of 
 the business. Having this information, why should he not report 
 thereon verbally or in writing? 
 
 All these suggestions have a bearing on the two thoughts 
 which are uppermost in the mind of a prospective purchaser, viz., 
 "Taking everything into consideration, is the business a desir- 
 able acquisition?" and "How much is it worth?" The auditor 
 may not wish to give a definite answer to either question, but he 
 can furnish figures and other information which will be of the 
 utmost interest. 
 
 (b) Period Covered : As stated at the commencement of this 
 chapter, the auditor should require definite instructions before 
 starting an investigation. These instructions usually specify the 
 period to be covered. As a prospective purchaser wishes to 
 know absolutely all that is possible about the past, it is usual to 
 verify the earnings for as many years back as time will permit. 
 Three years would be a minimum, while ten years would not 
 be too long a period for those who expect to make a permanent 
 investment. 
 
 As will be pointed out later, it is not necessary to audit the 
 accounts in the usual sense. An analysis is all that is required. 
 Therefore, it is very little more work to cover six years than 
 three, unless, of course, the records for past years are incomplete 
 or inaccurate. The longer the period, the more accurately will 
 
512 AUDITING 
 
 the trend of the business be shown. Most enterprises have good 
 and poor years, and the respective recurrence of these is of great 
 interest. 
 
 In no event should the results of two or more years be 
 lumped. A big year and a small year might make a satisfactory 
 average, but few wish to invest in a business where the small 
 year is the last. Therefore, each year must be shown separately, 
 and averages never used unless the actual results of the last year 
 or two are substantially above the average. 
 
 The auditor must not fail to inspect the results between the 
 date of the balance sheet and the time of the examination. The 
 most recent month should be compared with the same month for 
 previous years, and if an unfavorable result is shown, the fact 
 should be reported. 
 
 (c) Analysis of Earnings and Expenses : Gross Earnings : In 
 an audit it is always important to verify the gross earnings. In 
 many investigations the prospective purchaser is greatly inter- 
 ested therein and is almost indififerent with respect to the net. 
 He says that with his own appraisement of the physical property, 
 and a personal knowledge of local conditions, he requires noth- 
 ing additional except an accurate statement of the gross receipts 
 or earnings of the enterprise in order to determine upon the price 
 he is willing to pay for the property. The reason is that an expe- 
 rienced executive knows, or thinks he knows, the proper ratio of 
 operating expenses which will be incurred under proper manage- 
 ment, and it is of little moment to him how much the old manage- 
 ment has expended. 
 
 This procedure is followed in connection with the sale of 
 public utility companies oftener than with any other class. The 
 sales or output of these companies is, of course, more nearly con- 
 stant and dependable than with trading or manufacturing enter- 
 prises. But capable men in nearly all lines are found willing to 
 invest in a business with which they are familiar, and if reason- 
 ably assured of a minimum of gross earnings, will undertake to 
 guarantee a maximum of operating cost, irrespective of what the 
 previous owner may have done. 
 
 Recently a large and unsuccessful taxicab company was pur- 
 chased by a competitor who was willing to guarantee a satis- 
 factory profit on the purchase price if operated separately, and 
 
INVESTIGATIONS 513 
 
 an additional saving if consolidated with his own company. He 
 had managed a business with exactly the same problems as those 
 of his competitor, and had been able to produce a large profit 
 out of smaller gross earnings. He knew the competitor's short- 
 comings without seeing an analysis of its expenses. 
 
 This illustrates the importance of a thorough understanding 
 of the client's viewpoint before commencing an investigation. 
 If a purchaser is chiefly interested in gross earnings, the auditor 
 will take great care to state them properly, looking carefully 
 into the sources of revenue, comparing one period with another, 
 and noting any deductions therefrom in the shape of discounts, 
 returns, allowances, etc. The latter should be deducted from the 
 gross earnings and not included among the expenses. He will 
 then state the expenses and costs as shown by the books and 
 make such verification only as may be required. 
 
 Net Earnings : On the other hand, if a prospective purchaser 
 does not have any preconceived ideas as to the proper relation 
 between gross and net earnings, the auditor will make his exam- 
 ination exhaustive enough to enable him to prepare and submit 
 full and complete analyses of expenses as well as earnings. 
 
 The comparative statements of earnings will afford profit- 
 able data relating to the progress of the enterprise. Of all busi- 
 nesses in which a purchaser is interested, the one with a stable 
 earning power and small but sure earnings is preferred to the 
 one which fluctuates violently. Many business men manufactur- 
 ing a novelty, or working under patents, have an unusually pros- 
 perous year due to lack of competition or some similar cause. 
 They immediately talk of incorporating or reincorporating on 
 the basis of the one year's earnings, and commence to spend 
 money as if it were an annuity instead of the returns from an 
 exceptional year. 
 
 The auditor who is consulted in such a case will do his client 
 a kindness if he will point out the wisdom of waiting until he can 
 show a good three or five-year average before he is justified in 
 considering his business as on a stable basis, and one in which 
 others will care to invest. 
 
 Fluctuations must be noted and explained. Gross earnings 
 depend largely on general business conditions, but costs and 
 expenses do not, as a rule, vary to the same extent. 
 
514 
 
 AUDITING 
 
 It is necessary to obtain an analysis of the accounts and be 
 able to report the various stages from gross earnings to net 
 profits. In a trading business, for instance, the following form 
 of statement brings out the information which a prospective 
 purchaser requires : 
 
 A B COMPANY 
 
 Comparative Statement of EARNINGS AND EXPENSES for 3 years ended 
 
 May 31, 1913 
 
 YiABS Ended 
 
 1913 
 May 31 
 
 Per 1912 
 Cent May 31 
 
 Per 
 
 Cent 
 
 1911 Per ' 
 May 31 Cent 
 
 Gko33 Salis: 
 
 Less Allowances and Returns 
 
 
 
 
 NetSalea 
 
 
 
 
 
 Inventory, be^nning of period 
 
 Purchases, net 
 
 
 
 Less Inventory end of period 
 
 
 
 
 Cost of Sales 
 
 
 
 
 Gross ProBt 
 
 
 
 Ratio to Sales 
 
 RatiotoCost 
 
 
 
 
 Sbllinq Expenses: 
 
 Salesmen's Salaries 
 
 Salesmen's Expenses 
 
 Commissions . . 
 
 Advertising 
 
 Catalogs 
 
 Delivery Expenses 
 
 
 
 
 Total Selling Expenses 
 
 
 
 
 Ratio to Sales 
 
 
 
 ADUnnSTEUTION AND GENERAL EXPENSES: 
 
 Executive Salaries 
 
 Office Salaries 
 
 Office Expenses 
 
 Stationery and Office Supplies 
 
 Telephone and Telegraph 
 
 Traveling Expenses 
 
 Legal Expenses 
 
 Rent 
 
 Insurance . . . 
 
 Light, Heat, and Power 
 
 Building Repairs, and Maintenance 
 
 Depreciation on Furniture and Fixtures 
 
 Miscellaneous . 
 
 
 
 :::::::: :::::: 
 
 Total Administration and General Ex- 
 penses 
 
 
 
 Ratio to Sales 
 
 Total Expenses 
 
 
 
 Net Earnings 
 
 Deductions: Interest on Loans, etc 
 
 
 
 Net Profit 
 
 
 
INVESTIGATIONS 515 
 
 It will be noted that the percentages shown are gross profit 
 to sales, gross profit to cost, selling expenses to sales, administra- 
 tion and other expenses to sales. As an investigation implies a 
 comparison of two or more years, these percentages are of more 
 value, relatively, than the amounts. The net profit for each year 
 being shown, the next most important thing is to know how it 
 was made. If the sales were about the same for two successive 
 years, the variation in the percentages of expenses would be 
 most interesting, and to a prospective purchaser it might be a 
 deciding factor to learn that while the selling expenses increased, 
 the administration expenses decreased. 
 
 Verification of Sales : It will be assumed that all sales except 
 of recent date will be verified otherwise than through the sales 
 records. That is, after being charged to the personal accounts 
 of customers, if overdue they will be handled as doubtful 
 accounts. 
 
 As it is customary to accept recent sales as collectible, it is 
 necessary for the auditor to satisfy himself that they are bona 
 fide and not manipulated to produce a good showing just before 
 the date of the balance sheet. 
 
 The more common forms of manipulation are : 
 
 (i) Inclusion of goods sent on consignment and approval as completed 
 sales. This practice may result from ignorance, rather than fraudulent 
 intent. 
 
 (2) Sales or earnings may have been unduly inflated by charging out 
 wholly fictitious quantities and amounts. Where the earnings arise from 
 cash sales, the amount by which the earnings are to be increased is arbitrarily 
 added to the daily receipts. At least one instance is known of the im- 
 proper increase of street railway fares by a promoter who planned ahead 
 to sell out. He knew that the purchase price would be calculated on a 
 certain number of times the net profit realized, or be based on the gross 
 earnings of the most recent period. 
 
 It will be seen that if the good will of a property were to be sold 
 on a basis of four times the average net earnings for the last two years, 
 any method of increasing such earnings would at least double the cost 
 thereof, i. e., the addition to cash sales of each $ioo would be divided by 
 two to get the average for two years and then multiplied by four to arrive 
 at the purchase price, thus yielding a profit of at least one hundred per 
 cent for the fraudulent practice. 
 
 A scheme of this nature must necessarily be planned ahead, 
 which does not apply to most manipulations. This makes it 
 
5i6 AUDITING 
 
 extremely difficult to detect, and no general test can be devised 
 which will surely uncover the fraud. The auditor who keeps 
 constantly before him the possibility of fraud designed to inflate 
 the earnings will have the best chance of discovering it. 
 
 Where the legitimate cash sales or receipts are small, no one 
 would be bold enough to inflate them to any considerable extent. 
 Therefore, the most feasible method is to enter among the bona 
 fide sales fictitious names, quantities, and amounts. This fraud 
 will be disclosed to the auditor who investigates the average 
 number of new customers' accounts opened within a given 
 period. Any unusual increase would be worth while looking into 
 in any event. If legitimate, the question of a continuation 
 thereof would be important ; if not legitimate, it would be even 
 more important to uncover the irregularity. 
 
 If there has been an increase in prices shortly before the date 
 of the balance sheet, the cause thereof should be investigated. 
 Such increases are not always maintained, and it would be unsafe 
 to depend thereon unless the most positive evidence could be 
 secured of the propriety and wisdom of the change. 
 
 It may also have been the case that special contracts have 
 been undertaken which have realized large profits, but which 
 may never be repeated. For instance, a small steam railway 
 company reaped the advantage of a military encampment during 
 a considerable part of one summer. The increase over its' normal 
 traffic was enormous. Yet a prospective purchaser would have 
 no assurance whatever of a repetition of such earnings. 
 
 The period after the closing date up to the time of the investi- 
 gation must be scanned closely for rebates, allowances, and 
 returns to see if they constitute deductions from prior sales. 
 Likewise, the subsequent sales will be inspected, particularly if 
 suspiciously small, as it might indicate that shipments after the 
 closing date were carried back and charged under false dates. 
 
 The Turnover: Authorities differ greatly as to what this 
 term means. The dictionary definitions are : "A completed com- 
 mercial transaction"; "The money receipts of a business for a 
 given period." 
 
 The merchant who speaks of his "turnover" usually refers to 
 his gross sales, but if his answer were analyzed it would be found 
 that his reference was rather to his stock of goods than to the 
 
INVESTIGATIONS 517 
 
 sales value thereof. If he started his fiscal year with a certain 
 inventory, he would endeavor to "turn it over" several times 
 during the year. In this case it would mean the cost of the sales, 
 because his inventory and subsequent purchases are entered at 
 cost, and it is this stock that he is endeavoring to turn over to 
 the greatest possible advantage. 
 
 The banker does not look with favor on the borrower whose 
 gross sales are not several times as much as his starting 
 inventory, and it is a fair inference that sales and cost of sales 
 are here used interchangeably. 
 
 Uniformity is desirable in accountancy terminology, so the 
 author suggests this definition : The turnover of a merchant or 
 manufacturer represents the number of times his capital in the 
 form of stock in trade is reinvested in stock-in-trade during a 
 given period. 
 
 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 inventory. 
 The result will be the number of times the capital invested in 
 stock in trade has been turned over during the period. 
 
 The capital invested in the stock and the physical stock itself 
 may be used synonymously in referring to the "turnover" of a 
 business. 
 
 Profits on Fluctuations: Many enterprises using staple raw 
 materials frequently buy their requirements in advance, and in 
 numerous instances have found it more profitable to sell their 
 entire stock on a rapidly advancing market than to operate their 
 mills. This occurs oftener with cotton than with any other com- 
 modity, but the practice obtains in other lines, such as grain, 
 pork, copper, etc. 
 
 If such profits are actually realized, they should appear as a 
 special item in the current profit and loss account. On the other 
 hand, if the transactions have resulted in a net loss, the most 
 conservative method will be to include the loss in the current 
 accounts, on the theory that an extraordinary profit should not 
 be counted as operating income, but that safety will not permit 
 a loss to be ignored, inasmuch as it will have to be paid out of 
 current earnings. 
 
 Decrease in Expenses: The expenses of all classes will be 
 
5i8 AUDITING 
 
 compared for a number of years. If there has been any consid- 
 erable decrease during the period shortly before the balance- 
 sheet date, a careful analysis should be made to determine the 
 possibility of the omission of liabilities which have been incurred, 
 but the entry and payment thereof postponed. 
 
 The auditor must look at all expense payments after the clos- 
 ing of the books; if unduly large, the vouchers should be 
 examined and their dates noted, as some of them may be for 
 expenses incurred prior to the close of the fiscal period. 
 
 Advertising and Other Deferred Charges: It will be found 
 that excessive valuations are frequently placed upon the pros- 
 pective earning power of advertising and other forms of exploi- 
 tation. In the publishing business, for instance, it has been con- 
 sidered permissible to capitalize the expenses of establishing a 
 magazine. There is no possibility nor expectation of recouping 
 the preliminary expenses out of the earnings of the first year or 
 two. If successful, the early advertising, etc., will have been 
 justified and should be charged against the years which reap the 
 benefit. 
 
 In practice, however, the result is not ideal. Many period- 
 icals have incurred large preliminary expenses, capitalized same, 
 and have never been able to charge off any part thereof against 
 earnings. Other publications which have shown a loss in their 
 early years because no deferred charges were carried over have 
 realized large enough profits in subsequent years to recoup all 
 the preliminary expenses. 
 
 It is a difficult matter to settle at best, but is doubly hard 
 for a prospective purchaser. The best advice to give is to sug- 
 gest that if the business has been running for some time, all such 
 charges, unless very recent, should have been absorbed, and that 
 if too recent to forecast the result, the purchase of the pros- 
 pective profits arising therefrom is a pure gamble, modified per- 
 haps by evidence, if available, of what similar advertising ex- 
 penditure has produced in the past. 
 
 Leases : If the concern under investigation does not own the 
 land and buildings within which its business is transacted, the 
 matter of the lease and renewals thereof is of the utmost impor- 
 tance. It is safe to estimate that out of one hundred leases for 
 a long term, or which provide for extensions, more than seventy- 
 
INVESTIGATIONS ^19 
 
 five per cent call for a higher rental during the later years than 
 at the beginning of the term. Where the renewal rate is not 
 fixed, it usually is to be based on an appraisal, and, in perhaps 
 every case, it is contemplated by owner and lessee that the future 
 rental to be fixed on such appraisal will be higher as a result 
 thereof. 
 
 Therefore, the prospective purchaser must ascertain defi- 
 nitely whether he can retain the same premises for a reasonable 
 time if he so decides, and whether the prospects for an increased 
 business or other equivalents will compensate for the increased 
 expense if a long lease is desired. Conversely a prospective 
 purchaser may not be willing to buy the business unless it can 
 be removed economically to a new location. In such a case a 
 long lease might in itself prevent the consummation of the deal. 
 
 Strange as it may seem, prospective purchasers do not always 
 think of these matters during the early stages of negotiations. 
 The auditor should ascertain the precise state of affairs with 
 respect to the lease before he enters upon an investigation of 
 earnings, the result of which has no interest for a purchaser who 
 may not have known that a long lease on an ascending scale 
 could not be disposed of. 
 
 In other cases, a purchaser may be negotiating for several 
 properties with the intention of consolidating them. It may be 
 part of his plans to unite them all in one place. Obviously the 
 terms of the leases, if any, are of extreme importance. 
 
 Sometimes mergers are effected, and plants consolidated, 
 leaving certain plants idle. If the plans of the promoters con- 
 template leasing the idle plants at a remunerative rate, or leave 
 out of consideration the continuation of the payment of rentals 
 which cannot be evaded, a serious difference between estimated 
 and actual profits might ensue. 
 
 In conclusion, it cannot be stated too strongly that the loca- 
 tion of a business may determine its success or failure, and any 
 facts or opinions relative thereto which the auditor can furnish 
 will be of the greatest interest to his client. 
 
 Inventories: In an investigation for a prospective purchaser 
 the question of inventories is one of the most important. Little 
 need be added to the discussion on this subject on pages 107-112 
 except that the distinction must be especially noted between 
 
520 AUDITING 
 
 valuations properly incident to a going business and those which 
 apply in case of a purchase. 
 
 Naturally and properly the purchaser wishes to buy as 
 cheaply as possible, and the seller desires to realize as high a 
 price as he can secure. But in representing one or the other, the 
 auditor cannot allow any such considerations to affect his mind 
 in arriving at the earnings. The latter should be the same, 
 whether prepared for a vendor or a vendee. 
 
 Inventories vitally affect the profit and loss account and the 
 good will of a business rests upon the profits realized. The 
 result is that inventories actually fix or materially control the 
 purchase price of the business, because the overstatement of an 
 inventory results in an overstatement of profits. 
 
 An auditor need not, and, as a matter of fact he cannot, be 
 entirely indifferent to the interests of his client. If he represents 
 a purchaser, it is almost certain that the seller will have stated 
 the inventories at the highest possible price, so that he need not 
 be particularly concerned about not doing justice to him. 
 
 The experienced auditor will prepare a report the accuracy 
 of which he can maintain before conflicting interests if misunder- 
 standings arise, as is often the case when commercial enterprises 
 change hands. 
 
 Other Factors Which Affect Earnings: Inasmuch as all of 
 the items of assets and liabilities, as well as all sources of income 
 and every class of expenses, enter into the final adjustment of 
 the profit and loss account, the auditor should not pass finally 
 upon the amount of net profit or net loss, to which he will certify, 
 unless he has covered, or intentionally left untouched, all of the 
 procedure required in a balance-sheet audit. The practitioner 
 who does not have his own program for an investigation is, 
 therefore, referred to the chapters of this book describing a 
 balance-sheet audit. 
 
 (d) Future Requirements and Economies: An Auditor 
 Should Not Prophesy : The author has taken the position that an 
 auditor is bound to furnish to his client all of the information 
 bearing on the investigation or audit which he believes to be 
 reliable and relevant, and that he is by no means limited to the 
 figures which any intelligent bookkeeper might compile. 
 
 But it must be understood most positively that it is never 
 
INVESTIGATIONS 521 
 
 permissible for an auditor, as such, to certify to future earnings 
 or future results. An auditor can express his opinion as to the 
 effect particular transactions will have if applied to a future 
 date. For instance, an auditor would be justified in stating that 
 if a million dollars of bonds were sold at par the bank account 
 would be increased by the same amount. But an auditor would 
 not be justified in stating over his signature that if a milHon 
 dollars of bonds were sold at par and invested in the business, 
 savings would result sufficient to net an additional profit. 
 This would be pure surmise, for unexpected losses or expenses 
 might more than offset the savings, or the additional capital 
 might be lost entirely through errors of judgment in its expend- 
 iture. 
 
 Business men and financiers frequently ask their auditors to 
 calculate the effect certain changes will have on the results of 
 operations. For instance, an auditor will be asked to prepare a 
 statement showing the probable outcome if gross sales are 
 doubled, with no proportionate increase in fixed charges. This 
 is proper, profitable, and pleasing work for a public accountant, 
 and he should welcome the engagement, but it must be distinctly 
 understood, before the work commences and after it is finished, 
 that his work is performed in the capacity of an accountant and 
 not that of an auditor. He should refrain from submitting his 
 estimates on paper which bears his name at the top or the 
 bottom, otherwise there is a risk of the figures being put forth as 
 if they were certified to. 
 
 Great pressure is sometimes brought to bear on auditors to 
 have them certify to what are in reality only estimates. It is 
 an astonishing fact that certificates have been issued which 
 are so worded that the untrainejd mind reads therein that the 
 auditor is satisfied that if certain additional capital is raised, or 
 something of that kind, there will be sufficient earnings to 
 pay a large return thereon. The auditor who lends his name to 
 such near-fraud should be expelled from any accounting body to 
 which he may belong. 
 
 There are a number of matters which affect the future 
 upon which an auditor may and should give his opinion, and he 
 may and should discuss the relation which such matters have to 
 the past, but in no case should these be grouped in such a way 
 
522 AUDITING 
 
 that there can be read into the opinion a conclusion as to the 
 future net profit or net loss of an enterprise. The author believes 
 that this is the best test to apply when in doubt as to how far an 
 auditor should go in furnishing information. 
 
 Insufficient Capital: For instance, a business may have had 
 insufficient working capital, and discounts may not have been 
 taken advantage of. A prospective purchaser may ask that a 
 report be compiled which will assume adequate cash capital. An 
 analysis of past purchases may definitely fix the saving which 
 would have been made, but the point at issue is whether or not a 
 like saving can be realized in the future. 
 
 If an auditor is aske'd to prepare a statement setting forth 
 the past results and then stating that in his opinion the following 
 period will produce a given result, assuming the saving of dis- 
 counts, he is going far beyond his province. But if in his opinion 
 the discounts will continue, or some equivalent thereof, there can 
 be no valid objection to his stating in a certificate that assuming 
 ample capital and upon the same volume of business there will 
 be one item of saving, mentioning the amount. 
 
 There may be other undue expenses or losses due to insuffi- 
 cient capital, but most of the arguments advanced as to what 
 would have been accomplished are fallacies. 
 
 Naturally a prospective purchaser wants to know wherein 
 economies can be effected or profits increased, and evidence may 
 be available to prove the truth of the representations made. The 
 most common claim is that the output has been too small, and 
 that additional facilities would have meant greatly increased 
 profits. Output, however, must be sold to produce a profit, and 
 it is always easier to talk about a big increase in sales than to 
 secure actual orders. Men who are partially successful fre- 
 quently overestimate the buying capacity for what they sell. 
 The market may readily consume all that is offered, but if the 
 offerings were to double, the sales price of the whole might be 
 reduced to an unprofitable basis. 
 
 Large capital is by no means a guarantee of financial success, 
 and any investigation into the capital required for a particular 
 business, the effect of a lack of it in the past, and the possible 
 returns therefrom in the future, calls for more acumen and gen- 
 eral business knowledge than most men possess. Nevertheless, 
 
INVESTIGATIONS 523 
 
 there are times when an auditor can be of substantial value in 
 such an investigation, and there can be no objection to his plac- 
 ing at the disposal of his client the benefit of his experience, but 
 for his own sake he must not permit the publication of a certifi- 
 cate which can be directly or indirectly interpreted as a state- 
 ment of future results. 
 
 Comments on future requirements should always be accom- 
 panied by a statement as to the average net capital employed in 
 the old business. This will afford an opportunity for a pros- 
 pective purchaser to arrange for additional capital if the old is 
 inadequate. 
 
 Economies Exaggerated: One has but to read some of the 
 glowing prospectuses issued a few years ago to appreciate the 
 difference between expectation and realization. Fortunately not 
 much of the responsibility for the failure of many large enter- 
 prises can be traced to auditors, but a part of the blame might 
 not be improperly placed on their shoulders. 
 
 It has been stated in these pages that an accountant should 
 be available to make calculations and compile data, for which 
 others would take the responsibility. This is true, but no public 
 accountant should ever work in the capacity of a clerk. He may 
 assist in the preparation of a statement which purports to show 
 the economies to be effected by a merger of two or more con- 
 cerns, but if, through ignorance or lack of experience, estimates 
 are made which the accountant knows cannot be fulfilled, he 
 should not hesitate to express his convictions, and if it appears 
 that facts are to be ignored and the public deceived, he had better 
 withdraw in order to avoid any possible connection with the 
 enterprise. 
 
 Almost without exception promoters have, or seem to have, 
 visions of two or more plants being conducted on about the same 
 expense ratio as the most economical of those merged. Econo- 
 mies in all departments are prophesied, and, as a matter of fact, 
 many are possible and are effected. But they are sorely needed 
 to offset the extraordinary expenses and extravagances which 
 seem to be a necessary element in the promotion and establish- 
 ment of all such consolidations. 
 
 To start with, vast sums are paid in cash or securities to 
 promoters, attorneys, and insiders. Then engineers and account- 
 
524 AUDITING 
 
 ants must receive large fees, although far less in proportion than 
 those paid the lawyers. 
 
 The bankers, lawyers, anl others who become members of 
 the board would not think of attending a board meeting at the 
 dingy business offices of one of the old concerns, so a large and 
 expensive suite of offices is secured "downtown." With expen- 
 sive offices go expensive clerks, and so on down the line. How 
 many poorly paid clerks and others must be dismissed at the 
 works to pay a fractional part of the new and additional expenses 
 which were not referred to in the prospectus ? 
 
 If anyone thinks this description is an exaggeration, let him 
 examine a few of the popular consolidations of about ten years 
 ago. 
 
 Former Owners' Attitude : Except in rare cases, the business 
 which changes hands or consolidates with others has been pros- 
 perous. It is conceded that the personal element is the most 
 important factor in business life, so that if the personal attention 
 of the former proprietor is not available after the sale takes 
 place, it is absolutely essential that an equivalent be found, or 
 the success of former years will not be duplicated. 
 
 This is another of the matters with which an auditor is not 
 usually concerned, but no one has a better opportunity to observe 
 the relative position of each person responsible for the former 
 prosperity than the auditor who investigates the finances of the 
 business for a series of years. If the examination makes it appar- 
 ent that one or more of the proprietors, managers, or other offi- 
 cials were dominant in its affairs, there can be no reasonable 
 objection to this fact being communicated to the prospective 
 purchaser. 
 
 Many men think that ordinary ability, coupled with plenty 
 of money, can win success in almost any line of business, but this 
 is not true, as may be proved beyond a doubt by examining for 
 a while the bankruptcy announcements. Many concerns which 
 start in business with ample capital fail because they are not 
 properly managed. Other concerns with less capital, doing pre- 
 cisely the same kind of business, during the same period of time, 
 will realize large profits. 
 
 One of the most striking instances is that of the wholesale 
 grocery business. Here conditions are nearly equal. The same 
 
INVESTIGATIONS 525 
 
 kinds of goods are bought and sold. The same customers are 
 available to all, yet in the same city one concern will earn large 
 profits, while another doing a large business will not earn a 
 dollar of net profit. It is due to the personnel of the manage- 
 ment, and where successful executives can be retained, an auditor 
 will not be exceeding his duty if he comments on the matter. 
 
 Competition : Some business men wish to expand, or consoli- 
 date, or do something else that sounds big just as soon as they 
 have had one big year. It usually happens that the extraor- 
 dinary profits earned have been due to a monopoly of a certain 
 kind of product. Now economic laws will adjust an inordinate 
 profit by stimulating competition. Publicity which follows a 
 sale or the publication of earnings will, of course, spread the 
 knowledge of large profits. 
 
 An exception may be noted in the case of patented articles, 
 where the continuance of a monopoly is protected by law. But 
 where there are no patents of vital importance, the question of 
 competition must be seriously considered. 
 
 Another element which affects competition is the personal 
 attention referred to in the preceding section. If the business 
 deals in any goods which are dependent upon the taste of the 
 public, it must be borne in mind that the public is very fickle. 
 
 Popular demand may be increased by advertising or main- 
 tained more or less by fair dealing and courteous treatment, but 
 no one can foretell what the future will develop in the way of 
 competition, and for this reason a prospective purchaser must 
 think deeply before he commits himself to a proposition, which, 
 to yield a satisfactory return upon the purchase price, will have 
 to continue to earn so large a gross profit that there is an 
 endeavor to keep the facts secret. 
 
 How long an economic law can be arrested is for the 
 purchaser to decide. 
 
 (e) System of Accounts: Criticisms Should Be Postponed: 
 In special investigations such as here discussed, the auditor 
 should never express an opinion as to the condition of the 
 accounts, except in a confidential report to the prospective pur- 
 chaser. During the course of the work he must accept things as 
 he finds them, and in order to secure the sympathy or coopera- 
 tion of the office staff, he must be careful to praise anything 
 
526 AUDITING 
 
 which deserves praise, and refrain as much as possible from, 
 criticizing accounts or methods which cannot be approved. 
 
 When the purchase is consummated and the auditor is 
 requested to submit suggestions and criticisms, then his work- 
 ing papers should disclose full information available for use. 
 
 Condition of Accounts an Index to Proprietors: There are 
 some particularly shrewd bankers who make frequent purchases 
 of properties, and in other cases furnish capital, who consider 
 that an auditor's report on the condition of the accounts reflects 
 very accurately the kind of men who have been running the busi- 
 ness. 
 
 If profits have been large and no accounts worthy of the 
 name have been kept, it is apparent that these men have depended 
 upon their own ability to earn money, and as this cannot be sold 
 and transferred very readily it is not a safe plan to continue such 
 incomplete records. 
 
 Preparation for New System: Therefore, in their contracts 
 the bankers sometimes insert stipulations along the following 
 lines : 
 
 (i) That within sixty days after the formation of the new 
 company, public accountants satisfactory to the purchasers shall 
 be employed to devise and install a modern system of accounts 
 for the company which will permit of full and accurate reports 
 of its operations and its financial condition being made at least 
 monthly. (In many cases this provision is objected to, but 
 bankers are anxious to have the accounts reorganized wherever 
 dependable results are not readily available, and therefore hesi- 
 tate to finance a company whose accounts are unsatisfactory.) 
 
 (2) That said accountants shall be furnished all requisite 
 information and facilities for carrying into effect such changes 
 as may be necessary, and that the officers and employees of said 
 new company shall cooperate with the accountants in the instal- 
 lation and completion of the new system' within a reasonable 
 time, which in no event shall exceed twelve months from the 
 date hereof. 
 
 (3) That the reports contemplated by said proposed new 
 system shall be delivered each month to the board of directors of 
 the new company, one copy thereof to remain on file with the 
 secretary of the company, subject to the inspection of any mem- 
 
INVESTIGATIONS 527 
 
 ber of the board, and one copy thereof to be mailed each month 
 to the purchasers, as long as the (preferred) stock is not retired. 
 
 (4) That in the event of accountants being employed for the 
 purposes heretofore stated, then the said accountants shall be 
 retained to audit the accounts of the new company at least 
 annually. If the system in use is satisfactory and accountants 
 are not required immediately, they shall in any event be retained 
 to audit the accounts at least annually ; copies of their report to 
 be delivered and filed as set forth in paragraph (3). 
 
 (5) If vendors do not name accountants satisfactory to 
 purchasers, the latter may nominate and the vendors agree to 
 employ the accountants so nominated by the purchasers and to 
 carry out all of the provisions referring to accountants with the 
 same efifect as if said accountants were appointed by the vendors. 
 
CHAPTER XXIX 
 INVESTIGATIONS (Continued) 
 
 ON SALE OR PURCHASE OF A BUSINESS (Continued) 
 
 (f) Elimination of Unusual Items: Earnings: A purchaser 
 profits from future business only. Large special profits may- 
 have been made in the past, but his interest lies in the possible 
 profits of the future. Necessarily these are based largely on 
 past experience, but if there are items which probably will not 
 appear under subsequent conditions, they must be eliminated 
 from that part of the report upon which his opinion whether or 
 not to buy will be formed. 
 
 Income From Assets Not Taken Over : The auditor, in order 
 to make an intelligent report, must have a copy of the purchase 
 contract or option. In many cases there are items which appear 
 on the books which are not included in the purchase price and 
 which are to be retained by the vendor. It is important to ascer- 
 tain whether any income from assets of this nature has been 
 included in the current earnings. 
 
 Interest on Deposits: If the bank balances have been normal, 
 any interest thereon should not be eliminated unless it is known 
 that the future bank accounts are not to bear interest. Many 
 trust companies carry active business accounts and allow inter- 
 est, but are not in as good a position to extend loans as National 
 and State banks. 
 
 Some firms carry many hundreds of thousands of dollars on 
 deposit all the time, earning, perhaps, two or two and a half per 
 cent, just because they always want to be ready for an emer- 
 gency. It is not likely that anyone buying such a business would 
 contemplate the same practice. 
 
 Sale of Assets: The analysis of earnings will disclose 
 whether anything has been included which represents profit on 
 the sale of a portion of the capital assets. For instance, an old 
 building or some land may be sold at an advance over the book 
 value. This is clearly an extraordinary profit and must not be 
 included among the earnings. 
 
 528 
 
INVESTIGATIONS 529 
 
 The author was called upon to verify the earnings of a con- 
 cern and found that among the current earnings were profits on 
 the purchase and sale of the company's own preferred stock. 
 
 Appreciation of Assets : It is a common error to assume that 
 an appreciation in the value of land can offset the depreciation of 
 plant. 
 
 If a statement of earnings has been prepared from the books, 
 and an appraisal shows that the assets are equal to the book 
 value, but that the land has appreciated in value $100,000 while 
 the machinery has depreciated $100,000, then the amount of 
 appreciation must be ehminated and treated as an extraordinary 
 earning and the depreciation included among the expenses and 
 deducted from earnings. 
 
 Insurance Profit : Where a fire has occurred, it may be found 
 that the books show that a profit has been realized. This usually 
 occurs where book values have been written down to be conserv- 
 ative, but the insurance has been left undisturbed. As the 
 assured is entitled to recover the sound or replaceable value of 
 his property, he may be collecting for obsolete or abandoned 
 machinery, etc. In such case, as the prospective purchaser, in 
 order to be conservative, will follow the same system of charg- 
 ing off, and cannot depend on a fire, the apparent profit cannot be 
 included among the current earnings. 
 
 Damages for Change of Grade, etc.: Other extraordinary 
 receipts may arise out of damages collected from compulsory 
 change of grade, a portion of the premises being condemned for 
 municipal or public utility use, etc. These are all unusual items 
 and are not apt to recur in the same business, so they cannot be 
 included among current earnings. 
 
 Expenses: There may have been special losses or expenses 
 which the prospective purchaser can, or thinks he can, guard 
 against. These, too, must be separately stated. 
 
 Excessive Reserves: Just as some men decline to allow for 
 known losses, such as bad debts, depreciation, etc., others insist 
 on writing off all of their furniture and fixtures and create exces- 
 sive reserves for other wasting assets. 
 
 Since the passage of the Federal Corporation Tax Law, some 
 corporations have entered excessive depreciation in their books. 
 Upon a sale they would hardly admit that such charges were 
 
530 
 
 AUDITING 
 
 proper deductions from profits, and if the auditor finds that they 
 are excessive, he will adjust the accounts accordingly. 
 
 The auditor will endeavor to have the reserves represent 
 actual depreciation or prospective losses. When they go beyond 
 this they are in reahty part of the surplus and to be so treated. 
 
 Defalcations: It is to be assumed that a prospective 
 purchaser wise enough to employ a professional auditor to 
 investigate the business he expects to buy, will, if he acquires 
 the business, bond all employees and have the accounts audited 
 periodically thereafter, so that any past loss through defalcation 
 can be eliminated from the expenses. 
 
 Auditors should impress upon new executives the value of 
 surety bonds for all employees. Many employers who have post- 
 poned action for many years never do get around to it, but a new 
 proprietor can insist on this matter without offending any sensi- 
 tive employee. Failure to observe this precaution has entailed 
 enormous losses to some concerns. 
 
 Fire and Other Losses Not Insured : Likewise, the purchaser 
 will carry an ample line of all kinds of insurance, so that if 
 there has been a fire loss not fully covered, or if an employee has 
 been injured and no liability insurance has been carried, or if 
 plate-glass windows be broken, etc., etc., the losses so sustained 
 can be eliminated from the current expenses — which should 
 include, however, a sum equal to the premiums on such insur- 
 ance as if it had been carried. 
 
 Another form of protection which prudent business men 
 carry is "profit" insurance. This covers loss of the estimated 
 profit which might have been earned had no fire occurred. The 
 rate is about the same as for fire insurance, which in most manu- 
 facturing plants is extremely low. 
 
 It cannot be held, however, that an auditor can certify that 
 the earnings of a certain business would have been a given sum 
 if a fire had not occurred. If profit insurance had been carried, 
 and the face of the policies collected, there could be no objection 
 to stating the source of such receipts, but even then an auditor 
 could not include the income so derived among current earnings. 
 
 Actions at Law: Where any considerable expenditure has 
 been made by reason of a verdict or compromise arising out of 
 a suit on contract or infringement, etc., it might be that part of 
 
INVESTIGATIONS 531 
 
 such payment would be properly included among the current 
 expenses, but that a part would be applicable to prior periods. 
 The auditor must deal with such items on their own merits. 
 
 (g) Adjustments and Qualifications: Partners' Salaries: In 
 stating the accounts of a business in connection with a sale, it is 
 customary to eliminate from the expenses the amount charged 
 on the books as partners' salaries. This may be misleading, par- 
 ticularly when the earnings are shown in support of an issue of 
 bonds or preferred stock. For instance, the statement may be 
 made that the net earnings of a partnership have averaged 
 \ $48,000 per annum, this being four times the interest on an issue 
 of $200,000 six per cent preferred stock. In arriving at the net 
 profit, custom decrees that the partners' compensation may be 
 omitted. It is true that unless mention is made of the amount it 
 would be difficult for anyone without a knowledge of the facts 
 to form an opinion on the matter. Partners frequently pay 
 themselves large periodical sums carried on the books as salaries. 
 Many others credit themselves with about the equivalent of the 
 salary of a manager or good salesman, while in many cases no 
 salary at all is allowed for. 
 
 In the case mentioned it may be expected that after the cor- 
 poration is formed, the officers (former partners) will insist on 
 salaries unless they have stipulated that none will be voted or 
 drawn. Such a stipulation is rare, so that it would not be unus- 
 ual in a corporation of this size for salaries of $15,000 to $25,000 
 to be voted to the new officers. This becomes a charge to earn- 
 ings, and thereby reduces the amount available for dividends on 
 the preferred stock. In other words, the future net earnings will 
 be largely diminished, perhaps half, through the change of name 
 from "partners' withdrawals" (not an expense) to "officers' 
 salaries" (an expense). Therefore a charge should be inserted 
 for management salaries. In cases of financing there is frequently 
 some contract provision fixing the amount so to be paid. In any 
 event an intelligent estimate can and should be made. 
 
 An auditor is never justified in signing a certificate omitting 
 partners' compensation, unless the fact is clearly stated, and any 
 reference to the bearing past earnings have on a bond or stock 
 issue is qualified by this omission. 
 
 Contracts : If a business is of such a nature that contracts for 
 
532 AUDITING 
 
 purchases or sales to be received or delivered in the future are 
 the custom, it wrill not be sufficient to stop with the results of 
 the last fiscal period unless the effect of the contracts outstand- 
 ing at that time be considered. 
 
 For instance, contracts may have been entered into for raw 
 materials at a high figure, and at the time of the examination 
 the market may be much lower. The inventory may have been 
 priced at the lower price, but it is not usual to anticipate a loss on 
 purchase contracts not represented by deliveries. 
 
 If the contracts cannot be canceled, with the consequence 
 that the new period is saddled with the necessity of buying mate- 
 rials at an inflated price, the auditor will have to adjust the 
 accounts accordingly. It may be that the prospective purchaser 
 has full knowledge of the unfavorable agreements, but the 
 auditor must not assume this. If it is stated that unfavorable 
 contracts for purchases or sales can be canceled, something more 
 than the word of an interested party will be necessary to con- 
 vince the auditor. 
 
 Taxes: While considering adjustments, the subject of taxes 
 must be considered. It is becoming popular to levy taxes on 
 whatever person or thing will stand it. In many localities real 
 estate taxes are increasing steadily from year to year. At the 
 time of the examination, if an assessment has been made for the 
 following year, the auditor should inspect it and compare the 
 amount payable thereunder with the previous year. As there 
 may be an increase in the valuation as well as the rate, the 
 increased taxes may be a sufficiently large factor to force a some- 
 what lower price from the seller. 
 
 Royalties: Where royalties have been paid under a license, 
 and the financing provides for the purchase of the patents or 
 copyrights, it may be permissible to eliminate from expenses the 
 amounts paid in the past, so far as the possibilities of the future 
 are concerned. But it may be unsafe to make the adjustment 
 unless every detail of the acquisition of the patents is available 
 and it is found that a clear saving will result. Verbal statements 
 of this nature, relied on by auditors, have led to unfortunate 
 experiences in the past. 
 
 The adjustment must include a periodical allowance for the 
 extinguishment of the price paid for the patent or copyright. 
 
INVESTIGATIONS ' 533 
 
 Orders of Public Service Commissions: In making investiga- 
 tions of public service corporations operating within the juris- 
 diction of a public service commission, the auditor should not 
 fail to make a thorough inquiry into the question of whether any 
 orders issued by the commission have not yet been complied 
 with by the corporation whose accounts are the subject of exam- 
 ination. Compliance with such orders might require the expend- 
 iture of considerable sums of money — perhaps for purposes 
 which will not result in a corresponding increase of revenue; 
 instead of an increase in revenue, there may be only an increased 
 expense for maintaining or operating appliances required to be 
 installed. If the prospective purchaser had knowledge of the 
 matter, he would be in a position to protect himself when con- 
 ducting negotiations with the seller. In the absence of such 
 knowledge, however, he would receive a severe shock on being 
 required, after concluding the purchase, to make the entirely 
 unexpected expenditures necessitated by the orders issued before 
 his coming into possession of the property. 
 
 (h) Errors in the Books : As heretofore stated, an investiga- 
 tion is an audit for a special purpose. If the special purpose is 
 the location of errors, then the auditor will proceed as in a 
 regular audit and nothing additional need be said. But in other 
 classes of investigations, the question frequently arises as to 
 how far the auditor should, or must, go in order to satisfy him- 
 self that the accounts are correct. 
 
 For instance, in an inquiry into earnings, it is necessary that 
 he should be satisfied that the income is at least as much as the 
 aggregate to which he certifies. But suppose part of the income 
 which should have been included has never been carried into the 
 books, having been misappropriated, or lost through carelessness 
 or neglect? 
 
 As to this, the opinions of professional accountants differ. 
 Some say that in investigating the profits -of a business with 
 reference to a sale, an accountant is not expected to check the 
 books and entries for the purpose of detecting falsifications, 
 there being a marked difference between an audit and an investi- 
 gation with a view to profits, that some defalcations could not be 
 discovered without verifying footings, postings, and vouchers, 
 and that clients do not desire, and are unwilling to pay for, a 
 
534 
 
 AUDITING 
 
 detailed audit. On the other hand, it is contended that an auditor 
 is not justified in certifying to a balance sheet and profit and 
 loss account unless an audit has been made. 
 
 In the author's opinion, the test of what should be done 
 depends upon the nature of the result to be attained. If an 
 auditor is requested to examine the accounts of a business for 
 a period of years, to state and certify to the net earnings realized 
 and to the financial condition as of a certain date, then it is proper 
 to restrict oneself to the actual work necessary, and additional 
 work is superfluous. If income or assets have been omitted, and 
 the omission could not have been detected unless a complete 
 audit were made, nevertheless the auditor has fulfilled his duty. 
 If expenses or liabilities have been omitted, the auditor cannot 
 be excused even if a detailed audit were necessary to discover 
 the omissions. 
 
 No examination along the lines indicated could be considered 
 as complete in any event unless intelligent analyses were made 
 of the various income and expense accounts. Usually these 
 analyses will disclose fraud or errors of principle if they exist. 
 
 The final test of the sufficiency of the examination lies in the 
 skill with which the work has been handled. If the auditor has 
 brought to bear all of the care and skill which might reasonably 
 be demanded of an experienced practitioner, then he cannot be 
 held morally or professionally responsible for well concealed 
 errors or omissions, but it must be remembered that the degree 
 of care and skill called for is much greater than is expected or 
 legally demanded from an inexperienced person or one who does 
 not hold himself out as a professional auditor. 
 
 (i) Investigation on Behalf of a Retiring Partner When the 
 Business is Being Sold to a Continuing Partner: When the re- 
 tirement of a partner is caused by his death or by physical dis- 
 ability, a "continuing" partner may also be a "liquidating" part- 
 ner. In such case the continuing partner is charged with a 
 greater degree of responsibility than that to which the purchaser 
 of a business under other circumstances would be held. The 
 continuing partner is in the best position to protect his own in- 
 terests, and the auditor's connection with the liquidation of the 
 old firm will most frequently be as representative of the retiring 
 partner. 
 
INVESTIGATIONS 535 
 
 The auditor will need to do all the work which is usually 
 included in an investigation made for an intending purchaser, 
 but there are, in addition, certain other phases of the situation 
 which should receive consideration, and it is these of which men- 
 tion will be made. It is only equitable that the assets should be 
 valued on the basis of a going concern, and it is clearly the duty 
 of the auditor to see that they are not undervalued. It would be 
 most satisfactory to have independent appraisers employed to 
 value such assets as plant and stock in trade, due consideration 
 being given both to the circumstances of the case and the rights 
 of each of the partners. Frequently, however, this is not done, 
 and the business is liquidated by the continuing partner, who 
 himself values the various assets. While specific rules to be 
 followed can hardly be laid down, it should be observed that in 
 cases of doubt as to values the absent partner should have the 
 benefit thereof. This is only fair, as the surviving or continuing 
 partner is in a position to secure what he believes to be his 
 rights, whereas the retiring partner, through death or absence, 
 is not in the same position to urge the consideration of his rights. 
 It is an established rule of law that a liquidating partner must 
 not take advantage of his position, and this of itself is sufficient 
 reason for his deciding all doubtful cases in favor of the absent 
 partner. 
 
 Accounts receivable and any other choses in action should be 
 "worked out." The continuing partner is not entitled to any 
 commission for his own services in this connection, though he 
 should be reimbursed for the actual expenses incurred for cler- 
 ical work entailed thereby. Discounts and other allowances 
 credited to customers upon settlement of the outstanding 
 accounts should be carefully scrutinized. Goods returned by 
 customers subsequent to the date of dissolution would ordinarily 
 be taken into the stock of the new business, and, unless particular 
 attention is given to this class of transactions, the charge which 
 should be made to the new business and credited to the liquida- 
 tion of the old might very easily be overlooked. Unless the total 
 amount involved is very small indeed, all credits to old customers 
 other than for cash should be analyzed. Those which are for 
 goods returned can then be made the subject of further investi- 
 gation. 
 
536 AUDITING 
 
 The valuation of the stock on hand is likely to present con- 
 siderable difficulty. The usual rule of valuing the stock at 
 "market or cost, whichever is lower," does not necessarily apply 
 in such a case. The liquidating partner is under obligation to 
 secure the largest return for all the assets of the business, and he 
 has a right to sell the stock to himself, which he is in effect doing, 
 only if he is willing to pay as much, or more, for it than could 
 have been secured from anyone else. This is not to be construed 
 as meaning what could have been secured at a forced sale. 
 
 The fairest valuation would probably be the cost of duplicat- 
 ing the stock as of the date of dissolution, due allowance being 
 made for obsolete or imperfect stock. If the inventory includes 
 only staple goods, little difficulty will be encountered in ascer- 
 taining the present cost of duplicating them. If the goods, how- 
 ever, have been made to special order, or are otherwise difficult 
 to value, estimates could be secured from manufacturers for 
 making similar articles or the actual sales of the goods in the 
 inventory could be traced and the customary rates of gross profit 
 applied to estimate the cost. These matters should be covered 
 by an agreement. In drawing such agreements the auditor 
 should be consulted. 
 
 If it be agreed to value the stock on the basis of cost, it is to 
 be remembered that this would include not only the original 
 purchase price of the goods, but also freight, cartage, and any 
 other direct charges for handling and placing the goods in stock. 
 It is sometimes urged that the term "cost" in such a case should 
 include interest from the date of purchase to the date of the 
 inventory. This does not seem logical, however, inasmuch as, 
 if market prices were still the same as at the date the goods were 
 bought, the fact that the goods had been in stock a number of 
 months would not add to their value. On the contrary, the 
 longer the goods had been on hand the greater the probability 
 of their already being, or becoming at an early date, unsalable. 
 
 Profits realized or losses sustained on the completion of 
 contracts made prior to the dissolution of the partnership are to 
 be apportioned between the retiring and continuing partners. 
 Inasmuch as the retiring partner shared in the expenses of secur- 
 ing the contracts and participated in the risk of undertaking 
 them, it is only fair that he should participate in the profits 
 
INVESTIGATIONS 537 
 
 derived therefrom. On the other hand, he should also help to 
 bear the burden of any losses sustained in carrying out contracts 
 which were made prior to the dissolution of the partnership. 
 There is no reason why the continuing partner should be called 
 on to bear the burden alone, unless a specific agreement is 
 reached under which the continuing partner takes over the con- 
 tracts at specific values and assumes all further risk in connec- 
 tion with their completion. To do this it would, of course, be 
 necessary to secure the consent of all other parties to the con- 
 tracts, so that the retiring partner or his estate be released from 
 all liability for the execution of the contracts. 
 
 Usually the most equitable method of valuing machinery and 
 fixtures would seem to be cost less proper depreciation allow- 
 ances. If this differs materially from the cost of reproduction at 
 the present time (also making allowance in this case for accrued 
 depreciation), the valuation will probably have to be made the 
 subject of compromise between the parties. 
 
 While the correctness of the balance sheet is of preeminent 
 importance in an investigation such as the one under considera- 
 tion, the correctness of the income account is likewise of impor- 
 tance if the good will is to be valued on the basis of past earn- 
 ings. It is also necessary to review the expenses entering into 
 the income account for a period prior to the date of dissolution 
 so as to see that no prepaid expenses which would apply sub- 
 sequent to the date of dissolution have been absorbed by the old 
 business. The retiring partner will, in due course, be debited 
 with his proportion of all expenses chargeable to the old firm, 
 even though they may not have appeared among the liabilities 
 stated on the books at the time of his retirement. Prepaid 
 expenses applying to the new business would not, however, be 
 so likely to be brought into the liquidation account if they were 
 absorbed in the operations of the old firm. 
 
 There are still other questions, such as partners' salaries and 
 interest on partners' accounts, which will need to be carefully 
 considered in the light of the partnership agreement. 
 
 (j) Investigation for Those in Charge of Reorganizations: 
 There is an increasing demand for the services of accountants in 
 connection with reorganizations. The special features of such 
 examinations are admirably expressed by A. Lowes Dickinson, 
 
538 AUDITING 
 
 C. P. A., in his paper "Accounting Practice and Procedure," 
 which appears in the American Association Year Book for 1908 : 
 
 The consideration of a plan for the reorganization of a property which 
 has been reduced to a condition of insolvency requires a full and accurate 
 knowledge of all the existing conditions with regard to the property and 
 its past and probable future earning capacity. The elements to be in- 
 vestigated and determined will, therefore, be as follows : 
 
 (i) The sources and nature of the gross earnings and the prospects 
 of any increase therein without further expenditures for development. 
 
 (2) The cost of operation, with particular reference to the effect 
 thereon of bad management or bad organization, and to the possibility 
 of remedying these conditions ; and the proportion which the cost of opera- 
 tion has borne and may be expected to bear to the gross earnings. 
 
 (3) A comparison of the gross and net earnings and capitalization of 
 the property, with some actual or desirable standard, so as to determine 
 the proportion which one should bear to the other if the reorganization is 
 to prove successful. 
 
 (4) Hence to arrive at the total interest-bearing and dividend-paying 
 capital, which the reorganized property will stand on some fixed interest 
 basis. 
 
 (5) The rank of the different classes of obligations having regard to 
 the property pledged as security therefor; the margin of security; the rate 
 of interest; the date of maturity; the equivalent par value on the basis 
 of the standard rate of interest adopted for all classes ; and, if practicable, 
 the extent to which the properties specifically mortgaged show sufficient 
 earnings to meet interest on the indebtedness secured thereon. This class 
 of information will probably require a report from an engineer or other 
 expert on the value and the condition of the physical property. 
 
 (6) Following upon the determination of these factors, a considera- 
 tion of the various separately mortgaged divisions of the property, with 
 a view to determining whether any should be abandoned to the bond- 
 holders, rather than be included in a reorganization. And here it is im- 
 portant to observe that the contribution of any specific piece of property 
 to the general organization is not necessarily measured by its ability by 
 itself to earn interest on the obligations secured thereon. Numerous 
 other factors will enter into a consideration of this point, and it may 
 easily appear that a property earning little or nothing toward payment 
 of its obligations is sufficiently valuable to the organization, as a whole, 
 to be retained, if. possible. 
 
 (7) Another important factor is the amount of new money required 
 to be introduced for the purpose of paying off the floating debt and 
 rehabilitating the property, and the best method of raising such money, 
 whether by the issue of new prior lien securities ranking in front of or on 
 an equality with those issued in exchange for existing mortgages, or by 
 assessments on junior classes of securities, In the latter case it is im- 
 
II 
 
 INVESTIGATIONS 539 
 
 portant that sufficient inducement be given to the junior classes, in the 
 proportion of new securities issued for old, to induce them to pay these 
 assessments; while for the assessments themselves, the securities issued 
 should represent the par value of the cash paid in on some reasonable 
 market valuation. 
 
 (2) INVESTIGATION FOR CREDITORS, ETC. 
 
 Auditors are frequently called upon to make examinations 
 the scope of which is practically limited to certain accounts about 
 which the most complete detail is required. For instance, a 
 manufacturer may desire to extend a large line of credit to a 
 jobber or merchant, and before doing so wants to know the 
 latter's capacity for handling his line, as well as to know that his 
 financial condition and method of doing business are satisfactory. 
 
 Investigation on Behalf of a Present or Prospective Creditor : 
 Examinations along these lines may be divided into two general 
 classes : 
 
 For bankers or note brokers who propose to loan on the 
 promissory notes of the borrower, or for bankers who propose to 
 bring out bond or preferred stock issues. 
 
 For individuals or business concerns who propose to make 
 advances for various purposes, or who have extended or who ex- 
 pect to extend credit on open account. 
 
 In the main, the points to be observed have been discussed 
 in the chapters on the conduct of a balance-sheet audit, but there 
 are certain special precautions which may, with propriety, be 
 enlarged upon at this time. 
 
 (a) Examinations for Bankers 
 
 Extension of Business: The most important line of exami- 
 nation, after ascertaining the assets and liabilities and analyzing 
 the profit and loss account, is an inquiry into the plans for the 
 future which have been adopted or which are under considera- 
 tion. The average business man is not content with a stationary 
 business. He wishes to expand for the purpose of increasing his 
 profits, decreasing his expense ratio, and perhaps the most com- 
 pelling of all reasons is his ambition to outstrip his competitors. 
 
 If his floating debt has been burdensome, he may have been 
 
540 AUDITING 
 
 obliged to keep within certain bounds as to capacity and pro- 
 duction, but the moment he is financed it seems almost inevitable 
 that new liabilities are incurred sufficient to use up the additional 
 supply of credit almost before it is available. 
 
 Accountants do not always feel concerned with this phase of 
 business life, but as the lender should have some means of deter- 
 mining the use to which his money is to be put other than that 
 supplied or promised by the borrower, he naturally looks to the 
 professional auditor. True, he has looked in vain in many cases, 
 and this may explain the reason why so many banks, bankers, 
 and financiers have secured the services of men who can secure 
 and impart the information required, irrespective of the fact of 
 whether or not they have the degree of Certified Public Account- 
 ant. 
 
 Collateral v. Integrity: Which is better, to loan money to a 
 dishonest man on ample security, or to a perfectly honest man 
 who wishes to borrow on his own name and who cannot furnish 
 collateral? The former may seem to be more advisable, but 
 there are disadvantages in doing any business whatever with a 
 man who cannot be trusted. 
 
 Therefore, no matter how good the collateral may be, the 
 banker wants more information, and the auditor may be able to 
 furnish it. Facts relative to previous business experiences, pos- 
 sible failures or embarrassments caused by speculation, etc., will 
 be secured from the mercantile agencies, but inside information 
 relative to the personnel of the organization can be furnished by 
 the auditor. 
 
 Experience has demonstrated that where partners quarrel, 
 or where one does all the work, trouble will follow. Large con- 
 cerns, solvent so far as finances go, have been placed in the hands 
 of receivers because of internal dissensions. A banker does not 
 want to make a loan which may be paid off eventually by a 
 receiver, even if the assets are double the liabilities. 
 
 Then one or more departments of the business may be weak. 
 The sales force may be highly organized and efficient, but if the 
 manufacturing department is poorly managed, or is not coordi- 
 nated with the sales department, the results will not be satisfac- 
 tory. 
 
 If no criticism is justified and a man's honesty is unques- 
 
INVESTIGATIONS 541 
 
 tioned, a banker may prefer the risk to the apparent safety of a 
 loan secured by collateral. It has been said that "a crooked 
 borrower is always a wise window-dresser," and this observa- 
 tion may be enlarged to remind the banker that crooked bor- 
 rowers when negotiating a loan sometimes offer collateral to 
 which they do not have title. 
 
 Future Business: During the progress of any audit which 
 comprehends a balance sheet, there should be available full data 
 with respect to future business and the means whereby it is pro- 
 posed to finance it. 
 
 Schedules of orders booked, the time estimated to complete 
 same, the cost of the raw materials, labor, and other manufactur- 
 ing expenses, the time within which the proceeds of sales will 
 mature, the dates by which the liabilities for purchase will have 
 to be discharged, and many other factors are all to be compiled 
 and put into readable and dependable form. 
 
 If funds are to be furnished to meet pressing obligations, and 
 if any increase in the business means the tying up of additional 
 cash for a considerable period, then there may be a hesitancy 
 about supplying the needs unless a stipulation is furnished that 
 additional business will not be sought until the funds with which 
 to finance it are in sight. The auditor who can secure informa- 
 tion of this nature may be helpful to the banker and even more 
 so to the borrower, for it is of no permanent advantage to the 
 latter to be tided over one period of stringency merely to be 
 plunged into another and more serious situation. 
 
 Bank Loans to be Repaid: The auditor must bear in mind 
 that the banker whom he represents in these investigations is 
 considering the investment of deposits which are chiefly pay- 
 able on demand, therefore he is not contemplating the making of 
 a permanent loan, but one which will be repaid within a compar- 
 atively short period of time. If a banker were looking purely for 
 security, he would invest a large portion of his funds in real 
 estate mortgages. The security might be better than commer- 
 cial paper, but the maturities would be from one to three years, 
 and hence entirely unsuitable for his purposes. 
 
 If the auditor ascertains that the prospective borrower does 
 not expect to "clean up" at least once a year, he should so report 
 to his client. 
 
542 AUDITING 
 
 (b) Investigation for Purely Credit Purposes 
 
 The credit manager of a business concern or the representa- 
 tive of a capitalist who contemplates extending credit to a pros- 
 pective borrower or debtor must proceed along somewhat dif- 
 ferent lines than the professional auditor, whose duty is to report 
 upon actual conditions, and upon whom the responsibility is not 
 laid of having to determine immediate action, based more on the 
 estimated outcome of the future than on present financial 
 strength. 
 
 For instance, an auditor might ascertain and report that a 
 certain man had cash on hand of $100,000 and no debts. He 
 would have no further responsibility thereafter, unless it were 
 shown subsequently that there were undisclosed liabilities. We 
 will assume, however, that the facts were as reported. 
 
 The credit manager might have an entirely dififerent task 
 before him. He should use the same means to ascertain that the 
 $100,000 was actually on hand and free from liens, and that there 
 were no liabilities, but his work would then, in a sense, be merely 
 beginning. He should ascertain the past and present moral and 
 business reputation of the man ; he should have an accurate and 
 complete history of his business career; he should question him 
 in detail as to what he intends to do with the money; whether 
 his proposed business venture calls for a capital of more than 
 $100,000, and so on. 
 
 It has been said that the credit manager must always look 
 out for three essential elements in passing on a credit basis, viz., 
 character, capital, and capacity, three "C's," and therefore easily 
 remembered. 
 
 The author feels that there are so many points of contact 
 between a professional auditor and a credit manager that this 
 opportunity should be taken to discuss the similarities of their 
 work, with a view to standardizing as much of it as possible. 
 
 It is not contended that the auditor should attempt all the 
 manifold duties of the credit manager, nor that the latter should 
 burden himself with the technical knowledge required to make a 
 detailed audit. It is, however, urged, without fear of contradic- 
 tion, that an auditor would be able to render better service to his 
 clients if he could acquire some of the instincts of the successful 
 
INVESTIGATIONS 543 
 
 credit manager and keep constantly before him, when making 
 investigations involving proposed credits or investments, many 
 of the requirements which the science of credits has found to be 
 essential. Likewise, who will deny that the credit manager 
 could perform his work more easily and scientifically if he were 
 conversant with the principles, and could take advantage of the 
 experience, underlying the practice of professional auditing? 
 
 During the six months ended June 30, 1912, there were 8,317 
 business failures throughout the United States with liabilities of 
 $108,012,223, and resulting in losses to creditors of at least 
 ' $50,000,000, and the number of failures is steadily increasing. In 
 a very large proportion of these cases credit could not be secured 
 if the debtor were obliged to submit his books to an examination 
 by a professional auditor. 
 
 Is it unreasonable to suppose that the general use of auditors 
 to verify the accounts of concerns seeking credit would save ten 
 per cent of this annual loss of over $100,000,000? If a saving of 
 over ten millions of dollars could be effected by the expenditure 
 of, say, one million, would it not be worth while to attempt to 
 save another ten per cent or more by compulsory audits of all 
 concerns seeking credit? 
 
 Unscientific Methods: Such methods affect business suc- 
 cess quite as much as anything else. The auditor may find a 
 satisfactory surplus of assets, but if carelessness or incompe- 
 tence exists in the accounting and other departments, a day of 
 reckoning will surely arrive. 
 
 Signs of carelessness or incompetence may be found in lax 
 collection methods. More than one failure has resulted from a 
 policy of allowing collections to take care of themselves. 
 
 The precise procedure followed should be ascertained and 
 reduced to writing. The "follow-up" system must be examined 
 very carefully. It may be that the system is good, but that it is 
 not being followed. Then the relation between the departments 
 must be looked into. Coordination here is absolutely essential 
 to success. Sometimes a credit department will claim that the 
 salesmen are so anxious to sell that a considerable part of the 
 business must be refused. This brings up the question of coor- 
 dination among the various departments of a business. If it is 
 lacking, one of the elements of failure is present. 
 
544 AUDITING 
 
 An investigation into the methods of doing business thus 
 becomes a necessity where one is looking into the future proba- 
 bilities of success or failure. Almost anyone can sell goods, but 
 to insure financial success they must be sold at a price which will 
 yield a satisfactory profit and to customers who will pay. Here 
 again the methods of the prospective debtor are all-important, 
 and the representative of the lender or creditor not only has the 
 right to know whether or not scientific methods are in force, but 
 it is his positive duty to ascertain whether or not such is the case. 
 
 Lack of Capital : It is said that more failures result from lack 
 of capital than from any other cause. It may seem superfluous 
 to state that it is better to do a small but safe and profitable busi- 
 ness than to attempt to trade beyond the limits of capital 
 employed; but this overstretching is going on all the time. It 
 is a point on which the auditor and credit manager can secure 
 accurate information from the balance sheet, but this must be 
 supplemented by an inquiry into plans for extensions to plant, 
 commitments for large purchases for future delivery, and similar 
 negotiations. 
 
 Credit Risks : The passion of a salesman is to sell ; the dread 
 of a credit manager is to pass a credit which will produce a loss. 
 Between the two may lie the secret of a successful business and 
 large profits. The burden is upon the credit manager, and he 
 cannot escape it by turning down every order about which any 
 doubt exists. 
 
 The conclusions upon which he will base his final decision in 
 any case are dependent upon so many different circumstances 
 that they cannot be enumerated here, but it may be mentioned 
 that the margin between the cost and selling price of an article 
 is one of the most important factors to be considered when the 
 question of the acceptance or rejection of an order is to be settled. 
 If the gross profit is large, it is obvious that more risk may be 
 taken than where the margin of profit is too small to admit of 
 any material amount being set aside for bad debts. 
 
 In some lines the gross profit is so large that it would be 
 more economical to sell everybody than to maintain a credit 
 department; in others it is equally unnecessary to maintain such 
 a department, because all goods must be shipped sight draft 
 against bill of lading. The point seems obvious, yet many 
 
INVESTIGATIONS 545 
 
 accountants and credit managers do not differentiate between 
 the rules to be observed, which makes their general advice of 
 little or no value. 
 
 Insurance: A professional auditor does not always inquire 
 into the sufficiency of insurance of all descriptions, but it is 
 believed that the successful credit manager has this constantly in 
 mind. Auditors now see the importance of this line of inquiry, 
 and among certain firms it is an integral part of the audit pro- 
 gram. 
 
 Fire insurance is only one of the lines which should be 
 investigated. If the personality of a partner or an employee is 
 of great value, life insurance might be desirable. Except in a 
 very few lines of business, such as railway or taxicab, a reason- 
 able amount of liability insurance, both public and employers', 
 should always be carried. 
 
 Profit insurance is frequently as important as fire insurance, 
 especially where a seasonal business is conducted, and large pre- 
 liminary expenses, such as advertising, are incurred, and where 
 a total loss would result if a factory were to be destroyed. 
 
 Errors of Principle: It is not enough that a concern's finan- 
 cial statement shall look well, for sometimes actual conditions 
 are concealed through errors in bookkeeping. This state of 
 things exists in more cases than is generally known. 
 
 For instance, in a contracting business the bookkeeper, in 
 closing the accounts, closed all of the credit balances in individ- 
 ual contract accounts to profit and loss. He did not realize that 
 all of them were not completed and that a considerable liability 
 existed in respect of the cost of completion. His balance sheet 
 showed a much better financial position than the concern 
 deserved, but the bookkeeper maintained that it was correct 
 until he was shown how inaccurate it was. 
 
 Errors may be honestly made, and yet they will bring ruin 
 on a concern unless discovered and rectified. Failure to provide 
 for depreciation is the most common dereliction, and excessive 
 charges to asset accounts is a close second. The auditor is 
 always on the lookout for such errors, whether intentional or 
 unintentional, but few credit managers realize the importance of 
 ascertaining whether or not the books of a prospective debtor 
 have been regularly examined by a public accountant. , 
 
546 AUDITING 
 
 Fraud: Under this class the auditor will find far too many- 
 examples. The bankruptcy courts are full of cases in which 
 creditors have been grossly deceived. Many of these are so 
 flagrant that it seems impossible that the debtor should have 
 been able to incur such large debts, yet the fact is obvious that 
 credit managers by the hundred and business concerns by the 
 thousand extended credit to these bankrupts to an aggregate of 
 tens of millions of dollars. The schedules of the bankrupts' 
 debts speak for themselves. The most surprising feature of the 
 whole situation is that in many cases the most cursory examina- 
 tion of the bankrupts' books would have revealed to the trained 
 auditor that gross fraud was being practiced. A more intimate 
 relationship between professional auditors and credit managers 
 would prove to the latter that the auditor can be of inestimable 
 service in many ways. 
 
 Character : Last but not least is the element of character. In 
 modern business it is almost concealed, owing to the impossi- 
 bility of continuing the personal relations between bankers and 
 borrowers. The modern borrower's balance sheet may be sub- 
 mitted to hundreds of bankers. But the author would not like 
 to see the audit program of the auditor or credit manager omit 
 all consideration of character. 
 
 The banker has to consider primarily the present ability of 
 the borrower to repay the loan, but further than this his business 
 foresight will make it possible for the banker to size up his man 
 and determine whether there is not some inherent lack of char- 
 acter in him, either moral or executive, which may at some future 
 time make the risk more hazardous than if he were entirely 
 normal. 
 
 Some unprincipled business men pay all of their debts, but 
 many are found in the bankruptcy courts being relieved of their 
 obligations, and subsequent success does not incline them to pay 
 the debts thus discharged. 
 
 The honest man may fail honestly, but if he can he will pay 
 in time, and we may be thankful that there are many such. 
 Therefore let the auditor and the credit manager study human 
 nature and analyze the conditions presented to them not only 
 from the financial standpoint but from a moral point of view as 
 well. 
 
INVESTIGATIONS 547 
 
 (c) Investigation in Patent Litigation 
 
 An investigation to ascertain profits realized in the manu- 
 facture of patented articles, where infringement of patent rights 
 is claimed, and the claim is sustained, or when an examination is 
 ordered pending a decision, presents several novel features, as 
 compared with an ordinary statement of profits. 
 
 It is not intended to discuss the matter from a legal point 
 of view, and it may be that the principles hereinafter set forth 
 might not be upheld by the courts in some jurisdictions. It is 
 the author's experience, however, that most of these cases are 
 settled out of court owing to the enormous expenses involved 
 in the taking of testimony before masters, who are usually 
 appointed where matters of account are involved. 
 
 The following procedure, therefore, may be taken as the 
 result of actual practice, following negotiations which usually 
 involve concessions on both sides, rather than settled rules laid 
 down in judicial decisions. 
 
 General Accounting Principles Do Not Govern : The prelim- 
 inary conferences in a matter of this sort naturally bring out 
 opinions which differ radically. The injured party will claim, 
 everything that can be imagined, and the defendant will produce 
 a statement which shows that the manufacture of the infringing 
 article has been attended with ruinous losses. From the begin- 
 ning it is a question of gradually drawing the lines closer, until 
 each has stripped his case of redundant matters and the issue is 
 joined. 
 
 It will be found that ordinary accounting principles do not 
 form the basis of the claim nor of the defense. The following are 
 exceptions to accepted practice: 
 
 There would seem to be no excuse whatever for apportioning 
 any part of the general expenses as a part of the cost of the busi- 
 ness. The infringers would have had these expenses to pay in 
 any event in order to carry on their legitimate business. 
 
 If the principal, business of the defendants consists of manu- 
 facturing or dealing in infringing articles, then it may be proper 
 to include a certain part of the general expenses, but items of a 
 questionable nature should not be included. 
 
 As defendants are not supposed to have pushed the sale of 
 
548 AUDITING 
 
 the article, it hardly seems proper that any credit should be 
 claimed for special exhibitions. 
 
 Where the same kind of materials are legitimately used in 
 the manufacture of other goods handled by the defendants, and 
 the purchases are not earmarked at the time for any particular 
 department, it would seem improper that credit should be 
 allowed for any materials not clearly identified as having been 
 used in the infringing product. 
 
 Based on similar accountings, the defendants are not entitled 
 to place a scrap valuation upon materials remaining on hand 
 when they were compelled to stop the sale of the article, but they 
 could be compelled to scrap the articles on hand at that time, 
 and would not be entitled to any credit whatever for the entire 
 cost of the manufacture of said stock. 
 
 It does not seem conceivable that the defendants would be 
 permitted to make a profit out of their wrong-doing, and this 
 would be the result if general expenses and similar items were 
 included, as the tendency would be to reduce the expenses of 
 conducting their legitimate business. If they have been ordered 
 to account for the profit made by them in the manufacture and 
 sale of articles, the court will undoubtedly hold that the word 
 "profit" as here used means the difference between the proceeds , 
 from the sale of an article and the prime cost (that is, labor and 
 material) of such sales, and that the cost of goods on hand at the 
 end of the period should not be treated as an item of cost for 
 which credit can be claimed. 
 
 (3) FRAUD 
 
 Following the discovery of a defalcation may be heard 
 expressions of surprise, based on the fact that the defaulter was 
 a trusted employee. It does not seem to occur to most people 
 that, generally speaking, no one but a trusted employee has an 
 opportunity to defraud others. Many trusted employees prove 
 recreant to their trust every year, therefore mere business pru- 
 dence demands some form of supervision over all those who have 
 a chance to appropriate to their own use the property of others. 
 
 In the preceding chapters an attempt has been made to out- 
 line the procedure required in audits of various natures, but the 
 procedure there referred to was not intended to cover those cases 
 
INVESTIGATIONS 549 
 
 where a particular person is under suspicion or where a partic- 
 ular forin of fraud is suspected, or has been discovered, and where 
 it is important to locate the guilty party or parties without delay. 
 
 Then, again, it may be that an audit has been made along 
 usual lines without developing anything wrong; but it is found 
 that an employee is living beyond his means, or is constantly 
 seen in bad company, so that a special investigation becomes 
 desirable. The point immediately arises as to whether there are 
 any special checks, or verifications, which are not usually resorted 
 to in an ordinary audit, but which might be useful when applied 
 to specific cases. 
 
 Possibilities to be Studied : In all cases where suspicion exists 
 the quickest way to locate fraud is to ascertain definitely the 
 opportunities which are normally open to the person suspected, 
 and the possible chances which may not be usually open to such 
 person, but of which he may have taken advantage. 
 
 For instance, the treasurer of a company may be known to 
 be spending more than his income, and an inquiry is ordered. If 
 the business is at all large, it is obviously not worth while to 
 commence the investigation in the same way as a general 
 audit, but the wise course would be to look into the matters 
 under the personal charge of that officer. Any securities sup- 
 posed to be in his hands should be called for, and the method of 
 handling cash transactions should be inquired into. If he has 
 always insisted on opening the mail, it may be that customers' 
 accounts have been tampered with ; if he has assumed personal 
 charge of the periodical reconciUation of the bank's pass books 
 with the bank balance, it may be that funds have been withdrawn 
 from the bank and not reported. 
 
 If the gross profit is unexpectedly small, it may be that stock 
 is being stolen or that fictitious purchases appear in the books. 
 
 Extent of Fraud : Frequently the professional auditor is not 
 called in until the defalcation has been disclosed and his services 
 are desired to fix the total. In such a case experience is invalu- 
 able, for the position of the auditor may be a most difficult one. 
 The defaulter usually is called upon to give, or proffers, his 
 assistance, and professes to be most anxious to help get at the 
 whole truth. He will state the total amount as positively not 
 exceeding a certain total, and his employer is apt to believe him 
 
550 AUDITING 
 
 and to doubt the auditor, whose experience warrants him in stat- 
 ing that thieves rarely tell the truth, and that defaulters hardly 
 ever know the extent of their own fraud, and when they do know 
 will understate it materially in the hope that their attempts at 
 concealment may be at least partially successful. 
 
 There is only one safe rule, and that is to calculate every 
 possible source of income open to the defaulter, the maximum 
 amount of such income, and the longest time possible during 
 which the fraud may have been going on. 
 
 Records are often destroyed and many sources of income 
 cannot be traced subsequently ; therefore it is never wise to take 
 the word of a defaulter for the amount of his theft. 
 
 Attitude Toward a Defaulter: Whenever possible the 
 defaulter should be required to attend and assist the auditor. 
 This does not mean that his word is to be taken blindly or that 
 he is to be left alone with the books, but he can do no harm, and 
 in countless cases his presence has been of the greatest assist- 
 ance. 
 
 Here the experience and skill of the auditor have full play. 
 By the exercise of tact he may persuade the criminal to disclose 
 many things which the closest examination of the records would 
 not reveal. A clue is often as valuable as a complete disclosure, 
 and it rarely happens that a trained auditor spends any consider- 
 able time with a defaulter without discovering directly or inci- 
 dentally the system employed and other valuable information. 
 
 No one knows so well as professional auditors how small 
 a proportion of these crimes are made public, but defaulters 
 themselves seem to feel intuitively that if they promise to tell 
 all they know and to make restitution, all will be forgiven and 
 forgotten. Unfortunately, from the standpoint of example this 
 is often too true, but even though it is true there can be no objec- 
 tion to an auditor pointing out to the defaulter the fact that if he 
 lies to him (the auditor), it will aggravate his possible punish- 
 ment. If an examination is likely to result in litigation, the audi- 
 tor must pay particular attention to any admissions or statements 
 by the suspected party. 
 
 The chairman of a board of water commissioners kept a 
 cash book showing his receipts and disbursements. When the 
 balance was ascertained by auditors appointed by the munici- 
 
INVESTIGATIONS 551 
 
 pality, the chairman was informed of the amount shown by the 
 book to be due from him, the correctness of which he did not dis- 
 pute. On being asked if he could explain the balance against 
 him, he said he could not, and being then tojd that it would have 
 to be reported to the authorities, he replied : ''Well, you will just 
 have to report it." When he refused to pay subsequently and 
 suit was brought, the court held that this was sufficient evidence 
 upon which to recover the balance. 
 
 This supports the principle of law that the statement of an 
 account need not be confined to the original parties. The auditor 
 may have an exceptional chance to secure an admission, and if 
 there is any likelihood of its being used later, he should reduce 
 it to writing at once. This record may be useful in refreshing his 
 memory. 
 
 The Millwall Dock Case: This is one of the English cases 
 usually cited to illustrate fraudulent methods of manipulating 
 accounts. The managing director instructed the superintendent 
 to overstate accrued charges for storage and for advances made 
 for account of customers. There were 200 ledgers and 12,000 
 open accounts. The open items were taken off on sheets, certi- 
 fied by superintendent, chief clerk at docks and ledger clerk, and 
 the summary was signed by the managing director. 
 
 Rates were excessive, but calculations were correct, and the 
 auditors verified the footings and calculations. Outstandings 
 grew from $uo,ooo in 1870 to $1,150,000 in 1898. Of the latter 
 amount $1,000,000 was fictitious. For most of the period, the 
 managing director received a fixed salary, and thus did not parti- 
 cipate directly in the fraud, except that he kept his job. 
 
 The auditors could have discovered the manipulation at any 
 time if they had footed every other page, instead of every page, 
 of the sheets on which the outstandings were listed, and spent 
 the time thus saved in testing the accuracy of the charges as 
 transferred to the sheets. Or a subsequent test to ascertain 
 whether the accrued charges at the former audit were realized 
 would have disclosed the system of fraud. One hour thus spent 
 would have been sufficient to reveal the fraud, as the charges 
 were uniformly excessive. 
 
 The Bank of Liverpool Case: This is another celebrated 
 English case. 
 
552 AUDITING 
 
 The ledger clerk forged the signature of a depositor to a 
 cheque and stated that the payee was his mother. He had the 
 cheque cashed and did not charge it to the account of the de- 
 positor whose name. he forged when it came in at balancing time, 
 but debited some other account, reversing the entry next day. 
 
 When pass books of those with whose accounts he tampered 
 came in while auditors were there, he secured the books and 
 forged the audit clerk's initials therein. The bank inspector saw 
 the initials and did not verify the settlements. 
 
 While the internal audit may here be blamed, yet the case 
 illustrates the possibilities of fraud when a dishonest clerk con- 
 centrates his energies upon thinking out a scheme to outwit those 
 who are engrossed in the routine work of a large enterprise. 
 
CHAPTER XXX 
 HOLDING COMPANIES 
 
 Consolidated Balance Sheets and Profit and Loss Statements : 
 
 In the face of the Sherman Act, business combinations are being 
 formed daily. They may be in flagrant or in reasonable restraint 
 of trade, or they may deal with concerns operating solely within 
 the boundaries of a single State and thus escape Federal prose- 
 cution and be subject to State regulation only if buying or sell- 
 ing necessities. 
 
 Politicians and friends of the "plain people" may cry aloud 
 that competition must and shall be preserved, but the real fact 
 is that business men will compete up to a certain point only, and 
 any law which prohibits competitors who are losing money from 
 coming to an understanding or consolidating is doomed to ulti- 
 mate failure. Auditors will therefore be called upon more and 
 more to investigate proposed consolidations and to advise with 
 respect to their accounts after mergers have been effected. It is 
 not intended to discuss the economic features of holding com- 
 panies. Any one interested in this phase of the subject is referred 
 to the paper by William M. Lybrand, C. P. A., which appears in 
 the Year Book of the American Association of Public Account- 
 ants for 1908. 
 
 Balance Sheet: The usual statement of assets and liabilities 
 published by a holding company is wholly devoid of the informa- 
 tion an investor or stockholder seeks. On one side appears a 
 huge sum opposite the caption, "Securities of Subsidiary Com- 
 panies." Then there will be another item representing advances 
 (usually huge also) to subsidiaries; there may be a httle cash, 
 but other assets are scarce. 
 
 Nor is the lack of information found in connection with the 
 so-called "trusts" only. There are a great many combinations of 
 small concerns, and with these the failure to render intelligent 
 accounts is quite as-marked as is the case with larger enterprises. 
 
 553 
 
554 AUDITING 
 
 The chief criticism leveled against these formal statements 
 is that in the absence of data relative to the quick assets and lia- 
 bilities of the subsidiaries, no opinion can be formed as to whether 
 the concern as a whole is properly financed or whether there is 
 absolute need of additional working capital to prevent bank- 
 ruptcy. 
 
 The balance sheets of some holding companies show among 
 the assets the net assets of the subsidiaries. That is, from the 
 accounts receivable and inventories will be deducted the accounts 
 payable, the resulting balance being shown as an asset. This 
 is obviously wrong. The trade debts may be out of proportion 
 to the assets and may be overdue and pressing. 
 
 Strong pressure is sometimes brought to bear on an auditor 
 to induce him to prepare the balance sheet of a holding company 
 so that it will indicate a stronger financial position than actually 
 exists. The best answer to such a request is a positive declara- 
 tion on the part of the auditor that proper accounting procedure 
 requires a certain form of balance sheet and that there will be 
 no deviation therefrom. 
 
 Form of Balance Sheet: As just stated, the form of the 
 balance sheet is of great importance. Mr. Lybrand, in the paper 
 heretofore mentioned, covers this point: 
 
 It is now very generally recognized, however, that the submission of 
 the balance sheet of the holding company only does not furnish the owners 
 of the company with the information as to its real financial position to 
 which they may justly consider themselves entitled. 
 
 The holding company was, as heretofore stated, organized for the 
 purpose of acquiring the capital stocks of affiliated companies, and thus 
 effecting a combination which would bear the test of adverse legal scrutiny. 
 While each company under this scheme retains its corporate identity, and 
 is in the eyes of the law a separate corporation, yet there is a virtual 
 consolidation of ownership, the results of which can be properly expressed 
 in a statement of their accounts only by consolidating the balance sheets 
 of all the companies into one balance sheet, eliminating therefrom the inter- 
 company stocks, bonds, and accounts which indicate the relation of one 
 company to another and not to the public. 
 
 A consolidated balance sheet, therefore, is intended to reflect the 
 financial position of the whole group of affiliated companies, considered as 
 one undertaking. In a typical balance sheet of this character, the following 
 grouping and arrangement of the assets and liabilities has been adopted: 
 
HOLDING COMPANIES 555 
 
 ASSETS : LIABILITIES : 
 
 Property Account. Capital Stock of Holding Corpora- 
 
 Deferred Charges to Operation. tion. 
 
 Investments. Capital Stocks of Subsidiary Corn- 
 
 Sinking and Reserve Fund Assets. panics not owned by Holding 
 
 Current Assets. Corporation. 
 
 Bonded Indebtedness. 
 
 Current Liabilities. 
 
 Sinking and Reserve Funds. 
 
 Surplus. 
 
 When a holding company purchases the capital stock of another com- 
 pany, the price paid for this capital stock presumably represents the hold- 
 ing company's estimate of the value of the equity in the subsidiary com- 
 pany's assets. This price may be greater than the combined capital stock 
 and surplus account of the subsidiary company, in which event the dif- 
 ference must be assumed to denote the value of the subsidiary company's 
 good will, or other assets, not appearing on its balance sheet, otherwise, 
 if they were included there, the cost of the capital stock to the holding 
 company would be exactly equal to the combined capital and surplus of 
 the subsidiary company. On the other hand, if the price paid by the 
 holding company, for the capital stock of the subsidiary company, is less 
 than the combined capital and surplus, the difference must be assumed to 
 express the amount at which the assets of the subsidiary company are 
 overvalued on its books. 
 
 In consolidating the "Property" accounts of the subsidiary companies 
 (their property accounts including good will, trade marks, franchises, etc., 
 as well as tangible property), the total must, therefore, be increased or 
 reduced by as much as the cost of the capital stocks of the respective 
 subsidiary companies, as at the date of their purchase by the holding com- 
 pany exceeds or falls below their combined capital and surplus account. 
 
 It might seem at first thought that the surplus accounts of the sub- 
 sidiary companies should not be applied as stated in the foregoing para- 
 graph, but that they, together with the surplus accrued subsequent to the 
 purchase by the holding company, should be combined and their aggregate 
 entered on the consolidated balance sheet as the surplus of the whole un- 
 dertaking. The fallacy of this statement has been proven in various ways. 
 Perhaps the most simple and direct argument is somewhat along the fol- 
 lowing lines: the surplus of a corporation, generally speaking, represents 
 the balance of earnings which have accumulated from its operations, and 
 which have not been paid out to the stockholders, applied in immediate 
 reduction of valuation of assets or reserved for the ultimate replacement 
 thereof. As a surplus can accrue only during the operating of a company, 
 it is fairly obvious that the holding corporation prior to its organization 
 cannot have earned such a fund, and that therefore it would be entitled 
 to merge into its consolidated surplus account only the balances of profits 
 
556 AUDITING 
 
 accumulated by the subsidiary companies during the period of their own- 
 ership by the holding corporation. 
 
 Further, as the amount paid by the holding company for the capital 
 stock of a subsidiary company represents the holding company's estimate 
 of the equity in the subsidiary company, and as that equity is presumed 
 to be represented by its capital stock and surplus account, it follows that 
 in the process of consolidating, the capital stocks of the subsidiary com- 
 pany in the holding company's books will be eliminated, as will be the 
 capital stock and surplus account on the subsidiary company's books. The 
 surplus account being thus absorbed, cannot, of course, appear again as a 
 surplus in the consolidated balance sheet. 
 
 It will be noted from the foregoing that all intercompany- 
 accounts are eliminated, thus exhibiting the debts due from the 
 public and to the public. Any other form of balance sheet which 
 includes as assets accounts due by one company to another, and 
 as liabilities accounts due from one company to another, is mis- 
 leading and useless for the purpose of disclosing what will be 
 realized from the quick assets and the amounts which will have 
 to be paid. 
 
 Accounts Receivable: Where advances have been made to 
 subsidiary companies by the holding company itself, the aggre- 
 gate thereof will appear among the assets of the holding com- 
 pany, but the auditor should never permit the item to be stated 
 in such a manner as to sustain a belief on the part of any outsider 
 that the receivables are due from debtors other than subsidiary 
 companies. 
 
 Quoting again from Mr. Lybrand : 
 
 Frequently other large items of assets are advances made to the sub- 
 sidiary companies for which the latter may have issued their notes in 
 favor of the parent company. Such advances are usually made to provide 
 for extensions or additions to the plants of the subsidiary companies 
 after they have been acquired by the holding company, or they may have 
 been made for the purpose of furnishing additional funds to purchase 
 larger stocks of materials, to carry contracts requiring considerable time 
 to complete, or for any other legitimate business purpose. If the moneys 
 advanced have been for the purpose of adding to the plants of the subsidiary 
 companies, it may be that these loans will subsequently be funded by the 
 subsidiary companies through the medium of mortgage bonds, which, if 
 sold to the public, will enable the subsidiary companies to discharge their 
 debts to the parent company. Or possibly, if the whole of the authorized 
 stock of the subsidiary company is not outstanding, a further amount may 
 be issued and delivered to the parent company in settlement of the ad- 
 vances, thus changing the form of the asset on the holding company's 
 
HOLDING COMPANIES 557 
 
 books from an account receivable to a security ownership. It is improbable 
 that such a course would be pursued except in very special instances, as 
 the holding company would doubtless prefer to appear as a creditor of the 
 subsidiary company rather than as an owner of more shares of its capital 
 stock, because, if the subsidiary company were unprofitable and it became 
 necessary to wind it up, the holding company would claim, with the other 
 creditors, its proportion of the realizations from the subsidiary company's 
 assets. Such a position, we believe, would be assumed by the holding 
 company in the absence of direct ruling to the contrary, but serious doubt 
 has been cast recently on the ability of a holding company to sustain such 
 a contention where it is the owner of the entire capital stock issue of the 
 underlying company. 
 
 Advances made by a parent company to its subsidiary companies are 
 not always represented in the latter by tangible property. Such advances 
 may have been made to recoup the subsidiary company for losses sus- 
 tained by it in operating. The advances appearing on the books of the 
 parent company would, under such conditions, be nominal assets only, 
 and as such in a balance sheet of the holding company they should be 
 offset by a reserve sufficient to provide for the whole or such part of them 
 as may be represented by losses. 
 
 Profit and Loss Account: Certain holding companies con- 
 tinue to show as gross earnings only such dividends as have been 
 received during the period from the subsidiary companies. Such 
 practice merits the strongest censure. The author has heard it 
 contended that inasmuch as the only legal method which a cor- 
 poration has of distributing profits is by means of dividends, it 
 would be most improper for a holding company to take credit for 
 part or all of the earnings of a subsidiary company which had 
 not been so distributed. This sounds well in theory, but in prac- 
 tice it is the argument of dishonest men. Almost invariably the 
 sole reason for taking advantage of this technicality is that one 
 or more of the subsidiaries has incurred a net loss in excess of 
 the aggregate profits of all of the companies, and the manage- 
 ment of the holding company, wishing to conceal such loss, seeks 
 by subterfuge to justify the action. 
 
 An auditor cannot be too positive on this point. Wherever 
 a holding company owns and controls one or more subsidiaries, 
 the profits or losses of the subsidiaries must be stated for the 
 same period as that of the holding company and consolidated. 
 Any other method may lead to gross abuse. 
 
 The directors of a holding company, the sole income of which 
 was the dividends of subsidiaries, could withhold dividends from 
 
558 AUDITING 
 
 prosperous companies while they were accumulating the stock of 
 the holding company, and would be lavish with such dividends 
 whenever they desired to sell their holding company stock. This 
 is not mere supposition on the part of the author. Holding com- 
 pany profit and loss accounts are made up in the manner indi- 
 cated, and inexperienced professional auditors are sometimes 
 • induced to certify to their accuracy, being misled by the appar- 
 ent legality of the procedure. 
 
 As experienced and reputable auditors invariably decline to 
 permit their names to be connected with a form of statement 
 which is dishonest in fact if not in theory, this caution as to the 
 profit and loss account of holding companies should be taken 
 advantage of by an auditor who may have the matter presented 
 to him for the first time. 
 
 Ernest Reckitt, C. P. A., relates the following incident : 
 
 I have in mind a case where I was called in to make, as I supposed, 
 an audit of the books not only of the "Holding Company," but also of 
 those of the subsidiary companies, and was amazed to find that it was 
 proposed to have me audit only the "Holding Company's" books. Upon 
 explaining that I could give no certificate on such audit, the most specious 
 arguments were advanced and the president of the company attempted 
 to use the full force of his strong personality to persuade me to defer to 
 his wishes, which naturally only made me suspect still more the motives 
 which actuated him. Finally, and with great reluctance, they handed me 
 the books of the subsidiary companies, and I found out that two of the 
 companies had made losses aggregating over $200,000, no part of which 
 losses had been taken care of on the books of the "Holding Company," 
 though they had been careful to bring on to the books of the "Holding 
 Company" the profits made by other subsidiary companies. One year 
 later, the "Holding Company" and most of the subsidiary companies were 
 in bankruptcy, as they deserved to be. 
 
 The author was called upon several years ago to audit the 
 accounts of a holding company in a large Southern city, and of 
 all of its subsidiaries. The latter included enterprises of differ- 
 ent kinds, but as the holding company owned practically all of 
 the stock of each underlying company, it was necessary to con- 
 solidate the operations of the entire group in order to show its 
 exact net earnings. Unfortunately, several of the concerns were 
 not profitable, and the consolidated profit and loss account was 
 not a document to be proud of. 
 
HOLDING COMPANIES 559 
 
 One of the subsidiaries, however, was quite prosperous, and 
 its net earnings in themselves were sufficient to pay interest and 
 dividends on the holding company's bonded debt and capital 
 stock, but the losses of the other companies seriously depleted 
 the funds of the holding company and rendered dividends impos- 
 sible. 
 
 A short time afterwards, the president of the company 
 appeared in New York with a large block of the holding com- 
 pany's bonds for sale. He submitted to the bankers, not the 
 auditors' report, but a statement showing the earnings of the 
 profitable subsidiary and ignoring so far as possible the existence 
 of the other companies, and the bonds sold readily. 
 
 Quoting Mr. Lybrand on the matter of the preparation of the 
 profit and loss account : 
 
 Most of the comment that is applicable to the consolidated balance 
 sheet is pertinent to the consolidated profit and loss account. In the con- 
 solidated profit and loss account transfer of profits from subsidiary com- 
 panies to the holding company through the medium of dividends will be 
 ignored, and the earnings, expenses, and charges of the several com- 
 panies will be combined and stated as though the corporation were one 
 enterprise. 
 
 In the consolidated statement, therefore, will appear the entire gross 
 earnings of the group of affiliated companies. Such gross earnings will 
 represent cumulatively the operations of the several underlying companies, 
 i. e., merchandise transformed into a marketable condition by one com- 
 pany and transferred to a second company for further manipulation and 
 sale in a different form would appear in the gross earnings of each com- 
 pany and their aggregate in the consolidated profit and loss account. While 
 on the surface it would seem that there is a duplication of gross earnings 
 under this method, it is probably the only practical way in which to state 
 them where there is a large number of companies with very many manu- 
 facturing processes. 
 
 Again, as the property account of the various subsidiary companies 
 are consolidated in the balance sheet, it would seem that the gross opera- 
 tions of those companies should likewise be aggregated in order to show 
 the relation of the volume of business to the property investment. 
 
 From such gross earnings will be deducted the entire operating costs 
 incurred in producing those earnings, the balance resulting being then 
 subject to the addition of income of a miscellaneous nature, and the de- 
 duction of expenses which are not applicable directly to the manufacturing 
 and producing operations. 
 
 In stating the consolidated income and profit and loss account there 
 will probably be some difference of opinion as to the point at which charges 
 
S6o AUDITING 
 
 other than for ordinary operating should rest, in order that the current 
 net earnings of the undertaking may be shown. 
 
 It is fairly clear that from the gross earnings must first be deducted 
 the costs in labor, materials, and operating expenses incurred in pro- 
 ducing those earnings, in order that a— let us call it manufacturing— profit 
 may be shown. It is true that in an industrial enterprise, which includes 
 mining, land and water transportation, as well as many forms of manu- 
 facturing, such an expression is in a sense a misnomer, but as the mining 
 and transportation are really tributary to the manufacturing, the title 
 might stand. It is true also that there are so many different kinds of 
 products, with varying rates of profits included in the gross earnings that 
 comparatively little use can be made of the figures as a basis of com- 
 parison from year to year. Nevertheless, as it is impossible in a con- 
 densed statement to show the volume and profit of each line of business, 
 the aggregate figures will give the stockholder some information as to 
 the total business, and, in a rough way, the rate of profit thereon for com- 
 parison with preceding periods. 
 
 From the gross profit so ascertained would be deducted the adminis- 
 trative, selling, and general expenses, virtually common to the whole enter- 
 prise, and chargeable against the operations as a whole. The resulting 
 balance will be subject to adjustments because of extraordinary items re- 
 lating to operating, but which cannot be included fairly in the current 
 operating costs ; and by income from investments other than those rep- 
 resenting the holding company's ownership of the subsidiary companies. 
 
 The balance then carried forward from the current profit and loss to 
 the income or general profit and loss account will be reduced by reason 
 of reserves for depreciation, replacement, sinking fund requirements, etc., 
 which are properly appropriated out of current earnings. Logically, such 
 items should be deducted before the balance of current profits is struck, 
 because the depreciation and replacement reserve at least are charges 
 directly connected with operating, but as heretofore remarked, deprecia- 
 tion statistics are not sufficiently accurate, and the practice of reserving 
 for depreciation is not yet common enough to justify the inclusion of such 
 charges with the ordinary operating costs. Further, if they are stated 
 separately, attention is drawn to the fact that reserve for depreciation 
 has been made and to the amount of that provision. 
 
 The balance of profits, after deducting the foregoing reserves, shows 
 the position of the earnings with respect to the interest payable on the debt 
 of the subsidiary and holding companies. It may be held that interest 
 on bonds of subsidiary companies (being a lien which must be deducted 
 by the subsidiary company from its earnings before it can appropriate the 
 remainder to the holding company) should be applied before the balance 
 of current earnings is shown. It is suggested, however, that it is pre- 
 ferable 'to embrace all of the interest on the funded debt of the com- 
 panies in one group, in order that the total thereof may appear; also 
 because the bonded debt of the subsidiary companies may change by reason 
 of new securities of the holding company being issued in lieu thereof. 
 
HOLDING COMPANIES 561 
 
 or it may be reduced through the operation of the sinking funds, in either 
 of which events the interest charge would be lessened and a comparison of 
 operating profits from year to year disturbed. 
 
 After the deduction of interest on the bonded debt, the balance re- 
 maining represents the profits available for dividends. 
 
 Partial Ownership of Subsidiaries: The foregoing remarks 
 apply where the holding company owns all of the stock of the 
 subsidiary companies, but in those cases where the holding com- 
 pany owns part only of the stock, some adjustment of the con- 
 solidated profit and loss account may be necessary. 
 
 Where a profit is shown, the amount to be included as the 
 share of the holding company is the proportion the stock owned 
 by the holding company bears to the total capital outstanding. 
 It must be assumed that the minority stockholders will event- 
 ually receive through dividends their share of the profits. 
 
 Where a loss is shown, and where losses form the chronic 
 condition of the subsidiary, it may as well be recognized that the 
 holding company will have to assume all of it. This, of course, 
 applies only to those cases where a subsidiary company is so 
 largely owned by the holding company that the minority interest 
 cannot be depended upon to advance its share of the funds neces- 
 sary to take care of the loss. 
 
 The holding company may carry these advances as an asset, 
 but the auditor will place such a value upon these items as the 
 facts warrant, and it is reasonably certain that the final result 
 will be to include all of the loss in the consolidated profit and loss 
 account, although something less than one hundred per cent of 
 the stock of the subsidiary is owned. 
 
 Comparative Statements: Where the accounts of several 
 subsidiaries, operating along substantially the same lines, are 
 examined, one very important object is to endeavor so to state 
 the accounts that the results are reduced to a uniform basis. 
 Many adjustments may be necessary to take care of local condi- 
 tions, etc., but no form of presentation is clearer or more valuable. 
 
 Where comparative costs are feasible, it is important to ascer- 
 tain the amount of the plant investment, as it may be that the 
 costs as reported do not include depreciation nor interest. The 
 latter is usually omitted from costs on the ground that it is a 
 profit on capital employed and therefore cannot be an element of 
 
562 AUDITING 
 
 cost. Admitting this, "without prejudice," it might nevertheless 
 serve to conceal actual lack of ability on the part of the manager 
 of one factory as compared with another. One might keep twice 
 as much capital tied up in raw materials and goods in process as 
 the other, and where units of costs are stated in fractions of a 
 cent, the interest on the excessive capital employed might be 
 sufficient to prove the superiority of one manager over another. 
 
CHAPTER XXXI 
 INTEREST 
 
 The professional auditor should be thoroughly acquainted 
 with the various methods of calculating interest. There is a 
 remarkable lack of uniformity among business houses, and even 
 banks, on the subject. The audit clerk who verifies interest col- 
 lections or interest payments feels relieved if his own calcula- 
 tion agrees within a few dollars with the amount received or paid 
 and lets 'it go at that. 
 
 As the "few dollars" multiplied a number of times will aggre- 
 gate a considerable sum, it is important that the auditor famil- 
 iarize himself with, and require his clerks to learn, the laws and 
 customs governing interest, so that when a test is made it will 
 be done intelligently, and if the amount received is insufficient 
 or the amount paid is excessive, a report may be made thereon 
 with confidence in the correctness of the criticism. 
 
 The three factors entering into the calculation of interest are 
 principal, rate, and time. 
 
 Principal: Is simply the amount on which interest is to be 
 calculated. There are two methods of reckoning principal. In 
 bank discount the principal is regarded as the entire face of the 
 note. For example, the bank discount on a note for $i,ooo pay- 
 able at one year at six per cent would be $60, and the proceeds 
 paid to the customer would be $940. It will be noted that here 
 the customer has the use of only $940 for one year, and yet he 
 pays interest for the use of $1,000 for one year. The actual prin- 
 cipal on which interest should be chargeable is only $940. The 
 fictitious principal, on which interest actually is charged, is 
 $1,000. The true principal in such case is found by the following 
 proposition : 
 
 1.06 : I.CX3 :: $1,000 : X 
 which gives a present value of $94340 for X 
 
 In spite of the foregoing facts, it is now thoroughly Avell 
 settled by universal usage that this system of bank discount will 
 
 563 
 
564 AUDITING 
 
 be permitted by the courts, even though it does actually effec- 
 tuate usury. 
 
 The right is expressly given to national banks by U. S. Rev. 
 Stats. Sec. 5197, now Sec. 5197 of the U. S. Compiled Statutes. 
 
 The right is also given to New York Banks by Section 74 of 
 the Banking Law of that State. 
 
 But the practice of anticipating the interest in this fashion 
 has been held not to authorize the charging of interest on the 
 anticipated interest in case such interest is not paid at the date 
 of the execution of the note. 
 
 In the case of First National Bank v. Davis, 108 111. 633 
 (Sup. Ct. 111., 1884), a note was given for $8,000 at one year at 
 ten per cent. It was renewed at maturity. The renewal note, 
 instead of being for $8,800, was for $8,880, made up as follows : 
 $8,000 principal, $800 anticipated interest, and, as the bank did 
 not receive the $800 anticipated interest on the date of execution 
 of the renewal, but merely took the debtor's promise to pay the 
 $800 at one year, the bank added 10 per cent of this $800 (or 
 $80) to the face of the renewal note, making it total $8,880, as 
 stated. The court held this to be usury. 
 
 The question of principal also occurs where payments are 
 made on an old account which is drawing interest. Under such 
 circumstances the debtor sometimes claims that all payments 
 should apply on account of principal; but unless there is a clear 
 and specific agreement that they shall be so applied, the rule is 
 well settled that such payments are applicable in _ the first 
 instance to all arrears of interest before any application can be 
 made on account of principal. 
 
 The question of principal is also involved in cases dealing 
 with compounded interest. It has been held that interest may 
 be added to and become a part of principal at stated times and 
 under certain conditions, and the question of whether or not 
 this is permissible will sometimes determine whether or not the 
 transaction is usurious or otherwise. This is a point upon which 
 an auditor is frequently required to pass. 
 
 Loan accounts and book accounts between interrelated 
 enterprises sometimes run along for years without a final settle- 
 ment. When a statement is desired upon which a settlement 
 may be based, there is always a temptiation to state the transac- 
 
INTEREST 565 
 
 tions in as short rests or periods as possible, the interest being 
 calculated and included in each balance carried forward. This 
 results in compounding the interest, is illegal, and should never 
 be permitted by the auditor. 
 
 It may be a hardship to the lender, as compound interest 
 would be legal and proper in such a case if the accounts had been 
 written up properly at the time, interest actually entered in the 
 books, and statements prepared therefrom and submitted to the 
 borrower or debtor. If not objected to at the time nor within 
 a reasonable time thereafter, the transaction would have the 
 legal effect of an account stated, and each new starting balance, 
 although including interest calculated at shorter intervals than a 
 year, being acquiesced in, would be binding. 
 
 In the absence of special custom or agreement, however, 
 interest should not be compounded. 
 
 Rate of Interest: This rarely or never admits of dispute ex- 
 cept in those cases where a note, contract, bond, or other obliga- 
 tion is made in one jurisdiction, to be paid or performed in an- 
 other jurisdiction without specifying the rate of interest, and the 
 legal rate of interest in the two jurisdictions is different. Then 
 the question sometimes arises whether the rate at the place of 
 making the note or the rate at the place of payment is to govern. 
 
 A similar question arises where one rate of interest is the 
 legal rate at the time of making the note, contract, or bond, and 
 another legal rate is in force when the obligation falls due. 
 
 In the absence of an intention to the contrary shown by 
 express stipulation or otherwise, the rate of interest is to be 
 regulated by the law as it existed at the time and place of mak- 
 ing the contract, and not by the law existing when the debt falls 
 due or when the remedy is sought. (8 Cyc. 310.) 
 
 It is well settled, however, that the parties may contract 
 for the legal rate in either place and the contract will govern. 
 
 Time : The time which interest is to run gives rise to a wide 
 diversity of practice. 
 
 There is an underlying principle which is of very general, 
 although not absolutely universal, application, and it is this, that 
 if the first day of the interest period is included in the computa- 
 tion, then the last day shall be excluded ; and if the first day is 
 excluded, then the last day is included. The parties can, if they 
 
S66 AUDITING 
 
 will, contract otherwise. (See Blanchard v. Hilliard, ii Mass. 
 
 85-) 
 
 Custom in Banks and Trust Companies: In Kirkbride & 
 Sterrett's "The Modern Trust Company" (page 84), the rule is 
 stated to be : "In computing interest on loans, the actual number 
 of days is taken. If the day on which the loan was made is 
 included, the day of payment is not counted." 
 
 It is more or less common, however, for banks to count both 
 the first and last days when the interest is payable to themselves. 
 This custom will not override the common law rule unless the 
 parties expressly agree to it. The bank that figures time thus at the 
 full legal rate of interest in the State of Vermont is guilty of 
 usury, but not corrupt usury. Bank of Burlington v. Durkee, 
 I Vt. 399. The bank that does this same thing in the State of 
 Virginia is not guilty of usury at all. Crump v. Trytitle, 5 Leigh 
 251 (Court of Appeals of Virginia, 1834). 
 
 In the Crump case, last cited, the court even held that it was 
 proper for the bank to charge interest not only on the first and 
 last day of the original note, but also on the first and last day of 
 successive renewal notes, the result being that the bank received 
 double interest on every day that a renewal was executed. Many 
 banks follow that custom, although some banks are content with 
 charging the first and last day on the original note, and not on 
 the renewal note. 
 
 The legal fiction of the common law was that a day is indivis- 
 ible, and therefore even if a customer received his discount money 
 just before closing on the date of his note, and paid it immedi- 
 ately after opening on the date of maturity, he would still, in 
 strict contemplation of law, have had the use of that money all 
 of both the terminal days, and on that fiction the decision in the 
 Crump case was undoubtedly sound law. Whether it was equi- 
 table or not is another question. 
 
 Where banks, however, have to pay interest, instead of re- 
 ceive it, they apply a widely dififerent rule. 
 
 First: They quite generally credit interest on deposits only 
 the day after deposit, on the theory that most deposits are made 
 by cheque and it takes one day on an average to collect through 
 the clearing house. 
 
 Second : Some banks provide that deposits made between the 
 
INTEREST 567 
 
 second aild the fifteenth of the month shall draw interest from 
 the fifteenth ; and that deposits made between the sixteenth and 
 the first of the following month shall draw interest from the 
 latter date. 
 
 Assuming a uniform volume of deposits for each day of the 
 month, this arrangement is advantageous to the bank as against 
 its depositors in the ratio of 2 to i. 
 
 Third: Savings banks quite generally provide that deposits 
 made between the first and fifth day of the month shall draw 
 interest from the first, while deposits made after the fifth shall 
 draw interest from the first day of the following month. 
 
 Assuming a uniform volume of deposits for each day of the 
 month, this arrangement is to the advantage of the bank as 
 against its depositors in the ratio of 5 to i. 
 
 Fourth : Some banks allow interest on savings accounts only 
 by full calendar months. 
 
 Fifth : Some banks provide that if the depositor makes a 
 withdrawal during any semiannual interest period, he thereby 
 loses all interest which may have accrued thereon since the last 
 interest date. 
 
 This rule works largely to the profit of the banks and to the 
 loss of the depositors. 
 
 As to how far an auditor may wish to criticize these rules 
 is a question for individual determination. The fact is, however, 
 that most business men know nothing about the customs with 
 respect to interest. They can negotiate for a low rate of interest 
 on loans or a high rate on deposits, but they do not know that 
 their bank may have established arbitrary interest rules which 
 yield them a greater profit than other banks exact. It may 
 therefore be proper for the auditor to examine into the whole 
 matter and report thereon to the client. 
 
 Custom Among Business Houses: Business and commercial 
 houses as a rule count only the first or last day, but not both, 
 when they figure interest. 
 
 Custom Among Stock Brokers: Stock brokers settle pur- 
 chases the day following the sale, and they debit the customer's 
 account on the day of settlement. In charging monthly interest 
 to the customer, the broker includes both the day of settlement 
 and the last day of the month. The broker justifies this by 
 
568 AUDITING 
 
 showing that he, in turn, is compelled to pay interest on his loan 
 to the bank in like manner by including both the terminal days 
 of the period in his calculation. 
 
 The stock broker, by rendering accounts monthly and cal- 
 culating interest for the same period, compounds the interest 
 monthly. 
 
 New York Clearing House: In its ofHcial announcements, 
 the New York Clearing House includes the first day only and 
 excludes the last day. 
 
 The Treasury Department of the United States: In the 
 Treasury Department it is provided that : 
 
 Only one of the two days of date and due date of an obligation is taken 
 into account in stating the time for which interest is to be calculated. 
 
 The Unit Period : Interest, either expressly or impliedly, is at 
 such a rate "per annum." 
 
 Where the interest runs for one month, quarterly, or semi- 
 annually, the proportion is one-twelfth, one-fourth, or one-half 
 of a year. 
 
 A month is held to be one-twelfth of the year, no matter 
 whether the month have twenty-eight, twenty-nine, thirty, or 
 thirty-one days. 
 
 Both of the foregoing rules are in force universally and are 
 sanctioned by the rules of the United States Treasury Depart- 
 ment. 
 
 Where the interest runs, however, for so many days, there 
 is a sharp diversity of opinion as to whether a calendar year of 
 365 days (366 days for a leap year) or an artificial year of 360 
 days is the proper unit of calculation. 
 
 The New York Clearing House calculates interest on the 
 basis of 360 days to a year. For instance, the interest on $1,000 
 from January i, 1912, to March 12, 1912, at 4 per cent per annum 
 was officially calculated as $7.89. This represented 71 days on a 
 360-day-to-the-year basis. 
 
 It has also been held by the courts that the artificial year of . 
 360 days is a proper basis. State Bank of North CaroHna v. 
 Cowan, 8 Leigh 238 (Court of Appeals of Virginia, 1837). 
 
 But the better rule, at least in modern times, would seem to 
 be that the calendar year of 365 days is the proper basis. 
 
INTEREST 569 
 
 N. Y. Firemen Ins. Co. v. Ely, 2 Cowen 705 (Supreme Court 
 of New York, 1824), held that taking interest on the basis of 360 
 days to the year was usury. 
 
 Chap. 148 of the Acts of Massachusetts of 1909, approved 
 March 6, 1909, entitled, "An Act Relative to the Computation of 
 Interest on Bonds and Notes in DeaHngs with the Common- 
 wealth," makes the year of 365 days the standard for all loans to 
 or by the Commonwealth. 
 
 After many vicissitudes, the State of New York now has in 
 force the following (Sec. 58 of the General Construction Law of 
 New York) : 
 
 "The term years in a statute, contract, or any public or private instru- 
 ment, means 365 days, but the added day of a leap year and the day im- 
 mediately preceding shall, for the purpose of such computation, be counted 
 as one day ... the term year means twelve months, the term half 
 year, six months, and the term quarter of a year, three months." 
 
 The rules of the Treasury Department of the United States 
 Government are as follows : 
 
 In calculating interest for a fractional period, the time is the true 
 fraction of that period. For an annual rate, the time is the exact number 
 of days for which the interest runs divided by the number of days in the 
 year, 365 or 366; for a semiannual or quarterly period, it is the number 
 of days for which the interest runs divided by the number of days in the 
 particular half year or quarter year. 
 
 Unless the unit period is a month, the month does not enter into 
 interest computations, only days and the full unit period being considered. 
 
 The rule just enunciated is somewhat at variance with the 
 rule generally obtaining on bonds or mortgages where the inter- 
 est accrues regularly, as for example, quarterly or semiannually. 
 There, when interest is computed for a part of such quarterly or 
 semiannual period, it is the usual custom to state the time in 
 months and days rather than entirely in days. In such a calcula- 
 tion the number of full months from the initial date to the same 
 numbered day of the month next preceding the final date should 
 first be ascertained, and then the odd days' to the final date. 
 
 When we figure these odd days, there are two ways of mak- 
 ing the computation. 
 
 First : They may be taken at so many thirtieths of a month 
 (on the 360-day basis) . 
 
570 AUDITING 
 
 Second: They may be taken as so many twenty-eighths, 
 twenty-ninths, thirtieths, or thirty-firsts, according to the month 
 in which they fall. 
 
 Third: They may be taken as so many three hundred and 
 sixty-fifths of a year. 
 
 It is not assumed by any means that the foregoing discussion 
 covers the question of interest at all exhaustively, but the author 
 hopes that the customs and decisions reviewed will enable a 
 student or practitioner to substantiate any criticisms which he 
 may deem proper to make during the progress of an audit. 
 
CHAPTER XXXII 
 THE LIABILITIES OF AUDITORS 
 
 Legal Responsibility: In my opinion the quickest way to 
 weed out the incompetent men who now hold themselves out as 
 public accountants would be to make them understand the civil 
 responsibility of a professional accountant. Naturally, an unre- 
 liable, incompetent man cares nothing about his moral responsi- 
 bility, and so long as he knows that American courts have never 
 laid down specific rules regulating the duties or obligations of 
 public accountants, he probably feels safe from any legal respon- 
 sibility. One sure and very desirable result of the weeding out 
 process would be the raising of the professional standard, for a 
 few irresponsible men can offset the good work of ten times 
 their number. 
 
 As is well known, there are numerous English decisions deal- 
 ing with the rights and liabilities of professional auditors. In 
 view, however, of the total number of accountants in practice 
 and the number of years the decisions cover, the number does 
 not seem at all appalling. While the fact that we have no 
 reported decisions speaks well for the integrity and good judg- 
 ment of our accountants, yet it is felt that occasions have arisen 
 where a test case would have been made had it not been known 
 that any judgment involving money damages which might have 
 been rendered would have been worthless so far as the possibility 
 of collection was concerned. 
 
 It is unfortunate that anyone should be permitted to prac- 
 tice as a pubHc accountant who, in case of gross negligence or 
 malpractice, has so little financial responsibility that a judgment 
 against him would be worthless, and who, moreover, is beyond 
 the legal reach of his fellow practitioners, who at present have no 
 opportunity to prefer charges against one who is neither a mem- 
 ber of a State society nor certified by a State board. ' 
 
 The absence of decided cases, however, does not alter the 
 
 571 
 
572 AUDITING 
 
 principle of law that anyone who holds himself out to be skillful 
 in any trade or profession, and who is negligent in the perform- 
 ance of what he undertakes, becomes responsible in damages for 
 such failure. This civil responsibility is settled and cannot be 
 debated, but it should not be passed over lightly and should be 
 emphasized on all occasions. The measure of legal responsi- 
 bility, however, is much too low for a conscientious accountant. 
 The law requires of him only the skill of an ordinary skillful 
 accountant; the law gives him the privilege of assuming the 
 accuracy of many things unless he has definite suspicions to 
 the contrary, and, as already stated, the law never requires one 
 to measure up to the standard of the most skillful in the same 
 profession or trade. In this respect accountants are to be con- 
 gratulated, for it is common knowledge that the majority of 
 professional accountants in the United States seek to do more 
 for their clients than the law requires, and every year witnesses 
 a more general desire to advance the quality of services rendered. 
 
 It is earnestly hoped that further progress will be made in 
 this direction. Since the wish for high standards is general, let 
 each individual accountant do his part toward maintaining them. 
 Public opinion should be aroused so that unqualified practitioners 
 will gradually cease to practice, and in their place a united certi- 
 fied body will control all accountancy matters — not because the 
 law grants them exclusive privileges, but by reason of the fact 
 that they can be depended upon at all times and under all cir- 
 cumstances, while the others cannot.* 
 
 As heretofore stated, the State and Federal courts of the 
 United States appear to be barren of any decisions upon this 
 important question. 
 
 On the other hand, both the common and statute law of 
 Great Britain are prolific in decisions and enactments, prescrib- 
 ing with a good deal of exactness the precise nature of the liabil- 
 ities which an auditor may conceivably incur while in the exer- 
 cise of the multifarious activities incident to his profession. 
 
 It is highly probable that in the event of any litigation of 
 importance occurring here and involving that question, the courts 
 of America will look to the English cases as affording, if not 
 
 * The author wrote the foregoing article for the Journal of Accountancy several years 
 ago. 
 
LIABILITIES OF AUDITORS 573 
 
 binding precedents, at least valuable guides to the considerations 
 and principles of law applicable in such case. 
 
 For this reason a brief resume of some of the more impor- 
 tant English cases is in order. A number of English cases which 
 appear to turn entirely upon the peculiar enactments of certain 
 British statutes, and which therefore would be of little or no 
 value as precedents or analogies in American courts, are omitted. 
 
 As to the Exact Status of an "Auditor" in England: It should 
 be noted that the term "auditor" as used in England is not the 
 precise analogue of the term "auditor" as used in America. This 
 is explained by the official recognition given to auditors by the 
 English Companies Act. 
 
 The English courts make a sharp distinction between an 
 "auditor" and an "accountant" : 
 
 In Herbert Alfred Burleigh v. Ingram Clark, Lim., Chancery 
 Division, Apl. 2, 1901 (Acct. L. R., 1901, p. 651), it was held that 
 an accountant has a lien on such books as he has actually worked 
 upon, in respect of his proper remuneration for work upon those 
 books only. 
 
 An auditor, who merely does work in respect of the books, 
 has no such lien. 
 
 Wilde and others v. Cape and Dalgleish, decided by the 
 Queen's Bench Division, May 27, 1897 ("The Accountant," Eng., 
 June 5, 1897), rested on the following question : 
 
 "Did the accountant contract and agree to act as a simple accountant, 
 and merely to see that the books are brought to a correct balance, taking 
 the entries and balance in the books as correct; or, on the other hand, 
 did the accountant contract and agree to act as an auditor and make a 
 cash audit, and check receipts and payments, and examine the cash and bank 
 book, and be responsible for the accuracy of the cash transactions?" 
 
 The English "auditor" has certain statutory rights, powers, 
 duties, and obligations in connection with English corporations. 
 These rights, powers, duties, and obligations are not discussed 
 here with any fullness, as the present work relates only to Amer- 
 ican accountancy. Briefly stated, the "auditor" is required under 
 the English statutes to present his certificate to the stockholders 
 at their annual meetings, and is liable in connection with that 
 certificate under certain circumstances which will be briefly 
 touched on in some of the following cases. 
 
S74 AUDITING 
 
 As to the Lien of an Auditor : It seems that an auditor has no 
 lien for his fees on the books which he has examined, such, for 
 example, as an attorney has upon papers of a client in the State 
 of New York. Therefore, it seems even if an auditor has not 
 been paid his fees, he is, nevertheless, bound to surrender the 
 books and papers to his client on demand. See Burleigh v. Clark, 
 supra. 
 
 As to the Rights of an Auditor Who is Retained by the Year 
 and Dismissed During the Year: In such case the auditor is 
 entitled to his full year's pay. See Homan v. Quilter; City of 
 London Court, February 27, 1908 (Acct. L. R. 1908, p. 25), which 
 decided that an auditor employed at an annual fee and dismissed 
 during the currency of a year is entitled to a full year's fee. 
 
 As to the Criminal Liability of an Auditor for Corruptly and 
 Knowingly Certifying Falsely : Happily, the high standard of the 
 profession in America has left this question a moot one up to 
 the present time. Such a case, however, has arisen in England, 
 and the courts of that country did not shrink from the unpleasant 
 duty thereby cast upon them. See Dumbell's Banking Co., Lim. : 
 Special Court at Douglas, Isle of Man, November 5 to 14, 1900 
 (Acct. L. R. 1900, p. 181). 
 
 In this case two chartered accountants were convicted and 
 sentenced under a local statute for issuing false balance sheets, 
 knowing them to be false, and with intent to deceive, although it 
 was not shown that the accountants received any benefit there- 
 from other than the audit fees received by them. The corre- 
 spondence between the directors and auditors showed, however, 
 that the latter were aware of the unsatisfactory financial condi- 
 tion of' the bank, but they did not disclose the true state of affairs 
 to the stockholders. 
 
 It is believed that the criminal statutes of America would 
 result in a similar conviction and sentence, if the occasion should 
 ever arise. 
 
 AS TO THE CIVIL LIABILITY OF AN AUDITOR WHO 
 
 IS NEGLIGENT IN THE PREPARATION OF HIS 
 
 REPORT AND LIKE MATTERS 
 
 (i) In General: The following discussion in the select com- 
 mittee of the House of Lords, appointed in 1896 to inquire into 
 
LIABILITIES OF AUDITORS 575 
 
 the Company Law amendment may prove of interest, as indi- 
 cating the views of some very high English authorities. Mr. 
 Frederick Whinney, F. C. A., was before the committee, and the 
 proceedings, as officially reported, follow : 
 
 Passing to clause 29, which deals with the appointment of auditors, 
 he suggested the addition of words to the effect that, unless it was other- 
 wise provided by the articles of association, one of the auditors, or the 
 auditor, if there was only one, should be a professional accountant and 
 should not necessarily be a shareholder. In support of that proposition he 
 pointed out that joint-stock enterprise had grown very largely of late 
 years, and he maintained that very few balance sheets could be audited 
 properly except by a professional accountant. He went on to suggest the 
 insertion in the bill of a provision that no auditor other than the retiring 
 auditor should be appointed at a general meeting unless notice had been 
 sent out to the shareholders with the notice of the meeting. That, he said, 
 was brought forward with the object of preventing the question of the 
 auditor being "rushed," as was sometimes the case at present. The bill 
 provided that there should be a balance sheet containing all details — 
 technically, what was known as the trial balance. It was scarcely neces- 
 sary to provide for that by legislation, because a balance sheet could not 
 be made out , unless the details were given. As to the duties of auditors, 
 the bill proposed that they should use reasonable diligence with the view 
 of ascertaining that the books of the company had been properly kept and 
 recorded correctly the financial and trading transactions of the company. 
 The latter part of the section he did not object to, but he thought the 
 words "properly kept" should be omitted. "Properly kept" was a vague 
 term, and the section would be quite sufficient to meet the difficulty with- 
 out its insertion. It would be the duty of the auditors to say that the 
 books had not been properly kept if that was the case. 
 
 The bill cast upon auditors the duty of checking the balance sheet, 
 including the amount of debts due to the company after making a proper 
 deduction for debts considered to be bad or doubtful. It would be im- 
 possible for the auditors to do that in the case of large companies where 
 the debtors numbered, say, one thousand. In the case of banks, for in- 
 stance, where the number of debtors was very large, it was found neces- 
 sary to keep an aggregate account of debtors, showing the total amount 
 due to the company by its debtors. The auditors would have to take that 
 account, and schedules would be prepared, and, if necessary, would be 
 tested afterwards. The duty should not be thrown upon auditors of 
 checking every balance. In one case he might mention the debtors num- 
 bered 750,000. (Laughter.) It should be sufficient if they gave a cer- 
 tificate to the effect that they had used all reasonable care and diligence 
 in ascertaining that the balance sheet was true. 
 
 Lord Davey: "I should like to ask whether you conceive it to be the 
 proper duty of an auditor to say not only whether the books are properly 
 kept, but to go into questions behind the books and say whether the 
 
576 AUDITING 
 
 assets are properly valued?" A. "I do not know that I can give a better 
 definition of the duties of the auditor than that laid down by Lord Justice 
 Lindley. He said that it was the duty of an auditor to be honest, to ex- 
 ercise all reasonable care and skill to ascertain that which he certifies is 
 true, and to exercise all reasonable care and skill in ascertaining the truth." 
 
 Lord Fakrer: "That is all very well; but what is the truth which he 
 is to ascertain?" Lord Davey: "Yes; that is it. Can he, for instance, 
 when the properties are valued at a certain sum in the books, and on the 
 face of the books are properly valued, can it be his duty, not being a 
 valuer, to go into the question of value and say that the directors have 
 put too high a value on the real estate?" A. "No, I do not think so. It 
 would be giving the auditor a different position from that which it was 
 contemplated he should have, namely, that he should examine the accounts 
 of the directors and see whether they are correct. Anything calculated to 
 arouse his suspicion he ought, of course, to look into." 
 
 Lord Farrer: "After all, the responsibility lies with the directors?" 
 A. "Not altogether with the directors. There are the managers of the 
 company." 
 
 Lord Farrer: "Do you wish to place the auditor in the position of an 
 administrator, who is to check the directors in their management of the 
 company?" A. "Certainly not." 
 
 Lord Davey: "Is not the sounder principle this: that the auditor is 
 bound to know everything the books tell him, to have all the suspicions 
 that the books suggest, and to make all the inferences to what he finds 
 in the books would lead him?" A. "I think that would cover the whole 
 of his duty. I think it is his duty not to certify a balance sheet until he 
 believes it to be true, and he has taken all reasonable care that it is so. 
 He is bound to see that the balance sheet is brought before the share- 
 holders in such a form that they themselves can exercise their judgment 
 upon it." 
 
 The next suggestion he had to make was that the pains and penalties 
 of auditors should be modified. At present the auditor was supposed to 
 be responsible if dividends were paid out of capital. Lord Davey: "Is he? 
 I never knew it." The Lord Chancellor: "Putting aside fraudulent con- 
 nivance, what do you suppose to be the responsibility of an auditor?" 
 The Witness : "That if dividends have been paid out of capital, assuming, 
 of course, that the company is wound up, the directors and auditors are 
 responsible for the amount of the dividends so paid, subject to the Statute 
 of Limitations in favor of the auditors." Lord Davey: "Where do you 
 find that?" The Lord Chancellor: "I am not aware of any such law. I 
 am not aware of any case in which the innocent mistake of a director 
 has been held to be the subject for an action." The Witness: "There 
 was a case before Mr. Justice Stirling." Lord Davey: "There, there was 
 fraudulent connivance." The Witness: "I think there was not con- 
 nivance, but that the auditor himself was ignorant." The Lord Chancellor: 
 "To me it is a startling suggestion that for an innocent mistake an auditor 
 should be liable." 
 
LIABILITIES OF AUDITORS 577 
 
 (2) Cases Where the Auditor Was Held Not Liable: In re 
 
 Kingston Cotton Mill Co., 2 Ch. Div. 279 (Court of Appeal, May 
 19, 1896), the court said: 
 
 "I come now to the real question in this controversy, and that is, 
 whether the appellants have been guilty of any breach of duty to the com- 
 pany. To decide this question it is necessary to consider (i) what their 
 duty was; (2) how they performed it, and in what respects (if any) they 
 failed to perform it. ... I protest against the notion that an auditor is 
 bound to be suspicious, as distinguished from being reasonably careful. 
 To substitute the one expression for the other may easily lead to serious 
 error. I pass now to consider the complaint made against the auditors 
 in this particular case. The complaint is that they failed to detect certain 
 frauds. There is no charge of dishonesty on the part of the auditors. 
 They did not certify or pass anything which they did not honestly 
 believe to be true. It is said, however, that they were culpably care- 
 less. The circumstances are as follows: For several years frauds were 
 committed by the manager, who, in order to bolster up the company and 
 make it appear flourishing when it was the reverse, deliberately exag- 
 gerated both the quantities and values of the cotton and yarn in the 
 company's mills. He did this at the ends of the years 1890, 1891, 1892, 
 and 1893. There was no book or account (except the stock journal, to 
 which I will refer presently) showing the quantity or value of the cotton 
 or yarn in the mill at any one time. It would not be easy to keep such 
 a book. Nor is it wanted for ordinary purposes. There is considerable 
 waste (twenty or twenty-five per cent on the average) in the manufacture 
 of yarn from cotton, and the market prices of both cotton and yarn are 
 subject to great fluctuations. The balance sheets of each year contained 
 on the assets side entries of the values of the stock-in-trade at the end 
 of the year, and those entries were stated to be 'as per manager's cer- 
 tificate.' '■ 
 
 "There were also in the balance sheets entries on the opposite side of 
 the values of the stock-in-trade at the beginning of the year. The quantities 
 did not appear in either case. The auditors took the entry of the stock- 
 in-trade at the beginning of the year from the last preceding balance sheet, 
 and they took the values of the stock-in-trade at the end of the year from 
 the stock journal. The book contained a series of accounts under vari- 
 ous heads purporting to show the quantities and values of the company's 
 stock-in-trade at the end of each year, and a summary of all the accounts, 
 showing the total value of such stock-in-trade. The summary was signed 
 by the manager, and the value, as shown by it, was adopted by the 
 auditors and was inserted as an asset in the balance sheet, but 'as per 
 manager's certificate.' The summary always corresponded with the ac- 
 counts summarized, and the auditors ascertained that this was the case. 
 But they did not examine further into the accuracy of the accounts sum- 
 marized. The auditors did not profess to guarantee the correctness of 
 this item. They assumed no responsibility for it. They took the item 
 
578 AUDITING 
 
 from the manager, and the entry in the balance sheet showed that they 
 did so. I confess I cannot see that their omission to check his returns 
 was a breach of their duty to the company. 
 
 "It is no part of an auditor's duty to take stock. No one contends that 
 it is. He must rely on other people for details of the stock-in-trade in 
 hand. In the case of a cotton mill, he must rely on some skilled person 
 for the materials necessary to enable him to enter the stock-in-trade at 
 its proper value in the balance sheet. In this case the auditors relied 
 on the manager. He was a man of high character and of unquestioned 
 competence. He was trusted by every one who knew him. The learned 
 judge has held that the directors are not to be blamed for trusting him. 
 The auditors had no suspicion that he was not to be trusted to give ac- 
 curate information as to the stock-in-trade in hand, and they trusted him 
 accordingly in that matter. 
 
 "But it is said they ought not to have done so, and for this reason: 
 The stock journal showed the quantities — that is, the weight in pounds — 
 of the cotton and yarn at the end of each year. Other books showed the 
 quantities of cotton bought during the year and the quantities of yarn 
 sold during the year. If these books had been compared by the auditors 
 they would have found that the quantity of cotton and yarn in hand 
 at the end of the year ought to be much less than the quantity shown 
 in the stock journal, and so much less that the value of the cotton and 
 yarn entered in the stock journal could not be right, or, at all events, was 
 so abnormally large as to excite suspicion and demand further inquiry. 
 This is the view taken by the learned judge. But, although it is no doubt 
 true that such a process might have been gone through, and that, if gone 
 through, the fraud would have been discovered, can it be truly said that 
 the auditors were wanting in reasonable care in not thinking it necessary 
 to test the managing director's returns? I cannot bring myself to think 
 they were, nor do I think that any jury of business men would take a 
 different view. 
 
 "It is not sufficient to say that the frauds must have been detected 
 if the entries in the books had been put together in a way which never 
 occurred to anyone before suspicion was aroused. The question is whether, 
 no suspicion of anything wrong being entertained, there was a want of 
 reasonable care on the part of the auditors in relying on the returns made 
 by a competent and trusted expert relating to matters on which informa- 
 tion from such a person was essential. I cannot think there was. The 
 manager had no apparent conflict between his interest and his duty. His 
 position was not similar to that of a cashier who has to account for the 
 cash which he receives, and whose own account of his receipts and pay- 
 ments could not be reasonably taken by an auditor without further inquiry. 
 
 "It is the duty of an auditor to bring to bear on the work he has to 
 perform that skill, care, and caution which a reasonably competent, care- 
 ful, and cautious auditor would use. What is reasonable care, skill, and 
 caution must depend on the particular circumstances of each case. An 
 auditor is not bound to be a detective, or, as was said, to approach his 
 
LIABILITIES OF AUDITORS 579 
 
 work with suspicion, or with a foregone conclusion that there is some- 
 thing wrong. He is a watchdog, but not a bloodhound. He is justified 
 in believing tried servants of the company in whom confidence is placed 
 by the company. He is entitled to assume that they are honest and to 
 rely upon their representations, provided he takes reasonable care. If 
 there is anything calculated to excite suspicion, he should probe it to the 
 bottom, but in the absence of anything of that kind he is only bound to 
 be reasonably cautious and careful. . . . The duties of auditors must not 
 be rendered too onerous. Their work is responsible and laborious, and the 
 remuneration moderate. I should be sorry to see the liability of auditors 
 extend any further than In re The London and General Bank. Indeed, 
 I assented to that decision only on account of the inconsistency of the 
 statement made to the directors with the balance sheet certified by the 
 auditors and presented to the shareholders. This satisfied my mind that 
 the auditors deliberately concealed that from the shareholders which they 
 had communicated to the directors. It would be difiicult to say this was 
 not a breach of duty. Auditors must not be made liable for not tracking 
 out ingenious and carefully laid schemes of fraud when there is nothing 
 to arouse their suspicion, and when those frauds are perpetrated by tried 
 servants of the company and are undetected for years by the directors. 
 So to hold would make the position of an auditor intolerable." 
 
 In Maynards, Lim. v. Maynards and others; Chancery Divi- 
 sion, January 16, 1900 (Acct. L. R., 1900, p. 24), it was held that 
 where auditors act honestly and are honestly satisfied of the cor- 
 rectness of their report, they are not to be held liable. 
 
 In Short & Compton v. Brackett; Colchester County Court, 
 May 6, 1904 (Acct. L. R., 1904, p. 85) : 
 
 An accountant making an investigation of accounts for an incoming 
 partner is entitled to assume that the books are correct, the accountant 
 not having been instructed to audit, but merely to make up the account 
 from the books. 
 
 The Liverpool & Wigan Supply Association, Lim.; Liver- 
 pool Court of Bankruptcy, June 14, 1907 (Acct. L. R., 1907, p. 4). 
 The court said : 
 
 "In this case I think that the auditor was negligent as an auditor in the 
 sense that he relied on statements made to him by the directors, and did not 
 put in his certificate the fact that he was relying on the statements of the 
 directors. The auditor did not disclose that there was no cash book, and, if 
 it were material in this case to say so, I think the auditor ought to have dis- 
 closed it. I don't think he ought to have accepted the statements of a director 
 as to the taking of stock, and the balance sheets should have shown the 
 position of the company on the dates they purport to show the position. But 
 
58o AUDITING 
 
 none of these acts appear to me to have diminished the assets of the com- 
 pany as such." 
 
 Held, therefore, that the auditor was not liable. 
 
 (3) Cases Where the Auditor Has Been Held Liable : Leeds 
 Estate Building & Investment Society, Lim. v. Shepherd, L. R., 
 36 Ch. Div. 787 (August 9, 1887). 
 
 Dividends had been paid out of capital and the auditor had 
 passed the account. 
 
 Held that it was the duty of the auditor in verifying the accounts of 
 the company not to confine himself to verifying the arithmetical accuracy 
 of the balance sheet, but to inquire into its special accuracy and to ascer- 
 tain if it contained the particulars specified in the articles of association 
 and was properly drawn up to contain a true and accurate representation 
 of the company's affairs. 
 
 "In each of these years, L. (the auditor) certified that the accounts were 
 a true copy of those shown in the books of the company. That certificate 
 would naturally be understood to mean that the books of the company showed 
 (taking, for example, the certificate for the year 1879) that, on April 30, 
 1879, the company was entitled to 'moneys lent' to the amount of approxi- 
 mately £150,000. This was not in accordance with the fact; the accounts, in 
 this respect, did not truly represent the state of the company's affairs, and 
 it was a breach of duty upon L.'s part to certify as he did with reference to 
 them. The payment of the dividends, directors' fees, and bonuses to the 
 manager actually paid in those years appears to be the natural and imme- 
 diate consequence of such breach of duty; and I hold L. liable for damages 
 to the amount, of the money so paid." 
 
 In re London & General Bank, 2 Ch. Div. 673 (1895). 
 
 An auditor who is dissatisfied with the accounts of a com- 
 pany must plainly draw attention to the grounds of his dissatis- 
 faction in his certificate. 
 
 The court said: 
 
 "It is not part of an auditor's duty to give advice either to directors 
 or shareholders as to what they ought to do. An auditor has nothing 
 to do with the prudence or imprudence of making loans with or with- 
 out security. It is nothing to him whether the business of a com- 
 pany is being conducted prudently or imprudently, profitably or un- 
 profitably. It is nothing to him whether dividends are properly or im- 
 properly declared, provided he discharged his own duty to the shareholders. 
 His business is to ascertain and state the true financial position of the 
 company at the time of the audit, and his duty is confined to that. But 
 then comes the question: How is he to ascertain such position? The 
 answer is: By examining the books of the company. But he does not 
 
LIABILITIES OF AUDITORS 581 
 
 discharge his duty by doing this without inquiry and without taking any 
 trouble to see that the books of the company themselves show the com- 
 pany's true position. He must take reasonable care to ascertain that they 
 do. Unless he does this, his duty will be worse than a farce. Assuming 
 the books to be so kept as to show the true position of the company, 
 the auditor has to frame a balance sheet showing that position according 
 to the books, and to certify that the balance sheet presented is correct 
 in that sense. But his first duty is to examine the books, not merely 
 for the purpose of ascertaining what they do show, but also for the pur- 
 pose of satisfying himself that they show the true financial position of 
 the company. This is quite in accordance with the decision of Mr. justice 
 Stirling in the Leeds' Estate Company v. Shepherd, in 36 Chancery Division, 
 page 802. An auditor, however, is not bound to do more than exercise 
 reasonable care and skill in making inquiries and investigations. He is 
 not an insurer; he does not guarantee that the books do correctly show 
 the true position of the company's affairs; he does not guarantee that his 
 balance sheet is accurate according to the books of the company. If he 
 did, he would be responsible for an error on his part, even if he were 
 himself deceived, without any want of reasonable care on his part, say, 
 by the fraudulent concealment of the book from him. His obligation is 
 not so onerous as this. 
 
 "Such I take to be the duty of the auditor: he must be honest — that 
 is, he must not certify what he does not believe to be true, and he must 
 take reasonable care and skill before he believes that what he certifies 
 is true. 
 
 "What is reasonable care in any particular case must depend upon the 
 circumstances of that case. Where there is nothing to excite suspicion, 
 very little inquiry will be reasonable and sufficient; and in practice, I be- 
 lieve, business men select a few cases haphazard, see that they are right, 
 and assume that others like them are correct also. Where suspicion is 
 aroused more care is obviously necessary, but still an auditor is not bound 
 to exercise more than reasonable care and skill even in a case of sus- 
 picion, and he is perfectly justified in acting on the opinion of an expert 
 where special knowledge is required. 
 
 "Mr. Theobald's evidence satisfied me that he took the same view 
 as myself of his duty in investigating the company's books and pre- 
 paring his balance sheet. He did not content himself with making his bal- 
 ance sheet from the books without troubling himself about the truth of what 
 they showed. He checked the cash, examined vouchers for payments, saw 
 that the bills and securities entered in the books were correct, took rea- 
 sonable care to ascertain their value, and in one case obtained a solicitor's 
 opinion on the validity of an equitable charge. I see no trace whatever 
 of any failure by him in the performance of this part of his duty. 
 
 "The balance sheet and certificate of February, 1892, that is, for the 
 year 1891, was accompanied by a report to the directors of the bank. 
 Taking the balance sheet, the certificate, and report together, Mr. Theobald 
 stated to the directors the true financial position of the bank, and if this 
 
S82 AUDITING 
 
 report had been laid before the shareholders, Mr. Theobald would have 
 completely discharged his duty to them. Unfortunately, however, this 
 report was not laid before the shareholders, and it becomes necessary to 
 consider the legal consequences to Mr. Theobald of this circumstance. 
 
 "A person whose duty it is to convey information to others does not 
 discharge that duty by simply giving them so much information as is 
 calculated to induce them, or some of them, to ask for more. Information 
 and means of information are by no means equivalent terms. Still, there 
 may be circumstances under which information given in the shape of a 
 printed document circulated amongst a large body of shareholders would, 
 by its consequent publicity, be very injurious to their interests, and in 
 such a case I am not prepared to say that an auditor would fail to dis- 
 charge his duty, if, instead of publishing his report in such a way as to 
 insure publicity, he made a confidential report to the shareholders and in- 
 vited their attention to it, and told them where they could see it. The 
 auditor is to make a report to the shareholders, but the mode of doing 
 so, and the form of the report, are not prescribed. If, therefore, Mr. 
 Theobald had laid before the shareholders the balance sheet and the profit 
 and loss account accompanied by a certificate in the form in which he 
 had prepared it, he would, perbaps, have done enough, under the peculiar 
 circumstances of the case. I feel, however, the great danger of acting 
 on such a principle, and in order not to be misunderstood, I will add that 
 an auditor who gives shareholders means of information instead of in- 
 formation in respect of a company's financial position does so at his peril, 
 and runs the very serious risk of being held, judicially, to have failed to 
 discharge his duty. 
 
 "In this case I have no hesitation in saying that Mr. Theobald did fail 
 to discharge his duty to the shareholders in certifying and laying before 
 them the balance sheet of February, 1892, without any reference to the 
 report which he laid before the directors, and with no other warning 
 than is conveyed by the words, 'The value of the assets as shown on the 
 balance sheets is dependent upon realization.' The most important asset 
 on that balance sheet is put down as 'Loans to customers and other 
 securities, £346,975,' and on those a full and detailed report was made to 
 the directors, showing the very unsatisfactory state of these loans and 
 securities, and it is impossible to read the oral evidence, the report of 
 Mr. Balfour and Mr. Brock, dated December 22, 1891, and the report of 
 the auditor to the directors of February 3, 1892, without coming to the 
 conclusion that the entry of that large sum as a good asset without ex- 
 planation was justifiable. It is a mere truism to say that the value of 
 loans and securities depends upon their realization. We are told that a 
 statement to that effect is so unusual that the mere presence of those 
 words is enough to excite suspicion. But, as already stated, the duty of 
 an auditor is to convey information, not to arouse inquiry, and although 
 an auditor might infer from an unusual statement that something was 
 seriously wrong, it by no means follows that ordinary people would have 
 their suspicions aroused by a similar statement if, as in this case, its 
 
LIABILITIES OF AUDITORS 583 
 
 language expresses no more than any ordinary person would infer with- 
 out it. 
 
 "But Mr. Theobald relies on the fact that he was induced to omit 
 from his certificate all reference to the report which he made to the 
 directors, because Mr. Balfour, the chairman, promised to mention such 
 report in his speech to the shareholders, and he did so. But although 
 Mr. Balfour twice alluded to the report, he did so in such a way as to 
 avoid attracting attention to it. The second time he mentioned it was 
 after a dividend had been declared, and when a motion to reappoint the 
 auditors was before the meeting. The truth is that not a word was said 
 to convey to the shareholders the substance of the information contained 
 in the report, or to induce them to ask any question about it. The balance 
 sheet and the profit and loss account were true and correct in this sense, 
 that they were in accordance with the books. But they were, nevertheless, 
 entirely misleading, and misrepresented the real position of the company. 
 Under these circumstances, I am compelled to hold that Mr. Theobald 
 failed to discharge his duty to the shareholders with respect to the balance 
 sheet and certificate of February, 1892. Possibly he did not realize the 
 extent of his duty to the shareholders as distinguished from the directors, 
 and he, unfortunately, consented to leave the chairman to explain the true 
 state of the company to the shareholders instead of doing so himself. The 
 fact, however, remains, and cannot be got over, that the balance sheet and 
 certificate of February, 1892, did not show the true position of the com- 
 pany at the end of 1891, and that was owing to the omission by the auditor 
 to lay before the shareholders material information which he had obtained 
 in the course of his employment as auditor of the company, and to which 
 he called the attention of the directors. 
 
 "The real truth is that the assets of the bank were put down in the 
 balance sheet at far too high a figure, and this entry, though not mis- 
 leading if explained (as it was to the directors), was seriously mis- 
 leading in the absence of explanation." 
 
 Irish Woolen Company, Lim. v. Tyson and others, decided 
 by the Irish Court of Appeal, January 20, 1900 (Acct. L. R., 1900, 
 
 p. 13)- 
 
 The accounts of a company had been falsified and dividends 
 
 improperly paid out of capital in consequence. The auditor was 
 held responsible on the ground that the falsifications might have 
 been discovered by the exercise of reasonable care and skill from 
 an inspection of the books themselves. 
 
 "An accountant with a large business is not supposed to do every- 
 thing himself. The auditor is bound to give reasonable care and skill, 
 but this can also be exercised by his deputy. I do not think there is any- 
 thing to be gained by considering in the abstract the duties of an auditor 
 of a joint stock company. He is entitled to see the company's books and 
 the materials for their books, and also to ask for explanations. But he 
 
584 AUDITING 
 
 is not called on to seek for knowledge outside the company, or to com- 
 municate with customers or creditors. He is not an insurer against fraud 
 or error; and if fraud is alleged 'it must be shown with precision the acts 
 of negligence for which he is said to be responsible. Nine balance sheets 
 were prepared, and the figures on some represent the aggregate amount 
 of many items, but I propose to deal only with matters that have been 
 referred to during the hearing. There are three sets of figures with which 
 I will deal: (i) stock-in-trade; (2) sundry debtors; (3) sundry creditors 
 on the liability side of the balance sheet. Taking these in order . . . 
 There was certainly no duty cast on the auditor to take stock. What he 
 did was to have the calculations checked in his office, and this was done 
 with proper care. Mr. Kevans said he was particularly careful as to the 
 deduction for discount, and, as far as I could gather, the universal rate 
 of ten per cent seems reasonable. Moreover, an auditor has nothing to do 
 with the terms upon which the company, or a trader, buys or sells. . . . 
 As to the provision for the 'bad debts,' if there is any one thing upon 
 which an auditor is dependent upon the officers, it is the writing off, or 
 the making of a prospective allowance for, bad debts. He has no per- 
 sonal knowledge of the customers, and Mr. Kevans seems to have taken 
 particular attention in reference to this. (See questions 2,125 to 2,127 in 
 the evidence.) He said 'he had some special knowledge on the subject, 
 that he saw all ascertained bad debts duly written off, and that there was 
 a fund amounting to £500 as ■ a provision therefor.' For the foregoing 
 reasons there is no ground for alleging negligence against Mr. Kevans 
 on the 'assets side' of the balance sheet. . . . Now, dealing with 'sundry 
 creditors'; here, evidently, there is a fraud, and a curious thing is that 
 no one seemed to have derived any benefit from the fraud." 
 
 Dealing with the invoices, the learned judge detailed the practice in 
 connection with the statements of accounts being laid before the meet- 
 ings, and said: 
 
 "The ledger was used for the purchases made and for the payments 
 on account thereof. If, then, all this were rightly done, it would be easy 
 for the auditor to ascertain the amounts due to the creditors, but, un- 
 fortunately, the books were not correctly kept. The creditors' accounts 
 in the ledger did not show all the goods purchased up to the time for the 
 audit, nor could the auditor discover the omissions on account of many 
 of the invoices being either 'suppressed' or not put into the book until 
 a later date — a process described as 'carrying over.' There is some doubt 
 as to whether the deficiency arose from the suppression or the carrying 
 over, but my impression is that the whole of it comes within the last- 
 mentioned class, for at the end of 1894 we find they amounted to 
 i4,C9S. Mr. Peter White is now dead, and he should not be condemned 
 unheard, but it is difficult to believe that this system was not within his 
 own knowledge. As chief promoter, he was no doubt anxious to see that 
 the company was successful. Crawford, who was the secretary, appears 
 to have continued the process. It seems strange that a system of fraud 
 so long continued, and for so extensive a period, was never detected by 
 
LIABILITIES OF AUDITORS 585 
 
 the auditor. Once or twice he noticed something, and the explanation that 
 was given was 'that the goods were not taken into stock.' The question 
 is, Was it negligent not to have seen this? There is no doubt that both 
 the suppression and carrying over of invoices would have been detected 
 if the auditor had called for the creditors' statements of accounts upon 
 which payment was ordered and compared them with the ledger. I should 
 have thought this was part of the auditor's duty for many reasons; but 
 all the accountants examined, except Mr. Southworth, stated that this 
 course is never taken unless there is something to arouse suspicion. Mr. 
 Pixley, the eminent London accountant, says it could not well be done 
 except in the case of a very small concern. In the face of such evidence 
 I should not leave myself at liberty to hold that Mr. Kevans' assistants 
 were guilty of negligence in not looking at these statements of account 
 if they were engaged in an ordinary audit. Little time is allowed for 
 doing so; but in this case there was this system of monthly checking. 
 From the time that Crawford was accountant in 1890, the accounts of the 
 company were completely in his hands. Now, White, for the two years 
 following, may have given general directions, but he was often away in 
 America for months at a time, and it is clear that the monthly audit was 
 instituted for the purpose of seeing that he (Crawford) would do his 
 work regularly and honestly. I am unable to conceive how, if there was 
 nothing wrong about this monthly checking, it did not lead at an early 
 period to the detection of the frauds in this ledger. Mr. Kevans ought to 
 have found out, by the accounts, the payments that were made — and no 
 better means could be adopted than that of a comparison with the state- 
 ments of accounts. It ought to have been done in some way, and, if it 
 had, detection would have been certain. I do not base my decision on this 
 alone; apart altogether from the statements of account and the monthly 
 check, I do not understand how the carrying over of the invoices could 
 have escaped detection by the accountant, who should have used due care 
 and skill, and who wais not a mere machine. The invoices carried over were 
 ultimately posted to the ledger. If they were posted to their true dates, 
 it would be at once apparent that they were not entered in at the proper 
 time. If they were posted under false dates, why was this not detected 
 when the ledger accounts were checked with the invoices? And when no 
 invoices came into the books, it is admitted that this ought to have 
 excited suspicion. For these reasons I am of opinion that if due care 
 and skill had been exercised, the carrying over and suppression of in- 
 voices would have been discovered, and the auditor is liable for any 
 damage the company may have sustained from the understatement of 
 liabilities in the balance sheet due to this cause since January 4, 1892. I 
 consider that not only are Mr. Kevans and his assistants not free from 
 blame for this, but also for the mechanical way the audit was carried out. 
 "As regards the measure of the duty of a gentleman employed as 
 Mr. Kevans was in this case, the result is the same, as it occurs to me, 
 in all cases in which professional skill is employed, except one, the peculiar 
 instance of a barrister. The measure of duty is the bringing of reason- 
 
586 AUDITING 
 
 able care and skill to the performance of the business directed to be done, 
 having regard, first to the contract of employment, then to the character 
 of the business itself, to the remuneration of the defendant, and to all 
 the other circumstances of the case. In strict rule, however, the measure 
 of the duty is to be ascertained by applying to all the circumstances of 
 the case the best consideration, so as to ascertain what ought to have 
 been done under the circumstances. ... I think the fairest way to deal 
 with Mr. Kevans in this case is to treat him as being charged with having 
 failed to find just cause of suspicion on the face of these books, which 
 if found, would have imposed on him the duty of pursuing his suspicion 
 until he found whether it was or was not well founded. . . . The Eng- 
 lish cases have established that the auditor is entitled, in the absence of 
 the elements of suspicion, to assume that the books are honestly kept, 
 and that, therefore, unless on the face of a presumably honest book 
 something appears to excite his suspicion, he is not guilty of negligence, 
 whatever other people might be in their departments, if he does not dis- 
 cover that something was wrong. . . . 
 
 "I cannot conceive any more clear or glaring grounds of suspicion than 
 to discover in the account of a single customer items amounting to £600 
 having got into the books after the trial balance is struck under dates 
 going back two months prior to the period of the ascertaining of the 
 trial balance. ... It appears to me that the moment I come to the con- 
 clusion that that was on the face of it a suspicious mode of dealing with 
 Hill & Son's figures, I am bound to show how it would be corrected. . . . 
 That it would then have been necessary to call for the creditors' state- 
 ments of account, and at that moment they would have disclosed on the 
 face of them not merely those postdated items, but the suppressed in- 
 voices also ; and at the instant that this discovery was made, there is an 
 absolute conviction of something wrong forced upon the mind of the au- 
 ditor. It, therefore, occurs to me that, upon these two branches, all that 
 is required, both to show the negligence, to arouse suspicion, and to supply 
 the means of putting a stop to the frauds, is to be found on the face of 
 the books, and for all I have said I have no foundation except what is 
 upon the face of that book (creditors' ledger)." 
 
 Astrachan Steamship Co., Ltd. and others v. Harmood 
 Banner & Son ("Liverpool Mercury" of March 2 and 3, 1900; 
 also Spicer & Pegler "Practical Auditing," p. 410). 
 
 Action for alleged negligence in failing to detect defalcations. 
 The case was finally settled in favor of the plaintifif. 
 
 London Oil Storage Co., Lim. v. Seear, Hasluck & Co., 
 King's Bench Division, June i, 1904 (Acct. L. R., XXXI, p. i). 
 
 The auditor took no steps to verify the existence of petty 
 cash as stated in the balance sheet. The balance sheet showed 
 £796 petty cash, whereas only £30 was actually in the cash box. 
 
LIABILITIES OF AUDITORS 587 
 
 the bookkeeper having embezzled the difference. The court left 
 it for the jury to find as matter of fact, whether or not the au- 
 ditor's failure to verify this balance was negligent under the cir- 
 cumstances. The court charged the jury in part as follows: 
 
 "The auditor most undoubtedly does undertake very considerable re- 
 sponsibilities, and is liable for the proper discharge of his duties, and if 
 by neglect of his duties, or by want of reasonable care, he neglects his duty, 
 and damage is caused to the company as such, he is responsible for that 
 damage. I will not adopt any fanciful expression which may be quoted 
 from any particular judgment, but he has got to bring to bear upon those 
 duties reasonable and watchful care, he has got to discharge those duties 
 remembering that the company look to him to protect their interests. He 
 is not, however, supposed to be a man constantly going about suspecting 
 other people of doing wrong, and that is the only respect in which, I think, 
 Mr. Bankes in his most able speech pressed the matter a little too high. 
 While Mr. Hasluck has by the exercise of due and reasonable care to see 
 that all the officials of the company are doing their duty properly in so 
 far as the accounts are concerned, he is not bound to assume when he 
 comes to do his duty that he is dealing with fraudulent and dishonest 
 people; and there comes in the most important consideration from one 
 point of view — perhaps more important than the other, though I do not 
 think of such substantial weight in the matter — if circumstances of sus- 
 picion arise it is the duty of the auditor, in so far as those circumstances 
 relate to the financial position of the company, to probe them to the bottom." 
 
 The jury brought in a verdict for the plaintiff for five guineas with 
 the further statement that they considered the directors had been guilty 
 of gross negligence. 
 
 Smith V. Sheard, Liverpool Assizes, May 11, 1906 (Account- 
 ant, L. R., 1906, p. 65). 
 
 The plaintiff's cashier had embezzled about £700, and the 
 plaintiff thereupon sued the auditor, on the ground that the au- 
 ditor should have detected the embezzlement. The defendant 
 alleged that he had never been retained to make a complete audit, 
 but that the only work he undertook was the stating of accounts 
 between the partners. 
 
 The case was tried before a special jury, which found for the 
 plaintiff. 
 
 (4) Periodical Audits: Martin v. Isitt, decided before Lord 
 Chief Justice Russell, in the Queen's Bench Division, March 3 
 and 4, 1898 (Acct. L. R., 1898, p. 41)- 
 
 James Martin & Sons sued Isitt & Co., chartered account- 
 ants, alleging that as auditors they were negHgent in failing to 
 
588 AUDITING 
 
 check the cash book and the bank pass book, and that thereby a 
 clerk was able to embezzle i6i2. 
 
 The defendants had been retained to make monthly audits. 
 They claimed, however, that they had been unable to conduct 
 their work properly, owing to the tardiness of plaintiff's book- 
 keepers in giving them definite information on questioned items, 
 whereby they were kept about six months behind in their audit. 
 A trial of the case was begun, but the defendants settled during 
 the course of the trial. 
 
 (5) No Expedient Can Overcome the Obligation of the 
 Auditor to Make Full Disclosure to the Stockholders : Newton v. 
 Birmingham Small Arms Company, Lim., Chancery Division, 
 June 27, 1906 (22 Times, L. R., p. 664). 
 
 The Birmingham Small Arms Company, Ltd., passed a reso- 
 lution purporting to prevent the auditors appointed by the share- 
 holders from disclosing any information to the shareholders or 
 otherwise touching the "internal reserve fund" of the company. 
 An injunction to restrain the company from acting on this spe- 
 cial resolution was granted. 
 
 The court held that the shareholders were clearly entitled to 
 this information, and that the auditors could not lawfully with- 
 hold the information. 
 
 (6) As to the Liability of an Auditor for Libel : Lawless v. 
 Anglo-Egyptian Cotton & Oil Co. Lim. (4 Q. B. 262). 
 
 When the alleged libel is true in point of fact, and is pub- 
 lished by the auditor in good faith and without malice, and in 
 the bona ftde discharge of his duty, it would, no doubt, be held 
 to be privileged. 
 
 Summary 
 
 Based upon the foregoing decisions and upon the principles 
 of the common law in force in the United States, the professional 
 auditor's legal duties and liabilities may be summarized as 
 follows : 
 
 (i) Anyone who holds himself out as skilled in a profession 
 is charged with a higher degree of responsibility than one who 
 is inexperienced and who does not seek professional work. Act- 
 ing in a professional capacity, an auditor must do more than 
 ascertain the mere arithmetical accuracy of the accounts. If the 
 
LIABILITIES OF AUDITORS 589 
 
 accounts do not represent the true financial position of the under- 
 taking under examination, and if that fact is apparent or can 
 reasonably be deduced from the face of the accounts themselves, 
 then the auditor is under a legal obligation to discover and dis- 
 close the true state of affairs. 
 
 (2) The auditor, however, is not an insurer unless he assumes 
 such a position. If he uses reasonable care — the care of an ordi- 
 narily skillful auditor, under the circumstances of the case — no 
 legal responsibility is incurred by him. 
 
 (3) Reasonable care has been stated by the courts to depend 
 upon the circumstances of each case. Where there is no reason- 
 able ground for suspicion of fraud, it is not necessary to take 
 as many precautions as are requisite where the auditor is led to 
 believe that irregularities exist. 
 
 (4) Ordinarily what is known as a test audit is sufficient, 
 but in every case there must be a careful survey of the assets, the 
 liabilities, the income, and the expenses, in order that the auditor 
 may satisfy himself that the assets and the income are accounted 
 for, and that the liabilities and expenses are properly supported. 
 The auditor need not verify every item, but he must not omit any 
 part of an audit which the custom of the profession decrees 
 should be covered. 
 
 (5) The experience of other practitioners and access to recog- 
 nized authorities on the subject being available, a defense of 
 ignorance as to what is required in an audit will not save an 
 auditor from responsibility for failure to follow settled rules of 
 practice. 
 
 (6) The general rule of the common law, that all men are 
 considered honest until proved dishonest, may be observed by 
 an auditor with respect to the staff of the client ; but he is charged 
 with an exceptional degree of diligence in recognizing indica- 
 tions of dishonesty on the part of those who occupy responsible 
 positions. 
 
 (7) An auditor's relation to his client is in the highest degree 
 confidential, and he has no legal right to communicate with third 
 parties (debtors or creditors) unless he secures permission to do 
 so. If his position as auditor btcomes incompatible with hon- 
 esty, he may withdraw at any time, but he is not at liberty to 
 disclose to outsiders the cause of his withdrawal. 
 
590 AUDITING 
 
 (8) In communicating with his client, however, the auditor 
 is bound to disclose information, of whatever nature it may be, 
 which is of value to the client, and any suppression of material 
 facts is at his own risk. 
 
 (9) In the event of loss through^an auditor's negligence, the 
 client may recover damages against him. The measure of dam- 
 ages is the amount which the client or other interested party has 
 lost as a legal consequence of the auditor's failure to properly 
 perform his duty. 
 
 OFFICIAL LEGAL OPINION ON DUTIES AND 
 LIABILITIES OF AUDITORS 
 
 When the English Companies Act, 1907, was passed, the 
 Council of the Institute of Chartered Accountants in England 
 and Wales obtained the joint opinion of eminent counsel on the 
 clauses particularly affecting auditors. That opinion was as 
 follows : 
 
 (i) In our opinion the auditor's report to be made pursuant to para- 
 graph (2) of section 19 of the Companies Act, 1907, should, in cases where 
 the auditors have no special comments to make, run as follows: 
 
 "Report of the auditors to the shareholders of 
 Limited. 
 
 "We have audited the balance sheet of the 
 Limited, dated the day of , and (here 
 
 identify it as : 'above set forth' or 'within contained,' or 'a 
 copy of which is annexed hereto and initialed by us,' or 'a copy 
 of which has been initialed by us'). 
 
 "We have obtained all the information and explanations we 
 have required. 
 
 "In our opinion such balance sheet is properly drawn up 
 so as to exhibit a true and correct view of the state of the com- 
 pany's affairs according to the best of our information and 
 the explanations given us, and as shown by the books of the 
 company." 
 We consider that the report should identify very clearly the particular 
 balance sheet to which it refers, so that there may be no room for after- 
 dispute or confusion, and no danger that by mistake or otherwise the 
 balance sheet submitted to the shareholders, though bearing the proper date, 
 should not be the one actually referred to in the report. 
 
 Perhaps the surest mode of identification is to write the report at 
 the foot or indorse it on the balance sheet to be submitted, for by these 
 means the two documents are made inseparable; or, in other words, the 
 
LIABILITIES OF AUDITORS 591 
 
 report runs with the balance sheet. But, as above appears, there are al- 
 ternatives open. In any case, the auditors should keep a copy of the balance 
 sheet they audit, and place a memorandum of identity thereon, so that if 
 the question arises, they may be able to testify certainly as to the matter. 
 
 (2) Under the section, the auditors' report is to be attached to the 
 balance sheet or referred to at the foot thereof. In the former case we 
 consider that the attachment should be effected either by printing the two 
 documents continuously on the same sheet of paper or by fastening the 
 report to the balance sheet. We consider that the best mode of attachment 
 is that the report should be written or printed at the foot of the balance 
 sheet, or indorsed thereon. 
 
 (3) If the report is not attached to the balance sheet, there should 
 at the foot of the balance sheet be words referring to the report, e. g., 
 "the report to the shareholders of Messrs. , the com- 
 pany's auditors, on the above balance sheet, is dated the day of 
 
 and is open to inspection." 
 
 In our opinion it is for the directors to make the reference and settle 
 the form thereof, and not for the auditors. 
 
 (4) In our opinion the act does not impose on the auditors the duty 
 of seeing that the report is attached to the balance sheet, or referred to 
 at the foot thereof. This duty, we consider, is imposed on the company and 
 its directors. 
 
 (5) It appears to us that it is not the duty of the auditors to see that 
 the balance sheet is signed by the required number of directors. Subsection 
 (3) of section 19 clearly contemplates that the balance sheet is to be issued 
 after the report has been made, for a copy is to be attached or referred to. 
 As to cases in which there are no officers called directors, the balance sheet 
 should be signed by the manager or other person occupying the position of 
 director, for section 30 of the Act of 1900, with which the Act of 1907 is 
 to be read (see section 52), provides that the term "Directors'' includes 
 any person occupying the position of director, by whatever name called. 
 
 (6) In our opinion it is not the duty of the auditors to supply to 
 shareholders, when requested, copies of the balance sheet and their report, 
 or to furnish information to individual shareholders. 
 
 (7) In our opinion the statement in the form of a balance sheet referred 
 to in section 21 of the Act of 1907 is a document to be submitted by the 
 directors to the auditors for audit. The document must contain, as the 
 section requires, a summary of the compan^s capital, liabilities, and assets, 
 giving such particulars as would disclose the general nature of such lia- 
 bilities and assets, and how the value of the fixed assets has been arrived 
 at, but it is not necessary to include in it a statement of profit or loss. 
 
 We consider that in many cases the last-audited balance sheet will be 
 sufficient statement in the form of a balance sheet; but where the balance 
 sheet does not state how the value of the fixed assets has been arrived at, 
 it would, in order to comply with the section, have to be supplemented 
 by a note or memorandum stating how the value of such assets was ar- 
 rived at. 
 
592 AUDITING 
 
 Where the balance sheet, whether supplemented as aforesaid, or other- 
 wise, is adopted for the purposes of the section as a statement in the 
 form of a balance sheet, it should, in our opinion, be accompanied by a 
 copy of the report of the auditors on such balance sheet; and if it is so 
 supplemented, the auditors should certify that, according to the best of their 
 information, the method specified in the supplementary note or memorandum 
 has been adopted. 
 
 We consider, however, that it is open to the directors to frame the 
 statement "in the form of a balance sheet" referred to in section 21 in more 
 general terms than the balance sheet, provided that it complies with the 
 requirements of the section; but in such case the statement must be audited 
 by the company's auditors, and the result of the audit should be certified 
 at the foot of the statement. 
 
 (8) As to the general duties of the auditors, under section 19 of the 
 Act of 1907, we consider that they should perform these duties with due 
 regard to the provisions of the company's Articles of Association, in so far 
 as those Articles are consistent with the Acts, and that they should call 
 for all such information and explanations as they consider requisite to 
 enable them to make the report to the shareholders contemplated by the 
 section. They should not have the least hesitation in reporting fully as to 
 any unsatisfactory features in the position. 
 
 Lastly, we do not consider that the auditor's duties are limited to a 
 comparison of the figures in the balance sheet and those in the books. 
 No doubt he has to examine the books, but, as Lord Justice Lindley said 
 In re The London & General Bank (1895, 2 Ch. 683), "he does not dis- 
 charge his duty by doing this without inquiry and without taking any trouble 
 to see that the books themselves show the company's true position. He 
 must take reasonable care to ascertain that they do so." 
 
 The duties of the auditor are defined by the Companies (Consolidation) 
 Act, 1908, as follows: 
 
 Section 113. — (2) The auditors shall make a report to the share- 
 holders on the accounts examined by them, and on every balance sheet 
 laid before the company in general meeting during their tenure of office, 
 and the report shall state 
 
 (o) Whether or not they have obtained all the information and ex- 
 planations they have required ; and, 
 
 (6) Whether, in their opinion, the balance sheet referred to in the 
 report is properly drawn up so as to exhibit a true and correct view of 
 the state of the company's affairs according to the best of their information 
 and the explanations given to them, and as shown by the books of the 
 company. 
 
CHAPTER XXXIII 
 THE LIABILITIES OF DIRECTORS 
 
 It may be thought that the duties and responsibiHties of an 
 auditor are onerous enough without injecting into a treatise of 
 this nature an intimation that a professional auditor is charged 
 with looking after the directors of a corporation as well as its 
 officers and clerks. 
 
 Such is rarely the case, however, because most of the 
 directors in the United States who direct and who perform acts 
 which require review are officers as well, and the auditor 
 examines their transactions as such and not in their capacity as 
 directors. 
 
 Board-Minutes Inspection: Nevertheless, the auditor may 
 find in reading the minutes of the proceedings of the board of 
 directors or of an executive or other committee that one or more 
 directors have been intrusted with negotiations to purchase 
 property or with similar commissions. In such cases the auditor 
 should verify the transaction along the usual lines. 
 
 Compensation of Directors: Directors usually receive an 
 attendance fee ranging from five to fifty dollars, and so long as 
 there is nothing in the by-laws to prevent, the auditor can accept 
 as authority therefor a resolution which has been regularly 
 adopted. The minutes should record the names of all directors 
 present at each meeting, which will serve as a check on the 
 amount disbursed for this purpose. Compensation in excess of 
 the attendance fee is rarely paid to a director who is not an 
 officer. 
 
 If any sum is voted to one or more directors, the auditor 
 should ascertain whether the by-laws permit the payment, and 
 whether the action was taken at a full board meeting or whether 
 any were absent who might have objected. If any director who 
 is benefited votes for the resolution, or if his presence is neces- 
 sary to make a quorum, the action is voidable and may be at- 
 tacked. All such transactions should be reported to and ratified 
 
 593 
 
594 AUDITING 
 
 by the annual meeting of stockholders. If no such action has 
 been taken by the stockholders, the auditor should mention the 
 fact in his report. 
 
 It has been held by the courts that officers are not entitled 
 to compensation simply because they occupy office and perform 
 the duties incident thereto. Their salaries should be fixed before 
 election as directors, if possible. If this is not feasible, the 
 amounts paid to the directors in compensation for their services 
 should be reported to the annual meeting and be formally ap- 
 proved by the stockholders. 
 
 As a practical matter, where the officers and directors own 
 all or nearly all of the stock and are acting in good faith, it is not 
 necessary to report salaries nor other matters of detail to the 
 stockholders' meeting. 
 
 Directors May Inspect Books : It is not generally known that 
 a director has an absolute right to inspect the books and papers 
 of a corporation of which he is a director. There are a great 
 many men who represent minority interests on a board and 
 who are almost totally ignored in the management of the 
 company. Information with respect to finances or earnings is 
 rarely furnished to them, and is then handed out as if there were 
 no obligation to do so. 
 
 Auditors are frequently consulted by directors who state 
 that they have tried to secure information without success. The 
 auditor should advise them that their legal right to full access to 
 the books is unquestioned, and that they may be accompanied 
 by a professional auditor if they require assistance. Directors 
 are charged with a knowledge of what is going on, and if they 
 fail to keep informed, they may be held jointly responsible for 
 the acts of others. In all cases, therefore, where they have any 
 doubt as to what is going on, it is nothing more than simple 
 business prudence to employ an auditor who will ascertain exact 
 conditions. 
 
 Legal Liabilities of Directors: The auditor's consideration 
 of the possible legal liabilities of directors need not extend be- 
 yond matters connected with the accounts, but wherever 
 accounting questions are involved, the auditor's familiarity there- 
 with should be unquestioned. In the American Malting case, 
 decided in New York in 1904, the court discussed the relation 
 
LIABILITIES OF DIRECTORS 595 
 
 and duties of directors to the accounts. The decision is of suffi- 
 cient interest to warrant its reproduction in full : 
 
 Archibald A. Hutchinson and Victor K. McElheny, Jr., 
 on Behalf of Themselves and All Other Stockholders of 
 the American Malting Co., Similarly Situated, Plaintiffs, 
 
 V. 
 
 Alexander M. Curtiss and The American Malting Co., 
 
 Defendants. 
 (Supreme Court, New York Special Term, December, 1904.) 
 
 The statutes of this State allow the recovery, from directors of a 
 foreign corporation, of dividends unauthorized by the laws under which 
 such corporation is organized. It is the foreign statute that makes the 
 dividends unauthorized, but the recovery is to be had under the New York 
 statute. 
 
 No dividends can be made except from "surplus or net profits." 
 
 Contracts entered into by a corporation for future deliveries of a 
 product not yet made by it, from raw material not yet purchased, cannot 
 be taken as assets in figuring said surplus or net profits. Dividends can- 
 not be made on a mere hope or expectation of profits. 
 
 Where raw material is bought by weight, and after manufacture is 
 increased in weight and value, the corporation is entitled to treat it as an 
 asset at its increased value. 
 
 A director who is not present when an unauthorized dividend is de- 
 clared is not liable under the statute, even though he is present at a sub- 
 sequent meeting when the minutes of the former meeting are ratified. 
 
 A director, sued for unauthorized dividends, cannot be credited with 
 the profits which subsequently accrued under a change of management. 
 
 A director is not liable for commissions paid on the sale of bonds of a 
 corporation which had made unauthorized dividends in the absence of 
 proof of fraud and conspiracy for the defendant's personal benefit; such 
 loss is included in the loss caused by the illegal dividends which defendant 
 must pay. 
 
 Action against director for making unauthorized dividends. 
 Clarke, /.; 
 
 The American Malting Company was organized under the laws of New 
 Jersey, September 28, 1897. It began business on October 11, 1897. On 
 October 15, 1897, it filed a copy of its charter in the office of the Secretary 
 of State of New York to enable it to do business in this State, and re- 
 ceived the usual certificate for that purpose. The principal office of the 
 company was situated in the city of New York, at No. 80 Broadway, from 
 its organization until the fall of 1899, and since then it has been situated 
 continuously at East River and Sixty-third Street, New York City, The 
 company has had no plant or property in New Jersey. It has kept no 
 bank account there. It had merely a formal, statutory office in that State. 
 Its capital stock is $30,000,000, divided into 300,000 shares of $100 each, 
 of which 144,400 shares of preferred stock and 145,000 shares of common 
 
596 AUDITING 
 
 stock have been issued. The preferred stock is seven per cent cumulative, 
 having a preference as to dividends only. The company is engaged in the 
 manufacture and sale of malt. Its stock was issued to promoters for 
 twenty-one malting establishments, situated in various parts of the United 
 States, on which they had acquired options, and for $2,080,000 cash work- 
 ing capital. No stock-in-trade was, however, acquired by the issue of stock. 
 As soon as the organization was effected the company was compelled to 
 purchase from the vendors of the various malting plants their stocks of 
 barley and malt, for which the company issued its obligations, amounting 
 to upward of $1,600,000. A little over two months after the company began 
 business, and on December 20, 1897, the board of directors declared a 
 dividend of one and three-fourths per cent to preferred stockholders, pay- 
 able January 15, 1898. This amounted to $219,450. Thereafter a dividend 
 at the same rate was declared and made payable at each of the following 
 dates: April 15, 1898, $219,450; July 15, 1898, $219,450; October 15, 1898, 
 $219,450; January 15, 1899, $219,450; April 15, 1899, $252,700; July 15, 1899, 
 $252,700; October 15, 1899, $252,700. In all $1,855,350. Barely two weeks 
 after the payment of the dividend of October 15, i8gg, and on November 
 2, 1899, the minutes of the board of directors disclosed its serious financial 
 condition as reported to said board, viz., its outstanding obligations amounted 
 lo $2,800,000 in notes; that the officers were unable to negotiate further 
 temporary loans; that the company needed additional working capital, and 
 that the board authorized the sale of $4,000,000 mortgage bonds of the 
 company. Said bonds, six per cent fifteen-year gold mortgage bonds, were 
 subsequently disposed of at a discount of $400,000. This is an action brought 
 by plaintiffs as stockholders on behalf of themselves and all other stock- 
 holders similarly situated against the defendant Curtiss as director of the 
 company to compel him to account for and pay to the company the amount 
 of the dividends declared and paid as not having been paid out of the 
 profits, but out of the capital. The board of directors having upon demand 
 refused or neglected to bring suit in the name of the company, it was 
 joined as a party defendant. At first the company put in a defense, but 
 subsequently, its management having changed, it obtained leave to file an 
 amended answer admitting the allegations of the complaint and joining in 
 the prayer of the plaintiffs for the relief demanded. In a similar action 
 against another of the directors the complaint was dismissed upon the 
 trial. Upon appeal the Appellate Division reversed that judgment. Hutch- 
 inson V. Stadler, 85 App. Div. 428. That case settled the law for this 
 court to this extent; that an action could be maintained in the courts 
 of this State against a director of a New Jersey corporation to recover 
 the amount of dividends declared in violation of the laws of that State. 
 Two opinions were handed down, in which the learned justices arrived 
 at the conclusion that the action could be maintained upon different grounds. 
 With each of these opinions a justice concurred. The fifth learned justice 
 concurred in the result. I cite this division of opinion because this court 
 . is now called upon to apply the law, as laid down with this practical em- 
 barrassment, that while it was the unanimous decision that the action could 
 
LIABILITIES OF DIRECTORS 597 
 
 be maintained, yet the difference in the grounds therefor means a dif- 
 ference of hundreds of thousands of dollars in the judgment I am about 
 to order. As I interpret it that case holds this court has jurisdiction 
 because section twenty-three of the Stock Corporation Law of this State 
 provides: "The directors of a stock corporation shall not make dividends, 
 except from the surplus profits arising from the business of such corpora- 
 tion; nor divide, withdraw, or in any way pay to the stockholders, or any 
 of them, any part of the capital of such corporation, or reduce its capital 
 stock, except as authorized by law. In case of any violation of the pro- 
 visions of this section, the directors under whose administration the same 
 may have happened, except those who may have caused their dissent there- 
 from to be entered at large upon the minutes of such directors at the 
 time, or were not present when the same happened, shall jointly and severally 
 be liable to such corporation and to the creditors thereof to the full amount 
 of the capital of such corporation so divided, withdrawn, paid out, or re- 
 duced"; and because section thirty of the General Corporation Law of 
 New Jersey provides : "No corporation shall make dividends, except from 
 the surplus or net profits arising from its business, nor divide, withdraw, 
 or in any way pay to the stockholders, or any of them, any part of its 
 capital stock, or reduce its capital stock, except according to this act, and 
 in case of any violation of the provisions of this section the directors 
 under whose administration the same may happen shall be jointly and 
 severally liable at any time within six years after paying such dividends 
 to the corporation and to its creditors in the event of its dissolution or in- 
 solvency to the full amount of the dividend made or capital stock so 
 divided, withdrawn, paid out, or reduced, with interest on the same from 
 the time such liability accrued; provided that any director who may have 
 been absent when the same was done, or who may have dissented from 
 the act or resolution by which the same was done, may exonerate himself 
 from such liability by causing his dissent to be entered at large on the 
 minutes of the directors at the time the same was done, or forthwith 
 after he shall have notice of the same, and by causing a true copy of said 
 dissent to be published within two weeks after the same shall have been 
 so entered in a newspaper published in the county where the corporation has 
 its principal office"; and because section sixty of the Stock Corporation Law 
 of this State provides: "Except as otherwise provided in this chapter the 
 officers, directors, and stockholders of a foreign stock corporation trans- 
 acting business in this State, except moneyed and railroad corporations, 
 shall be liable under the provisions of this chapter, in the same manner 
 and to the same extent as the officers, directors, and stockholders of a 
 domestic corporation for: I. The making of unauthorized dividends . . . 
 Such liabilities may be enforced in the courts of this State in the same 
 manner as similar liabilities imposed by law upon the officers, directors, 
 and stockholders of domestic corporations." That is, by virtue of the 
 statutes, this State allows the recovery of dividends unauthorized by the 
 State of New Jersey from directors of a New Jersey corporation in the 
 same manner and to the same extent as the directors of a domestic cor- 
 
598 AUDITING 
 
 poration. That is, it is the New Jersey statute which makes the dividend 
 unauthorized, but the recovery is to be had according to the New York 
 statute. What, then, is unauthorized? "No corporation shall make dividends 
 except from the surplus or net profits arising from its business." Net 
 profits are defined in the Century Dictionary as "what remains as the clear 
 gain of any business after deducting the capital invested in the business, 
 the expenses incurred in its management, and the losses sustained by its 
 operation." And the controlling question of fact is, were these dividends 
 paid from "net profits"? 
 
 The twenty-one branches, located in many places and in different 
 States, which were actually engaged in the business of manufacturing the 
 malt from the barley, sent in to the general office in New York daily, 
 weekly, and monthly statements in great detail of their business. From 
 these statements branch books were made, and from these a general set 
 of books was prepared. All of the books and papers from the general 
 office, which were used in the accounting department, were produced in 
 court, identified, and marked in evidence. The defendant objects to the 
 summaries made up from these books, and from any and all conclusions 
 of fact to be drawn from said books and said summaries upon the ground 
 that concededly the contracts and the contract books were not produced 
 and were not considered. It was in evidence that malt was always over- 
 sold, that contracts for future deliveries, running over many months, were 
 entered into, and the claim is that such contracts were required to be 
 taken into consideration when it came to be determined whether any par- 
 ticular dividend was warranted or not. Such claim, in my opinion, is un- 
 founded. The law is that "No corporation shall make dividends except 
 from the surplus or net profits." These contracts were to deliver at a 
 future time a product not yet made from raw material, not yet purchased, 
 with the aid of labor not yet expended. The price agreed to be paid at 
 that future time had to cover all the possible contingencies of the market 
 in the meanwhile, and might show a profit, and ran the chance of showing 
 a loss. When the sales actually took place they were entered in the books. 
 But to calculate months in advance on the results of the future trans- 
 actions, and on such calculations to declare dividends, was to base such 
 dividends on paper profits — hoped for profits, future profits — and not upon 
 the surplus or net profits required by law. It does not seem to me that 
 you can "divide," that is, make a dividend of a hope based on an expecta- 
 tion of a future delivery at a favorable price of what is not yet in ex- 
 istence, under the statute. So the objection to the books upon that ground 
 is of no weight. From the books certain statements were made up for the 
 aid of the court upon different theories and in different ways. One set of 
 statements was testified to be exactly what the books showed, without the 
 change of a figure. These exhibits are known as lo P, lo Q. As to these 
 statements I do not understand that there is any controversy as to the 
 accuracy of the figures. A second statement, known as lo R, lo S, is 
 identical with the foregoing, with the elimination of one entry, which, as 
 a matter of fact, was eliminated by the company itself some months after 
 
LIABILITIES OF DIRECTORS 599 
 
 its entry. There was entered on the books on December 31, 1898, an item 
 of $388,063.36 of the anticipated or estimated future profits on contracts 
 for future deliveries running over many months. This entry, for the rea- 
 sons stated in regard to the contracts for future deliveries, was unjusti- 
 fiable. The company subsequently removed this entry. The actual trans- 
 actions, that is, the deliveries of the malt called for by the contracts and 
 the receipts in payment therefor being reported from time to time as they 
 occurred, resulting in double credits, the cancellation or reversal of the 
 entry was absolutely required. On the other hand, I find against the 
 plaintiffs in regard to their contention as to the increase account. Barley 
 is bought by the bushel of forty-eight pounds. Malt, the manufactured 
 ■article made from barley by steeping, is dealt in by the bushel of thirty- 
 four pounds. The process of manufacture produces about fifteen per cent 
 more of malt by the bushel than the barley measures from which it is 
 produced. The amount of this fifteen per cent excess is reported from each 
 of the manufactories month by month as increase. Of course, this in- 
 crease has a value, as it is sold as malt at malt prices. For the purpose 
 of inventory the company has ascribed to it the value of the barley. This, 
 plaintiffs claim, is error, because that amount has already once been charged 
 to malt account, and they say this increase should have no value ascribed 
 to it until sold and delivered, when its proceeds go into the books as 
 cash. But it certainly is an asset of the company, and as an asset at in- 
 ventory periods, or when it is necessary to ascertain the actual condition 
 of the company, it must be valued in some way. As it has always been 
 the custom in the malting business to treat it as treated by this company, 
 I am unwilling to disregard that custom. The accounts upon which I 
 based my conclusions treated it as this company did. I find that at the 
 time of the declaration and payment of the third dividend, July, 1898, a 
 deficit was caused thereby of $142,774.59, and from that time to the end of 
 the period under consideration none of the dividends were paid out of net 
 profits, but all were paid out of capital. But it appears that defendant 
 Curtiss was not present at the meeting on February 28, 1899, when the 
 dividend paid April 15, 1899, was authorized. Under the New York 
 statute — under which we are proceeding — a director who was not present 
 when the dividend was declared is not liable. The approval of the minutes 
 at the following June meeting, at which he was present, was only the 
 authentication of the proof of what had happened at the previous meeting. 
 He is, therefore, not to be held liable for that dividend. He is liable, in 
 my judgment, as follows: For dividends paid July 15, 1898, to the extent 
 of $142,774.59; October IS, 1898, $219,450; January 15, 1899, $219,450; July 
 IS, 1899, $252,700; October 15, 1899, $252,700— $1,087,074.59, with interest 
 thereon from the several dates of payment. As the highest court of New 
 Jersey, interpreting the law of the State under which this company was 
 incorporated, held, "for the full protection of the company the liability of 
 the directors must be absolute" (Appleton v. Am. Malting Co.), I find 
 against the defendant upon his claim that the accrued profits of the com- 
 pany, made under a changed management, can be credited in his favor 
 
6oo AUDITING 
 
 against his liability. It is claimed that this is a harsh law. If it were, such 
 complaint should be made to the Legislature, and not to the court. It does 
 not seem to me that in these days of great corporations and of combina- 
 tions into one of many corporations it is asking too much of directors, 
 fiduciary officers as they are, that they should obey the law of their incor- 
 poration, and not bring their companies to the verge of bankruptcy and 
 ruin by the payment of quarterly dividends on preferred stock out of 
 capital instead of net earnings. As to the second cause of action: While 
 the allegations are profuse as to a "willful, fraudulent, and illegal con- 
 spiracy," the proof failed to establish that there was any such conspiracy 
 for defendant's personal benefit. The cases establishing the cause of action 
 pointed at in these allegations have been where directors have diverted 
 to themselves for their own benefit the property of the company. The 
 damage here flowed out of the making of the dividends, if any there was. 
 It was alleged that the company had to issue bonds, and that the commis- 
 sions, discounts, and interest thereon amount to $650,000, which, as a waste 
 of its funds, the plaintiff seeks to recover. But as I find that this flowed 
 as a damage only from the declaration and payment of the dividends, I 
 am persuaded by the language of Mr. Justice Hatch in Hutchinson v. Stadler, 
 supra, that it does not under the facts of this case constitute a separate 
 cause of action. He says: ja point of fact the statute of the State of 
 New Jersey upon this subject, as well as our own, does little more than 
 lay down a rule of damage to be enforced against directors for breach of 
 duty. At common law a recovery could be had for the waste, but the ex- 
 tent of the recovery would depend upon the damage sustained by the cor- 
 poration and be the subject of proof. The statute measures the loss sus- 
 tained, which is usually the correct amount, and authorizes a recovery 
 therefrom of the individuals who produced that result." It seems to 
 me that any other theory would result in turning the amount recovered 
 for illegal dividends into a penalty. The Court of Errors and Appeals 
 of New Jersey, in this very matter, as well as our Appellate Division, have 
 held: "The liability imposed by the statute is not penal in its character. 
 Its sole purpose is not to punish, but to provide for the making of com- 
 pensation by wrongdoers for the injury sustained by their wrongful act." 
 This alleged loss must, therefore, be held to have been included in that 
 for which the defendant is required to make compensation by paying into 
 the company an amount equal to the illegal dividends. 
 
CHAPTER XXXIV 
 FEDERAL EXCISE TAX ON CORPORATIONS 
 
 Of all the various methods and schemes of taxation enacted 
 by the Federal Congress or by State Legislatures, there is none 
 which is of more importance to the auditor than that portion of 
 the Payne-Aldrich tariff act which relates to the taxation of 
 corporations based upon net income in excess of $S,ooo. 
 
 To all intents and purposes this is an income tax, and, al- 
 though it has been declared constitutional by the Supreme Court 
 of the United States, it is very generally admitted that to describe 
 it as other than an income tax is a legal fiction. 
 
 Income taxation has been known in Great Britain since the 
 close of the eighteenth century, and in many other countries the 
 principle has been applied with at least fairly satisfactory 
 results; but there is in America a deep-rooted antipathy to the 
 idea of taxing incomes, and this receives constitutional indorse- 
 ment by clause four of Article I, section ii of the National Con- 
 stitution, which is as follows : 
 
 No capitation or other direct tax shall be laid, unless in propor- 
 tion to the census or enumeration hereinbefore directed to be taken. 
 
 At the time of the War of 1812 an income tax was proposed, 
 but was rejected by Congress. During the Civil War, however, 
 an income tax was imposed and continued in force until 1872. 
 The Wilson tariff bill, passed in 1894, contained provision for a 
 tax of two per cent on incomes in excess of $4,000, but this was 
 declared unconstitutional by the Supreme Court, and no serious 
 effort was made to secure the passage of an income tax between 
 that time and 1909, when the Payne-Aldrich bill became law. 
 
 The evasion of the constitutional disability which character- 
 ized the corporation tax found so much favor in certain quarters 
 that a bill was introduced in the second session of the sixty- 
 second Congress by the leader of the majority, the Hon. Oscar 
 W. Underwood, to extend the provisions of the corporation tax 
 law to include the income or profits of firms, copartnerships, and 
 
 601 
 
6o2 AUDITING 
 
 individuals. Although this bill did not become law, it was largely 
 supported in the House of Representatives and serves as an illus- 
 tration of the ease with which a legal fiction may be used to 
 evade a constitutional limitation. (See text of bill, p. 632.) 
 
 Sooner or later it is believed that the necessary number of 
 State Legislatures will ratify the proposal to amend the Federal 
 Constitution so that income taxation may be permitted under its 
 true name, but until that has been done the Federal corporation 
 tax section of the Payne-Aldrich tariff law remains the chief 
 center of interest to the auditor of corporations upon which the 
 tax falls. 
 
 The full text of the law (section 38 of the tariff act, approved 
 August 5, 1909) follows : 
 
 ions Sec. 38. That every corporation, joint stock company or association, 
 
 I Tax organized for profit and having a capital stock represented by shares, and 
 every insurance company now or hereafter organized under the laws of 
 the United States or of any State or Territory of the United States, or 
 under the Acts of Congress applicable to Alaska or the District of Columbia, 
 or now or hereafter organized under the laws of any foreign country and 
 engaged in business in any State or Territory of the United States or in 
 Alaska or in the District of Columbia, shall be subject to pay annually a 
 it of special excise tax with respect to the carrying on or doing business by 
 '™^ such corporation, joint stock company or association, or insurance com- 
 pany, equivalent to one per centum upon the entire net income over and 
 above five thousand dollars received by it from all sources during such 
 year, exclusive of amounts received by it as dividends upon stock of other 
 corporations, joint stock companies or associations, or insurance companies, 
 subject to the tax hereby imposed; or if organized under the laws of any 
 foreign country, upon the amount of net income over and above five 
 thousand dollars received by it from business transacted and capital invested 
 within the United States and its Territories, Alaska, and the District of 
 Columbia during such year, exclusive of amounts so received by it as 
 dividends upon stock of other corporations, joint stock companies, or 
 associations, or insurance companies, subject to the tax hereby imposed: 
 Provided, however. That nothing in this section contained shall apply to 
 labor, agricultural or horticultural organizations, or to fraternal beneficiary 
 ms societies, orders, or associations operating under the lodge system, and 
 ct to providing for the payment of life, sick, accident, and other benefits to the 
 members of such societies, orders, or associations, and dependents of such 
 members, nor to domestic building and loan associations, organized and 
 operated exclusively for the mutual benefit of their members, nor to any 
 
 *The marginal notes are here inserted for the convenience of the reader; they are not an 
 integral part of the law. 
 
CORPORATION TAX LAW 
 
 603 
 
 corporation or association organized and operated exclusively for religious, 
 charitable, or educational purposes, no part of the net income of which 
 inures to the benefit of any private stockholder or individual. 
 
 Second. Such net income shall be ascertained by deducting from the 
 gross amount of the income of such corporation, joint stock company or 
 association, or insurance company, received within the year from all sources : 
 
 1st. All the ordinary and necessary expenses actually paid within the 
 year out of income in the maintenance and operation of its business and 
 properties, including all charges, such ' as rentals or franchise payments, 
 required to be made as a condition to the continued use or possession of 
 property. 
 
 and. All losses actually sustained within the year and not compensated 
 by insurance or otherwise, including a reasonable allowance for depreciation 
 of property, if any, and in the case of insurance companies the sums other 
 than dividends, paid within the year on policy and annuity contracts and 
 the net addition, if any, required by law to be made within the year to 
 reserve funds. 
 
 3rd. Interest actually paid within the year on its bonded or other in- 
 debtedness to an amount of such bonded and other indebtedness not ex- 
 ceeding the paid-up capital stock of such corporation, joint stock company 
 or association, or insurance company, outstanding at the close of the year, 
 and in the case of a bank, banking association, or trust company, all inter- 
 est actually paid by it within the year on deposits. 
 
 4th. All sums paid within the year for taxes imposed under the au- 
 thority of the United States or of any State or Territory thereof, or im- 
 posed by the government of any foreign country as a condition to carrying 
 on business therein. 
 
 Sth. All amounts received by it within the year as dividends upon stock 
 of other corporations, joint stock companies or associations, or insurance 
 companies, subject to the tax hereby imposed : 
 
 Provided, That in the case of a corporation, joint stock company, or 
 association, or insurance company, organized under the laws of a foreign 
 country, such net income shall be ascertained by deducting from the gross 
 amount of its income received within the year from business transacted 
 and capital invested within the United States and any of its Territories, 
 Alaska, and the District of Columbia: 
 
 1st. All the ordinary and necessary expenses actually paid within the 
 year out of earnings in the maintenance and operation of its business and 
 property within the United States and its Territories, Alaska, and the Dis- 
 trict of Columbia, including all charges such as rentals or franchise pay- 
 ments required to be made as a condition to the continued use or possession 
 of property. 
 
 2nd. All losses actually sustained within the year in business con- 
 ducted by it within the United States or its Territories, Alaska, or the Dis- 
 trict of Columbia not compensated by insurance or otherwise, including a 
 reasonable allowance for depreciation of property, if any, and in the case 
 of insurance companies the sums other than dividends, paid within the year 
 
 How "Net In- 
 come" Shall 
 Be Ascertained 
 
 How "Net In- 
 come" of For- 
 eign Corpora- 
 tions Shall Be 
 Ascertained 
 
6o4 AUDITING 
 
 on policy and annuity contracts and the net addition, if any, required by 
 law to be made within the year to reserve funds. 
 
 3rd. Interest actually paid within the year on its bonded or other in- 
 debtedness to an amount of such bonded and other indebtedness, not ex- 
 ceeding the proportion of its paid-up capital stock outstanding at the close 
 of the year which the gross amount of its income for the year from business 
 transacted and capital invested within the United States and any of its 
 Territories, Alaska, and the District of Columbia bears to the gross amount 
 of its income derived from all sources within and without the United States. 
 4th. The sums paid by it within the year for taxes imposed under the 
 authority of the United States or of any State or Territory thereof. 
 
 Sth. All amounts received by it within the year as dividends upon stock 
 of other corporations, joint stock companies or associations, and insurance 
 companies, subject to the tax hereby imposed. In the case of assessment 
 insurance companies, the actual deposit of sums with State or Territorial 
 officers, pursuant to law, as additions to guaranty or reserve funds shall be 
 treated as being payments required by law to reserve funds. 
 
 Third. There shall be deducted from the amount of the net income of 
 each of such corporations, joint stock companies or associations, or insurance 
 
 ' companies, ascertained as provided in the foregoing paragraphs of this 
 section, the sum of five thousand dollars, and said tax shall be computed 
 upon the remainder of said net income of such corporation, joint stock 
 company or association, or insurance company, for the year ending Decem- 
 ber thirty-first, nineteen hundred and nine, and for each calendar year 
 
 bd thereafter; and on or before the first day of March, nineteen hundred and 
 ten, and the first day of March in each year thereafter, a true and accurate 
 return, under oath or affirmation of its president, vice-president, or other 
 principal officer, and its treasurer or assistant treasurer, shall be made by 
 each of the corporations, joint stock companies or associations, and in- 
 surance companies, subject to the tax imposed by this section, to the Col- 
 lector of Internal Revenue for the district in which such corporation, joint 
 stock company or association, or insurance company, has its principal place 
 of business, or, in the case of a corporation, joint stock company or associa- 
 tion, or insurance company, organized under the laws of a foreign country, 
 in the place where its principal business is carried on within the United 
 States, in such form as the Commissioner of Internal Revenue, with the 
 approval of the Secretary of the Treasury, shall prescribe, setting forth: 
 
 5e 1st. The total amount of the paid-up capital stock of such corporation, 
 
 joint stock company or association, or insurance company, outstanding at 
 the close of the year. 
 
 2nd. The total amount of the bonded and other indebtedness of such 
 corporation, joint stock company or association, or insurance company, at 
 the close of the year. 
 
 3rd. The gross amount of the income of such corporation, joint stock 
 company or association, or insurance company, received during such year 
 from all sources, and if organized under the laws of a foreign country, the 
 gross amount of its income received within the year from business trans- 
 
CORPORATION TAX LAW 605 
 
 acted and capital invested within the United States and any of its Ter- 
 ritories, Alaska, and the District of Columbia; also the amount received 
 by such corporation, joint stock company or association, or insurance com- 
 pany, within the year by way of dividends upon stock of other corporations, 
 joint stock companies or associations, or insurance companies, subject to 
 the tax imposed by this section. 
 
 4th. The total amount of all the ordinary and necessary expenses 
 actually paid out of earnings in the maintenance and operation of the busi- 
 ness and properties of such corporation, joint stock company or associa- 
 tion, or insurance company, within the year, stating separately all charges 
 such as rentals or franchise payments required to be made as a condition 
 to the continued use or possession of property, and if organized under the 
 laws of a foreign country, the amount so paid in the maintenance and 
 operation of its business within the United States and its Territories, 
 Alaska, and the District of Columbia. 
 
 Sth. The total amount of all losses actually sustained during the year 
 and not compensated by insurance or otherwise, stating separately any 
 amounts allowed for depreciation of property, and in the case of insurance 
 companies, the sums other than dividends, paid within the year on policy 
 and annuity contracts and the net addition, if any, required by law to be 
 made within the year to reserve funds; and in the case of a corporation, 
 joint stock company or association, or insurance company, organized under 
 the laws of a foreign country, all losses actually sustained by it during the 
 year in business conducted by it within the United States or its Territories, 
 Alaska, and the District of Columbia, not compensated by insurance 
 or otherwise, stating separately any amounts allowed for depreciation of 
 property, and in the case of insurance companies the sums other than 
 dividends, paid within the year on policy and annuity contracts and the 
 net addition, if any, required by law to be made within the year to reserve 
 fund. 
 
 6th. The amount of interest actually paid within the year on its bonded 
 or other indebtedness to an amount of such bonded and other indebtedness 
 not exceeding the paid-up capital stock of such corporation, joint stock 
 company or association, or insurance company, outstanding at the close of 
 the year, and in the case of a bank, banking association, or trust company, 
 stating separately all interest paid by it within the year on deposits; or in 
 case of a corporation, joint stock company or association, or insurance com- 
 pany, organized under the laws of a foreign country, interest so paid on its 
 bonded or other indebtedness to an amount of such bonded and other in- 
 debtedness not exceeding the proportion of its paid-up capital stock out- 
 standing at the close of the year, which the gross amount of its income 
 for the year from business transacted and capital invested within the United 
 States and any of its Territories, Alaska, and the District of Columbia, 
 bears to the gross amount of its income derived from all sources within 
 and without the United States. 
 
 7th. The amount paid by it within the year for taxes imposed under 
 the authority of the United States or any State or Territory thereof, and 
 
6o6 AUDITING 
 
 separately the amount so paid by it for taxes imposed by the government 
 of any foreign country as a condition to carrying on business therein. 
 
 8th. The net income of such corporation, joint stock company or as- 
 sociation, or insurance company, after making the deductions in this section 
 authorized. All such returns shall, as received, be transmitted forthwith 
 by the collector to the Commissioner of Internal Revenue. 
 
 Re- Fourth. Whenever evidence shall be produced before the Commissioner 
 
 of Internal Revenue which, in the opinion of the Commissioner, justifies 
 the belief that the return made by any corporation, joint stock company or 
 association, or insurance company, is incorrect, or whenever any collector 
 shall report to the Commissioner of Internal Revenue that any corporation, 
 
 I joint stock company or association, or insurance company, has failed to 
 
 make a return as required by law, the Commissioner of Internal Revenue 
 may require from the corporation, joint stock company or association, or 
 insurance company making such return, such further information with ref- 
 erence to its capital, income, losses, and expenditures as he may deem 
 expedient; and the Commissioner of Internal Revenue, for the purpose of 
 ascertaining the correctness of such return or for the purpose of making 
 
 ,y Be a return where none has been made, is hereby authorized, by any regularly 
 appointed revenue agent specially designated by him for that purpose, to 
 examine any books and papers bearing upon the matters required to be 
 included in the return of such corporation, joint stock company or as- 
 sociation, or insurance company, and to require the attendance of any 
 oiEcer or employee of such corporation, joint stock company or association, 
 or insurance company, and to take his testimony with reference to the 
 matter required by law to be included in such return, with power to ad- 
 
 aurts niinister oaths to such person or persons; and the Commissioner of Internal 
 Revenue may also invoke the aid of any court of the United States having 
 jurisdiction to require the attendance of such officers or employees and 
 the production of such books and papers. Upon the information so ac- 
 quired, the Commissioner of Internal Revenue may amend any return or 
 make a return where none has been made. All proceedings taken by the 
 Commissioner of Internal Revenue under the provisions of this section shall 
 be subject to the approval of the Secretary of the Treasury. 
 
 to Fifth. All returns shall be retained by the Commissioner of Internal 
 
 *^* Revenue, who shall make assessments thereon; and in case of any return 
 made with false or fraudulent intent, he shall add one hundred per centum 
 of such tax, and in case of a refusal or neglect to make a return or to 
 verify the same as aforesaid, he shall add fifty per centum of such tax. 
 In case of neglect occasioned by the sickness or absence of an officer of 
 such corporation, joint stock company or association, or insurance com- 
 pany, required to make said return, or for other sufficient reason, the col- 
 lector may allow such further time for making and delivering such re- 
 turn as he may deem necessary, not exceeding thirty days. The amount 
 so added to the tax shall be collected at the same time and in the same 
 manner as the tax originally assessed unless the refusal, neglect, or falsity 
 is discovered after the date for payment of said taxes, in which case the 
 
 urn 
 
CORPORATION TAX LAW 
 
 607 
 
 amount so added shall be paid by the delinquent corporation, joint stock 
 company, or association, or insurance company, immediately upon notice 
 given by the collector. All assessments shall be made, and the several 
 corporations, joint stock companies or associations, or insurance companies, 
 shall be notified of the amount for which they are respectively liable on 
 or before the first day of June of each successive year, and said assess- 
 ments shall be paid on or before the thirtieth day of June, except in cases 
 of refusal or neglect to make such return, and in cases of false or fraudu- 
 lent returns, in which cases the Commissioner of Internal Revenue shall, 
 upon the discovery thereof, at any time within three years after said 
 return is due, make a return upon information obtained as above provided 
 for, and the assessment made by the Commissioner of Internal Revenue 
 thereon shall be paid by such corporation, joint stock company or associa- 
 tion, or insurance company, immediately upon notification of the amount 
 of such assessment; and to any sum or sums due and unpaid after the 
 thirtieth day of June in any year, and for ten days after notice and 
 demand thereof by the collector, there shall be added the sum of five per 
 centum on the amount of tax unpaid and interest at the rate of one per 
 centum per month upon said tax from the time the same becomes due. 
 
 Sixth. When the assessment shall be made, as provided in this section, 
 the returns, together with any corrections thereof which may have been 
 made by the Commissioner, shall be filed in the office of the Commissioner 
 of Internal Revenue and shall constitute public records and be open to 
 inspection as such. 
 
 Seventh. It shall be unlawful for any collector, deputy collector, agent, 
 clerk, or other officer or employee of the United States to divulge or make 
 known in any manner whatever not provided by law to any person any in- 
 formation obtained by him in the discharge of his official duty, or to divulge 
 or make known in any manner not provided by law any document received, 
 evidence taken, or report made under this section except upon the special 
 direction of the President; and any offense against the foregoing pro- 
 vision shall be a misdemeanor and be punished by a fine not exceeding 
 one thousand dollars, or by imprisonment not exceeding one year, or both, 
 at the discretion of the court. 
 
 Eighth. If any of the corporations, joint stock companies or associa- 
 tions, or insurance companies, aforesaid, shall refuse or neglect to make 
 a return at the time or times hereinbefore specified in each year, or shall 
 render a false or fraudulent return, such corporation, joint stock com- 
 pany or association, or insurance company, shall be liable to a penalty 
 of not less than one thousand dollars and not exceeding ten thousand 
 dollars. 
 
 Any person authorized by law to make, render, sign, or verify any 
 return, who makes any false or fraudulent return, or statement, with in- 
 tent to defeat or evade the assessment required by this section to be made, 
 shall be guilty of a misdemeanor, and shall be fined not exceeding one 
 thousand dollars or be imprisoned not exceeding one year, or both, at the 
 discretion of the court, with the costs of prosecution. 
 
 Delinquent 
 Taxes 
 
 Reports Public 
 Records 
 
 Information 
 Not to Be 
 Divulged 
 
 Penalty for 
 False or No 
 Return 
 
irts 
 lic- 
 
 608 AUDITING 
 
 All laws relating to the collection, remission, and refund of internal 
 revenue taxes, so far as applicable to and not inconsistent with the pro- 
 visions of this section, are hereby extended and made applicable to the 
 tax imposed by this section. 
 
 Jurisdiction is hereby conferred upon the circuit and district courts 
 of the United States for the district within which any person summoned 
 under this section to appear to testify or to produce books, as aforesaid, 
 shall reside, to compel such attendance, production of books, and testimony 
 by appropriate process. 
 
 As soon as the text of the bill was made known some of the 
 leading accounting firms, recognizing the impracticability of the 
 bill as drafted, prepared a letter which was sent to each member 
 of Congress and to the Attorney General. Although the letter 
 and resultant correspondence have previously been published, it 
 is necessary to a clear understanding of the case that they should 
 be given here. The letter was signed by twelve accounting firms 
 in New York. 
 
 New York City, July 8, 1909. 
 Dear Sir: 
 
 On reading the text of the proposed corporation tax law, as reported 
 in the Commercial and Financial Chronicle of July 3, 1909, we have formed 
 the opinion that some of its provisions are absolutely impossible of ap- 
 plication, and others violate all the accepted principles of sound accounting. 
 
 Under the third clause it is provided "that there shall be deducted from 
 the amount of the net income of each of such corporations, . . . ascer- 
 tained as provided in the foregoing paragraphs of this section, the sum of 
 $5,000, and said tax shall be computed upon the remainder of said net in- 
 come of such corporation . . . for the year ending December 31, 1909, and 
 for each year thereafter, and on or before the ist day of March, 1910, and 
 the 1st day of March of each year thereafter, a true and accurate return 
 under oath or affirmation of its president," etc., etc. 
 
 In connection with this clause we would call attention to the fact that, 
 as you are no doubt aware, the fiscal year of a number of corporations is 
 not, and for business reasons cannot be, the calendar year, and consequently, 
 having in mind that in such cases an inventory was not taken at the be- 
 ginning of the calendar year 1909, it is and will be quite impossible for any 
 business, corporation, or institution, whose fiscal year does not terminate 
 with the calendar year, to make a true return of its profits as required by 
 the proposed law. 
 
 Under clause i the tax is to be charged upon the "entire net income,'' 
 and the net income is to be "ascertained by deducting from the gross amount 
 of the income . . . from all sources," 
 
 (i) "Expenses actually paid," 
 
 (2) "Losses actually sustained," 
 
CORPORATION TAX LAW 609 
 
 (3) "Interest actually paid," 
 in each case "within the year." The words '"actually paid" convey, and it 
 is to be presumed are intended to convey, actual disbursements out of the 
 treasury. 
 
 The proper deductions should be : 
 
 (i) Expenses actually incurred because the payment is not necessarily 
 made in the year in which the expense is incurred; 
 
 (2) Losses actually ascertained because losses may be incurred and the 
 amount not be ascertained until a subsequent period; 
 
 (3) Interest actually accrued because interest is never paid until the 
 end of the period during which it accrues, and the interest accrued is the 
 proper charge against income. 
 
 In clause I the bill refers to "net income received" ; in clause 2 it 
 refers to "gross income" without the addition of word "received" ; in clause 
 3, paragraph 3, it refers to "gross income received." There is here a com- 
 plete confusion between income and income received, which can only lead 
 to endless complication. 
 
 Two methods may be adopted for taxation purposes, either 
 
 (i) To tax the difference between actual cash receipts on revenue ac- 
 count and actual cash payments on revenue account, which difference will 
 seldom if ever represent the profits of a manufacturing concern; or 
 
 (2) To tax profits made up in the ordinary commercial way, namely, 
 to ascertain the gross income earned, whether received or not, and to 
 deduct therefrom — 
 
 1. Expenses actually incurred during the year, whether paid or not; 
 
 2. Losses actually ascertained and written off during the year whenever 
 incurred; 
 
 3. Interest accrued during the year, whether paid or not; 
 
 4. A reasonable allowance for depreciation of property; and 
 
 5. Taxes. 
 
 As accountants actively engaged in the audit and examination of a 
 number of varied businesses and enterprises, we unhesitatingly say that 
 the law as framed is absolutely impossible of application, and would sug- 
 gest that in the said clauses I, 2, and 3 of paragraph 2, the words "actually 
 paid" and "actually sustained" be changed to read "actually incurred" and 
 "actually ascertained," and that the third clause be changed to read so that 
 the return will be based on the last completed fiscal year prior to December 
 31st in cases where the fiscal year of a corporation is not the calendar 
 year. Yours very truly, 
 
 (Signed by twelve firms of accountants.) 
 
 The Attorney General replied as follows : 
 
 Washington, D. C, July 12, 1909. 
 
 Gentlemen : 
 
 I am in receipt of the letter signed by your firm and a number of 
 
 others with respect to the proposed corporation tax law, in which you 
 
 advise me that you have formed the opinion that some of its provisions 
 
6io AUDITING 
 
 are absolutely impossible of application and others' violate all the accepted 
 principles of sound accounting. 
 
 You first call my attention to the fact that "the fiscal year of a number 
 of corporations is not, and for business reasons cannot be, the calendar 
 year, and consequently, having in mind that in such cases an inventory 
 was not taken at the beginning of the calendar year 1909, it is and will be 
 quite impossible for any business, corporation or institution, whose fiscal 
 year does not terminate with the calendar year, to make a true return of 
 its profits as required by the proposed law." 
 
 I beg to call your attention, in the first place, to the fact that the 
 proposed law does not impose a tax upon "profits," but upon "the entire 
 net income over and above five thousand dollars received by" the corporation, 
 joint stock company or association, or insurance company, subject to the 
 law, from "all sources during such year." It has been the uniform prac- 
 tice of the Government in framing revenue bills to require the tax to be 
 paid as of a fixed date, and, so far as I have been able to ascertain, in every 
 instance the tax is imposed for the calendar year ending December 31st. 
 Such was the income tax law of 1894. It may be inconvenient, but it is 
 certainly not impossible for any corporation which keeps just and true 
 books of account to make up a return such as that required by the pro- 
 posed law, particularly as the return requires statements of actual receipts 
 and payments, and not, as you recommend in your communication, of ex- 
 penses "incurred," interest "accrued," and losses "ascertained." 
 
 2. You next object that the proposed law authorizes the deductions of 
 "expenses actually paid," and you contend that this should be changed to 
 read "expenses actually incurred." The bill was purposely framed to deal 
 with receipts and disbursements made within the year for which the tax 
 was to be imposed, and the words "actually paid" were employed ad- 
 visedly. The same may be said with respect to losses actually sustained 
 and interest actually paid. The theory of the framers of the bill in this 
 respect differs from that which you advocate. 
 
 3. You then object that in Clause i the bill refers to "net income 
 received"; in Clause 2 it refers to "gross income" without the addition of the 
 word "received"; and in Clause 3, Paragraph 3, it refers to "gross income 
 received," and you comment: "There is here a complete confusion between 
 income and income received, which can only lead to endless complication." 
 
 I cannot agree that there is any confusion whatever in this respect. 
 "Gross income" in Clause 2 obviously and necessarily means "gross income 
 received." The tax is imposed by Clause I upon the entire net income above 
 five thousand dollars received from all sources during the year. By Clause 
 2 "such net income" is to be ascertained by deducting from the gross amount 
 of the income from all sources the specified items; and if anybody could 
 question whether that meant "gross income received," his doubt would be 
 removed by the provisions in Paragraph 3 of Clause 3. 
 
 Your further statement that "as accountants actively engaged in the 
 audit and examination of a number of varied businesses and enterprises, 
 we unhesitatingly say that the law as framed is absolutely impossible of 
 
CORPORA.TION TAX LAW 6ii 
 
 application," causes me very great surprise. My personal acquaintance 
 with you and a number of the other signers of the letter leads me to the 
 belief that you have underestimated your capacity. Certainly the state- 
 ment of objections made in your letter is entirely insufficient to support the 
 conclusion which you express. 
 
 I am, respectfully yours, 
 
 (Signed) George W. Wickersham, 
 
 Attorney General. 
 
 The following reply, stating in more detail the reasons why 
 the law as framed was impossible of application, was sent to the 
 Attorney General: 
 
 New York, July 21, 1909. 
 Dear Sir: 
 
 We have to acknowledge receipt of your letter of July 12th, replying 
 to ours of July 8th. 
 
 Our only object in addressing you was to be of assistance in a matter 
 of practical accounting which enters into the proposed law, as to which 
 we believe that our experience specially qualifies us to speak. We have 
 purposely refrained from any reference to the policy involved in the law, 
 with which we, as accountants, are not concerned. 
 
 The views expressed in your letter of the 12th instant would seem 
 to indicate that you have not fully appreciated the difficulties which will 
 be met with in carrying into effect the provisions of the proposed law as 
 amplified and explained in your letter; and we therefore feel that, in justice 
 to ourselves, we must refer at greater length to some matters which were 
 only briefly touched upon in our letter of July 8th. 
 
 We are glad to have your clear expression as to the intention of the 
 law to deal with Receipts and Disbursements only (presumably on Income 
 Account) and not with Income Earned (or Profits) and Expenditures In- 
 • curred. Under these circumstances it would seem better to use the term 
 "Receipts on Income Account" and "Disbursements on Income Account" 
 rather than "Income" and "Expense," as the latter terms are more commonly 
 defined and used in relation to Income Earned and Expenses Incurred. In 
 any case, if in Clause 2 "Gross Income" means, as you state it is intended 
 to mean, "Gross Income Received," it would certainly be better to say so 
 and thus remove any possible ambiguity. 
 
 We note that you refer to the precedent of the Income Tax Law of 
 1894. We believe that this law was declared unconstitutional before there 
 had been time to experience the difficulties and uncertainties which any 
 attempt to enforce it, if drawn on the lines of the present bill, would have 
 involved. In this connection we may perhaps point to the precedent of 
 the English Income Tax Law, which has stood the test of over half a 
 century. In this case the tax is on Profits, which in this country are fre- 
 quently termed "Net Income"; and the accounts of corporations prepared 
 in the regular course of business for their respective fiscal years are and 
 
6i2 AUDITING 
 
 always have been accepted as the basis of taxation, subject to minor pro- 
 visions as to rates of depreciation, interest deductions, etc. 
 
 Our main criticism of the bill in its present form is that in the large 
 majority of cases it will be impossible of application for the year 1909, as 
 explained in our previous letter, and very difficult and expensive, if not al- 
 together impossible, in subsequent years. 
 
 Railroads perhaps require the simplest form of accounting obtaining 
 among business corporations. These accounts are kept in a form pre- 
 scribed by the Interstate Commerce Commission, and severe penalties can be 
 inflicted for any departure from those forms. They must be kept on a 
 basis not of Receipts and Disbursements, but of Earnings, whether col- 
 lected in cash or not, and of Expenses, whether paid or not, which in both 
 cases accrue during the fiscal year closing on June 30th, the outstanding 
 Income and Expense items uncollected and unpaid running into very 
 large figures and frequently varying considerably in amount between one 
 year and another. While it would be possible to prepare also an account 
 of Receipts and Disbursements, this would involve a great deal of extra 
 work in the compilation of special data and would raise most difficult 
 questions as to the proper distribution between Capital and Income of large 
 payments for stores, the ultimate use of which is not and cannot be known 
 at the time of payment. 
 
 Turning now from this, which is perhaps the most simple case, to that 
 of a large manufacturing concern producing all kinds of finished products 
 out of purchases of ore and other raw materials, an accurate or even 
 approximate statement of Cash Receipts and Disbursements on Income Ac- 
 count is a practical impossibility at any time. Cash Receipts arising from 
 sales of products can be ascertained without much difficulty beyond requir- 
 ing considerable extra work. But no system of accounting can give even 
 approximately "the ordinary and necessary expenses actually paid within 
 the year out of Income in the maintenance and operation of its business 
 and properties." Such expenses presumably must include the cost of the 
 goods sold. Into this cost, and following it through all the intricate ac- 
 counting which has been found to be necessary, are raw materials actually 
 used in manufacture, labor expended, and innumerable items of expense 
 which are taken into costs as they accrue, quite irrespective of the date 
 of payment. Very large inventories are carried of materials and supplies 
 which are purchased at one period, paid for at another, and used at all 
 sorts of times, in all sorts of quantities, and for all sorts of purposes, 
 mainly for manufacture into products for sale, but to a large extent for 
 additions to or extensions of the plant. Such as are used for the latter 
 purpose are not, as we understand the proposed law, a proper deduction 
 from Gross Income, and yet long before they are used all identity between 
 the materials themselves and the disbursements made for them has been 
 lost. There is, in our opinion, no method by which any such statement 
 as that called for in the proposed law can be prepared short of an entirely 
 independent and separate set of books, designed to follow each bill paid 
 through to the ultimate destination of the materials or services covered 
 
CORPORATION TAX LAW 613 
 
 thereby, thus duplicating the present cost of the Accounting Department 
 and serving no useful purpose whatever. Even if such method were 
 adopted, it is very doubtful if it would produce the results required with 
 even approximate accuracy. 
 
 Without unduly burdening this letter, it is impossible to go into 
 further details here; but the facts must, in the opinion of any one familiar 
 with the operations and accounts of a complicated modern manufacturing 
 concern, fully justify the conclusions which we expressed in our letter of 
 July 8th, and which we now emphatically indorse. Whether the proposed 
 method is physically impossible, or merely, as you state, "inconvenient," 
 it will, we think, be generally conceded that it is in the general interest 
 of the effective administration of laws relating to taxes that they should 
 involve as little inconvenience as possible upon those required to make 
 returns thereunder. The basis for arriving at the amount liable to taxation 
 suggested in our former letter would have the advantage of simplicity, 
 and if the tax is to be a permanent institution, its efficient operation would 
 be greatly facilitated by conformity with regular accounting methods. 
 
 We have felt it our duty to protest strongly against the wording of 
 the proposed bill upon the grounds set forth, but our object is to help, 
 and not to hinder. If you think any good purpose would be served by 
 our appearing before you and discussing this matter fully with a view of 
 arriving at a satisfactory solution, which we are satisfied can be done, we 
 shall be pleased to hold ourselves at your disposal for this purpose. 
 
 Regretting our inability to in any way modify the conclusions already 
 expressed. We are. Dear Sir, 
 
 Yours very truly, 
 (Signed by eleven firms of accountants.) 
 
 The Attorney General's reply to the second letter of the ac- 
 countants was as follows: 
 
 Washington, D. C, July 22, 1909. 
 Dear Sirs: 
 
 I have a letter dated the 21st instant, signed by yourself and a num- 
 ber of other firms of accountants, in response to my letter of July 12th, 
 replying to your former letter of July 8th. In your last letter you set 
 forth in somewhat more detail the following proposition: 
 
 "But no system of accounting can give even approximately 'the ordi- 
 nary and necessary expenses actually paid within the year out of income 
 in the maintenance and operation of its business and properties.'" 
 
 I think the bare statement of that proposition would be received with 
 very great incredulity by most minds. Certainly, I am quite unable to 
 assent to it. However, it is now too late to attempt to recast the cor- 
 poration tax amendment bill on the basis of such proposition. 
 Respectfully yours, 
 
 (Signed) George W. Wickersham, 
 
 Attorney General. 
 
6i4 AUDITING 
 
 A glance at the text of the law as it stands on the statute 
 books will show that in spite of the protest of the accountants, 
 who in this case were the men best qualified to judge of the work- 
 ability of the law, the bill was allowed to pass in its awkward 
 and unworkable form. Those interested in the subject should 
 compare the law with the accountants' letters and the Treasury- 
 explanations. It will be found that the position of the account- 
 ants was fully confirmed although no recognition of this fact has 
 been made. The Treasury Department practically rewrote the 
 law, thus proving its impracticability. Out of this have resulted 
 some interesting incidents. Where litigation is resorted to, the 
 court follows the law — not the interpretation thereof by the 
 Treasury. Probably nine-tenths of the returns would, or could 
 be altered if the law were followed instead of the prescribed 
 forms. 
 
 For some time after the passage of the act the Treasury De- 
 partment, which was intrusted with the collection of the tax, and 
 the Attorney General's department, which was responsible for 
 the wording of the law, were unable to agree as to the method 
 of collection, the exemptions to be allowed, and the calculation 
 of net profits. 
 
 While things were in this chaotic condition in the Govern- 
 ment offices, corporations were equally undecided as to what 
 returns were desired and what amount of taxes each would be 
 called upon to pay. Shortly after the passage of the act, however, 
 the Treasury Department issued an explanation of the law and 
 the regulations which would be laid down for its administration. 
 The text of this explanation follows. 
 
 Corporation Excise Tax 
 
 PREPARATION OF BLANKS AND REGULATIONS 
 
 In the preparation of blanks and regulations for the administration 
 of the Corporation Excise Tax, provided for in section 38 of the tariff 
 act of August S, 1909, the first question was to ascertain the real intent 
 of the law. After ascertaining the real intent of the law, the problem was 
 then to so prepare the forms and regulations as to carry out that intent 
 and at the same time avoid, as far as consistent, unnecessary and un- 
 reasonable interference with ordinary practices of business. The standard 
 adopted in making the regulations was that they should be fair, just, and 
 reasonable to the taxpaying corporations as well as to the Government. 
 
CORPORATION TAX LAW 615 
 
 A study of the act discloses clearly that the intent of the law is as 
 follows : 
 
 1. That the law is a revenue measure and should be construed liberally 
 for the purpose of producing revenue for the Government. 
 
 2. That the real intent of the law is to collect a tax of l per cent on 
 the net income, less $5,000, of the individual corporation, joint stock com- 
 pany, or association, liable to the tax. 
 
 In order to clearly understand the intent of the law a few primary 
 definitions are essential: 
 
 NET INCOME 
 
 The term "net income" as used in this law means not only net profits 
 arising from the operation of the principal business of the corporation, 
 but all items of income received from other sources, such as investments, 
 holdings in other companies, and businesses, etc. The expression "net 
 income" is used because there can be no question as to its embracing 
 amounts of income received from these outside sources, whereas there 
 might be some question as to whether or not such items would be in- 
 cluded in the expression "net profits" or "net earnings." 
 
 GROSS INCOME 
 
 In the same manner the term "gross income" includes gross profits, 
 the expression being used because there can be no question but what it 
 embraces all items of income received by any corporation from any source, 
 while there might be some question as to whether "gross profits" or "gross 
 earnings" would embrace such items. 
 
 A great amount of adverse criticism of this law is due to misap- 
 prehension of the proper definitions of these terms. The opinion was 
 advanced that because "gross income" was not "gross profits" it must be 
 "gross receipts," and that, in the same way, because "net income" was not 
 "net profits," it meant "net receipts." An examination of the law, however, 
 will show that if gross income meant gross receipts, the statutory de- 
 ductions therefrom would not leave net receipts, but would leave merely 
 an arbitrary sum. It also appeared from calculations that if these in- 
 terpretations were given to the law from mercantile and manufacturing 
 companies alone, the amount of tax received would be many times the 
 sum which was estimated to be collected from all corporations, joint stock 
 companies, and associations of whatever nature. 
 
 It is clear, therefore, that the purpose of the law was not to put a tax 
 on receipts, but a tax on profits; and that the terms "gross income" and 
 "net income" are used because, while they are practically indentical with 
 "gross profits" and "net profits," they are yet more embrasive and conse- 
 quently permit a more comprehensive administration of the law. 
 
 The law requires that the return from every corporation, joint stock 
 company, and association liable to the tax shall show the "gross amount 
 of the income . . . received during the year from all sources," and au- 
 thorizes certain deductions such as "ordinary and necessary expenses 
 
6i6 AUDITING 
 
 actually paid out of earnings in the business and property of such cor- 
 porations . . . within the year; all losses sustained during the year; 
 amount of interest actually paid within the year; amount paid by it within 
 the year for taxes; amount received within the year as dividends upon 
 stock of other corporations liable to this tax, etc." 
 
 Very careful consideration has been given to these expressions in 
 order to determine what evidence shall be required in order to determine 
 what items are to be considered as "income" in calculating "gross income," 
 and what items should be allowed as deductions under the language of the 
 law. An impression has obtained in some quarters that no item should 
 be considered in making up the account of the corporation, either as in- 
 come or a deduction, unless its receipt or disbursement was evidenced by 
 an actual cash transaction. It was owing to this interpretation placed on 
 the law that a great number of accountants throughout the country de- 
 clared that the law was impossible of administration, and if their interpre- 
 tation of the law had been correct, there would indeed have been the most 
 serious difficulty. 
 
 Upon first reading the law and studying the authorities relating to the 
 language used, it would appear that the words admit of no interpreta- 
 tion other than that an item must have been evidenced by the actual dis- 
 bursement of cash, or something of equal value, before it could be con- 
 sidered in making up the account of a corporation. It is interesting to 
 note, however, that all definitions and decisions regarding the expression 
 "actually paid," consider the matter from the standpoint of debtor and 
 creditor, and not from the standpoint of the individual himself, or in this 
 case, from within a corporation concerned solely with its own accounts 
 from which alone the law requires this return for taxation to he made, and 
 not taking into consideration the standpoint of the debtor. 
 
 It is clear that to hold that the phrase "actually paid within the year" 
 requires evidence of actual disbursement in cash during the year would 
 prohibit anything like accurate returns being made by any corporation, and 
 would render it impossible to carry out what is the main purpose of the 
 law, because to subtract from the gross income the deductions specified 
 in the statute, calculated on a cash basis, would give net income, on which 
 the tax is to be measured, only when the entire business transacted by 
 the corporation is done in cash and the transactions are completed every 
 day. It is not believed that there is any such corporation in existence. The 
 return predicated on gross income received in cash and deductions rep- 
 resented by cash transactions, will vary from the real net income somewhat 
 in proportion as the business transacted by the corporation varies from the 
 absolutely cash basis. 
 
 This is viewing the matter in its simplest aspect. When we contem- 
 plate the complications and intricacies of the business affairs of a great 
 corporation, with its many dealings with other corporations and individuals 
 which are never settled in cash, but are settled on somewhat the clearing- 
 house plan; its many advances of funds and long-deferred statements of 
 accounts, purchases of supplies and materials at one time, which are mixed 
 
CORPORATION TAX LAW 617 
 
 with supplies and materials already on hand and those purchased at other 
 times, and which are used and disbursed without any relation to their time 
 of purchase, any attempt to follow each of these transactions out into the 
 cashbook and to settle the accounts of such complicated actions of a cor- 
 poration on the cashbook instead of on the ledger would result in inex- 
 tricable confusion, uncertainty, and inaccuracy, and the friction occasioned 
 the business world by such an attempt would be a very serious proposition. 
 
 Relating to statutory deductions, the regulation is to the effect that 
 the deductions authorized shall include all expense items under the various 
 heads acknowledged as liabilities by the corporation making the return 
 and entered as such on its books from January i to December 31 of the 
 year for which return is made. It will appear, therefore, that the return 
 is to be made up from the ledger and not the cash book, and that entry 
 on the ledger from January i to December 31 of the year for which return 
 is made is the evidence which will determine whether or not an item is 
 to be taken account of in making the return. 
 
 It is believed that this 'interpretation furnishes a practical working 
 method by which the amount of income subject to the tax can be fairly 
 and justly determined in every case. 
 
 Of course, in administering a law applying to so many taxpayers (lists 
 prepared by collectors show something over 400,000 corporations which will 
 have to make returns) some of the returns will be inaccurate. The causes 
 of inaccuracy will be two : First, honest error ; Second, willful intent to de- 
 fraud the Government of revenue. If an honest error is made in calculat- 
 ing the return for one year, it will be corrected if possible, and even if 
 not corrected in one year, it would more than probably correct itself later. 
 Where fraudulent purpose is discovered, vigorous prosecution will follow. 
 This bureau feels that in dealing with the incorporated business of the 
 country it is dealing, in the main, with honest men. However, the regula- 
 tions are drawn sufficiently rigid to restrain anyone who does not measure 
 up to this standard. 
 
 The regulations do not call for specific methods of keeping accounts 
 or any particular method of bookkeeping; the requirement is simply that 
 the transaction be so recorded that accurate returns can be made there- 
 from and verified when necessary. 
 
 In many corporations, mercantile and manufacturing particularly, an 
 inventory, or its equivalent, is essential at the close of each calendar year. 
 The law specifically states that the tax shall be collected for the calendar 
 year, and no return for any other period can be accepted. Provision is, 
 however, made for preparing returns for the present year, when no in- 
 ventory or equivalent was taken at close of last calendar year. Provision 
 is made for a method of fairly determining amount of loss and depreciation 
 claimed; also for a fair adjustment of profit or loss in case of sale of 
 capital assets acquired prior to January I, 1909; also for properly accounting 
 for materials and supplies, etc. 
 
 Great numbers of communications have been received relative to the 
 publicity clause. While there is apparently some inconsistency between 
 
6i8 AUDITING 
 
 the two paragraphs of the law relating to making public the information 
 received, the language of the law relating to filing returns for record and 
 public inspection is so clear that the Bureau of Internal Revenue has no 
 discretion whatever in the matter. 
 
 The forms and regulations will go to the collector of each district, 
 who will send copies of the blanks and a copy of the regulations to every 
 corporation whose name and address the collector has been able to secure. 
 Failure to receive the blanks or any notice relative thereto will not excuse 
 a corporation from making the return required by law, nor will it relieve 
 it from penalties for failure so to do. If copies of blanks and regulations 
 are not received on or about January i, application should be made to 
 the collector in whose district the principal office of the corporation is lo- 
 cated, so that the return can be in the hands of the collector by the time 
 required in the statute. 
 
 The regulations issued by the Commissioner of Internal 
 Revenue are as follows : 
 
 REGULATIONS 
 
 Relative to 
 
 Excise Tax on Corporations, Joint Stock Companies, Associations and 
 
 Insurance Companies. 
 
 Imposed by authority of Section 38, Act of August S. ipoP- 
 
 Article I 
 
 The attention of collectors and others is specially called to the fact that 
 the tax imposed by this section of the law applies to all corporations, 
 joint stock companies, associations, or insurance companies described (ex- 
 cept those specifically exempted), without reference to the kind of business 
 carried on, and that the tax is to be computed upon the net income of 
 such corporations, joint stock companies, associations, and insurance com- 
 panies, which shall be calculated by subtracting from the gross income re- 
 ceived from all sources during the year certain deductions specifically set 
 forth in the statute. 
 
 Every corporation, joint stock company, association, or insurance com- 
 pany not specifically enumerated as exempt shall make the return required 
 by law, whether it may have net income liable to tax or not. 
 
 In the case of corporations, joint stock companies, associations, or in- 
 surance companies organized under the authority of the United States 
 or any State or Territory thereof, including Alaska and District of Columbia, 
 such net income relates not only to the business carried on within the con- 
 fines of the United States, but to income received from business trans- 
 acted in any foreign country as well. In case of corporations, joint stock 
 companies, and associations organized under the authority of foreign coun- 
 tries, the terms "Gross income," "Net income," and "Authorized deductions" 
 relate only to business transacted within the United States or any State or 
 Territory thereof. 
 
CORPORATION TAX LAW 619 
 
 Article II. — Gross Income 
 
 The following definitions and rules are given for determining the 
 gross income of the various classes of corporations: 
 
 I A. Banks and other financial institutio'ns. — Gross income consists of 
 the gross revenue derived from the operation and management of the busi- 
 ness and property of the corporation making the return, together with all 
 amounts of income (including dividends received on stock of other cor- 
 porations, joint stock companies, associations, and insurance companies 
 subject to this tax) derived from all other sources, as shown by the entries 
 on its book^ from January i to December 31 of the year for which return 
 is made. 
 
 I B. Insurance compainies. — Same as i A above. 
 
 2. Transportation companies. — Same as i A above. 
 
 3. Manufacturing companies. — Gross income received during the year 
 from all sources will consist of the total amount, ascertained through an 
 accounting, that shows the difference between the price received for the 
 goods as sold and the cost of such goods as manufactured. The cost of 
 goods manufactured shall be ascertained by an addition of a charge to 
 the account of the cost of goods as manufactured during the year of the 
 sum of the inventory at beginning of the year and a credit to the account 
 of the sum of the inventory at the end of the year. To this amount 
 should be added all items of income received during the year from other 
 sources, including dividends received on stock of other corporations, joint 
 stock companies, associations, and insurance companies subject to this tax. 
 In the determination of the cost of goods manufactured and sold as above 
 such cost shall comprehend all charges for maintenance and operation of 
 manufacturing plant, but shall not embrace allowances for depreciation of 
 property nor for losses sustained which are to be taken account of in ascer- 
 taining the net income subject to tax under the proper heading in the 
 authorized deductions. 
 
 4. Mercantile companies. — Gross amount of income received during 
 the year from all sources consists of the total amount ascertained through 
 inventory, or its equivalent, which shows the difference between the price 
 received for goods sold and the cost of goods purchased during the year, 
 with an addition of a charge to the account of the sum of the inventory at 
 beginning of the year and a credit to the account of the sum of the in- 
 ventory at the end of the year. To this amount should be added all items 
 of income received during the year from other sources inclusive of divi- 
 dends received on stock of other corporations, joint stock companies, as- 
 sociations, and insurance companies subject to this tax. In determining 
 this amount no account shall be taken of allowances for depreciation of 
 property, nor for losses sustained which are to be taken account of in as- 
 certaining the net income subject to tax under the proper heading in the 
 authorized deductions. 
 
 5. Miscellaneous. — Gross income consists of the gross revenue de- 
 rived from the operation and management of the business and property 
 
620 AUDITING 
 
 of the corporation making the return, together with all amounts of income 
 (including dividends received on stock of other corporations, joint stock 
 companies, associations, and insurance companies subject to this tax) de- 
 rived from all other sources as shown by the entries on the books from 
 January i to December 31 of the year for which return is made. 
 
 It will be noted from these definitions that gross income is practically 
 the same as gross profits, the only difference being that gross income is 
 more inclusive, embracing as it does not only gross profits of the cor- 
 poration, joint stock company and association itself, but also all amounts 
 of income received from other sources. It is immaterial whether any item 
 of gross income is evidenced by cash receipts during the year or in such 
 other manner as to entitle it to proper entry on the books of the cor- 
 poration from January i to December 31 for the year in which return is 
 made. 
 
 Sale of capital assets. — In ascertaining income derived from the sale 
 of capital^ assets, if the assets were acquired subsequent to January I, 
 igog, the difference between the selling price and the buying price shall 
 constitute an item of gross income to be added to or subtracted from gross 
 income according to whether the selling price was greater or less than 
 the buying price. If the capital assets were acquired prior to January i, 
 1909, the amount of increment or depreciation representing the difference 
 between the selling and buying price is to be adjusted so as to fairly de- 
 termine the proportion of the loss or gain arising subsequent to January 
 I, 1909, and which proportion shall be deducted from or added to the 
 gross income for the year in which the sale was made. But for the 
 purpose of determining the selling price, as provided in this section, there 
 shall be added to the price actually realized on sale any amount which 
 has already been set aside and deducted from gross income by way of 
 depreciation as defined in article 4, and has not been paid out in making 
 good such depreciation on the property sold. 
 
 Where a corporation is engaged in carrying on more than one class 
 of business, gross income derived from the different classes of business 
 shall be ascertained according to the definitions above, applicable thereto. 
 
 Article III. — Net Income 
 "Net income shall be ascertained by deducting from the gross amount 
 of the income of such corporation, joint stock company or association, or 
 insurance company, received within the year from all sources, (first) all 
 the ordinary and necessary expenses actually paid within the year out of 
 income in the maintenance and operation of its business and properties, 
 including all charges such as rentals or franchise payments required to be 
 made as a condition to the continued use or possession of property; (sec- 
 ond) all losses actually sustained within the year and not compensated 
 by insurance or otherwise, including a reasonable allowance for deprecia- 
 tion of property, if any, and in the case of insurance companies the sums 
 other than dividends, paid within the year on policy and annuity con- 
 tracts and the net addition, if any, required by law to be made within 
 
CORPORATION TAX LAW 621 
 
 the year to reserve funds; (third) interest actually paid within the year 
 on its bonded or other indebtedness to an amount of such bonded and other 
 indebtedness not exceeding the paid-up capital stock of such corporation, 
 joint stock company or association, or insurance company, outstanding 
 at the close of the year, and in the case of a bank, banking association, 
 or trust company, all interest actually paid by it within the year on de- 
 posits." In case of corporations, joint stock companies, and associations 
 organized under the laws of a foreign country, "the proportion of its 
 paid-up capital stock outstanding at the close of the year which the gross 
 amount of its income for the year from business transacted and capital 
 invested within the United States and any of its Territories, Alaska, and 
 the District of Columbia, bears to the gross amount of its income de- 
 rived from all sources within and without the United States; (fourth) 
 all sums paid by it within the year for taxes imposed under the authority 
 of the United States or of any State or Territory thereof, or imposed 
 by the government of any foreign country as a condition to carrying on 
 business therein; (fifth) all amounts received by it within the year as 
 dividend upon stock of other corporations, joint stock companies or as- 
 sociations, or insurance companies, subject to the tax hereby imposed." 
 
 The section further provides : 
 
 That in the case of a corporation, joint stock company, or association, 
 or insurance company, organized under the laws of a foreign country, such 
 net income shall be ascertained (by making like deductions) from the 
 gross amount of its income received within the year from business trans- 
 acted and its capital invested within the United States and any of its 
 Territories, Alaska, and the District of Columbia. 
 
 Also that: 
 
 In the case of assessment insurance companies the actual deposit of 
 suras with state or territorial officers, pursuant to law, as additions to 
 guaranty or reserve fund, shall be treated as being payments required by 
 law to reserve fund. 
 
 Also (third paragraph) that: 
 
 There shall be deducted from the amount of the net income of each 
 of such corporations, joint stock companies, or associations, or insurance 
 companies, ascertained as provided in the foregoing paragraphs of this 
 section, the sum of five thousand dollars. 
 
 The net income, therefore, is the remainder of the gross income after 
 making the specified deductions. 
 
 Article IV. — Deductions 
 The specified deductions actually paid within the year, set forth in the 
 statute and as described in Article III preceding, shall include all proper 
 items of expenses and charges under the respective heads as designated. 
 The amount returned for ordinary and necessary expenses actually paid 
 within the year out of 'income in maintenance and operation of the busi- 
 ness and properties of the corporation should not, however, embrace al- 
 lowances for depreciation of fixed property which are otherwise to be 
 
622 AUDITING 
 
 taken account of under the proper heading in the authorized deductions, 
 nor expenses paid within the year and charged to such allowances for 
 depreciation credited in the current year or in previous years. In ascer- 
 taining expenses proper to be included in the deductions to be made 
 under this article, corporations carrying materials and supplies on hand 
 for use should include in such expenses the charges for materials and 
 supplies only to the amount that the same are actually disbursed and 
 used in operation and maintenance during the year for which the return 
 is made. 
 
 It is immaterial whether the deductions are evidenced by actual dis- 
 bursements in cash, or whether evidenced in such other way as to be 
 properly acknowledged by the corporate officers and so entered on the 
 books as to constitute a liability against the assets of the corporation, joint 
 stock company, association, or insurance company making the return. 
 
 Losses. — ^The deduction for losses must be in respect of losses actually 
 sustained during the year and not compensated by insurance or otherwise. 
 It must be based upon the difference between the cost value and salvage 
 value of the property or assets, including in the latter value such amount, 
 if any, as has in the current or previous years been set aside and de- 
 ducted from gross income by way of depreciation as defined in the follow- 
 ing section and not been paid out in making good such depreciation. 
 
 Depreciation. — The deduction for depreciation should be the estimated 
 amount of the loss, accrued during the year to which the return relates, in 
 the value of the property in respect of which such deduction is claimed 
 that arises from exhaustion, wear and tear, or obsolescence out of the 
 uses to which the property is put, and which loss has not been made good 
 by payments for ordinary maintenance and repairs deducted under the 
 heading of expenses of maintenance and operation or in the ascertainment 
 of gross income. This estimate should be formed upon the assumed life 
 of the property, its cost value, and its use. Expenses paid in any one 
 year in making good exhaustion, wear and tear, or obsolescence in re- 
 spect of which any deduction for depreciation is claimed, must not be 
 included in the deduction for expense of maintenance and operation of 
 the property or in the ascertainment of gross income, but must be made 
 out of accumulative allowances deducted for depreciation in current and 
 previous years. 
 
 Article V. — Inventories 
 
 It will be noted that an, inventory or its equivalent of materials, 
 supplies, and merchandise on hand for use or sale at the close of each 
 calendar year is essential in the case of certain corporations in order to 
 determine the gross income, and in case of other corporations to determine 
 their expenses of operation. Where such inventory or its equivalent was 
 not taken at the close of the year 1908, a supplemental statement showing 
 such inventory approximately must be submitted with the return on the 
 regular form. Such supplemental statement shall be verified under oath 
 by the treasurer or principal financial officer in submitting the same. 
 
CORPORATION TAX LAW 623 
 
 Where any item under any of the deductions is of an unusual nature, 
 a special explanatory note referring to such item shall be made and at- 
 tached to the form at the appropriate place and made a part thereof by 
 proper reference. 
 
 Paragraph 3 of said section 38 also provides: 
 
 And said tax shall be computed upon the remainder of said net income 
 of such corporation, joint stock company or association, or insurance com- 
 pany, for the year ending December thirty-first, nineteen hundred and 
 nine,* and for each calendar year thereafter; and on or before the first 
 day of March, nineteen hundred and ten, and the first day of March in 
 each year thereafter, a true and accurate return under oath or affirmation 
 of its president, vice-president, or other principal officer, and its treasurer 
 or assistant treasurer, shall be made by each of the corporations, joint 
 stock companies or associations, and insurance companies, subject to the 
 tax imposed by this section, to the collector of internal revenue for the 
 district in which such corporation, joint stock company or association, or 
 insurance company, has its principal place of business, or, in the case of 
 a corporation, joint stock company or association, or insurance company, 
 organized under the laws of a foreign country, in the place where its 
 principal business is carried on within the United States, in such form 
 as the Commissioner of Internal Revenue, with the approval of the Sec- 
 retary of the Treasury, shall prescribe. 
 
 Each return so made is required to set forth: 
 
 (a) The total amount of the paid-up capital sfock of such corpora- 
 tions, joint stock companies or associations, or insurance companies, out- 
 standing at the close of the year; 
 
 (6) The total amount of bonded and other indebtedness of such 
 corporation, joint stock company or association, or insurance company, 
 at the close of the year; 
 
 (c) The gross amount of the income of such corporation, joint stock 
 company or association, or insurance company, received during the year 
 from all sources, and if organized under the laws of a foreign country, 
 the gross amount of its income received within the year from business 
 transacted and capital invested within the United States and any of its 
 Territories, Alaska, and the District of Columbia. 
 
 Such returns are also required to set forth the items claimed as 
 deductions (Article IV), also the net income after such deductions have 
 been made. 
 
 Article VI 
 
 Under the authority conferred by this act forms of returns have been 
 prescribed, in which the various items specified in the law are to be stated. 
 
 Blank forms of this return will be mailed to collectors and should 
 be furnished to every corporation, not expressly excepted, on or before 
 January I, 1910, and on or before January I of each year thereafter. 
 Failure on the part of any corporation, joint stock company, association, 
 or insurance company liable to this tax to receive a blank form will not 
 
624 AUDITING 
 
 excuse it from making the return required by law, or relieve it from 
 any penalties for failure to make the return in the prescribed time. Cor- 
 porations not supplied with the proper forms for making the return should 
 make application therefor to the collector of internal revenue in whose 
 district is located its principal place of business. Each corporation should 
 carefully prepare its return so as to fully and clearly set forth the data 
 therein called for. 
 
 Bookkeeping. — No particular system of bookkeeping or accounting will 
 be required by the Department. However, the business transacted by- cor- 
 porations, joint stock companies, associations, or insurance companies must 
 be so recorded that each and every item therein set forth may be readily 
 verified by an examination of the books and accounts, where such examina- 
 tion is deemed necessary. 
 
 Calendar year. — ^As the law specifically provides that the tax imposed 
 shall be computed on the net income during each "calendar year" returns 
 of income based on any period other than the calendar year cannot be 
 accepted. 
 
 Corporations organized during the year or going into liquidation dur- 
 ing the year should nevertheless render a sworn return on the prescribed 
 
 form. „ T, ^ _ . . 
 
 . . . Royal E. Cabeix, Commissioner. 
 
 Franklin MacVeagh, 
 
 Secretary of the Treasury. 
 
 Since the date .of the explanation given above, the Treasury 
 Department has been called upon to render decisions on various 
 questions not fully elucidated before. These decisions have been 
 gathered in a synopsis issued by the Commissioner of Internal 
 Revenue under date of December 5, 191 1, of which the text is 
 given below, with the exception of paragraphs 83-94, inclusive, 
 and 96 to the end, which are quoted earlier in this volume in 
 Chapter XXII, "The Corporation Tax Law and Depreciation." 
 
 Classes of Corporations, etc., Subject to Tax 
 
 1. The tax imposed by the act applies to all corporations, joint stock 
 companies, and associations, and every insurance company except those 
 specifically exempted, without reference to the kind of business carried on. 
 
 2. Every corporation, etc., not specifically enumerated as exempt shall 
 make the return required by law, although its net income during the year may 
 not have exceeded $S,ooo. (Opinion Attorney-General, January 24, 1910.) 
 
 3. Corporations claiming special exemption should nevertheless make 
 return (in blank, if desired), accompanied by a statement setting forth 
 the ground on which exemption, is claimed. Failure to receive blanks 
 upon which to make return is no excuse for delinquency in making re- 
 turn, as there is no duty imposed upon the Government to furnish cor- 
 porations with such blanks. 
 
CORPORATION TAX LAW 625 
 
 4. Charitable institutions supported by voluntary contributions or State 
 appropriations are held to be exempt from the payment of the special 
 excise tax on corporations, but should file a return in blank as provided 
 in paragraph 3 hereof. 
 
 5. Corporations, etc., organized during the year or going into liquidation 
 during the year should nevertheless render a sworn return on the pre- 
 scribed form. The tax imposed, however, does not apply to corporations 
 which went out of existence prior to the passage of the act (August S, 1909). 
 
 6. Where company has dissolved and the required return is not made 
 by its officers, such return will be prepared by Commissioner. (T. D., 
 1736.) 
 
 7. Where corporation has gone into bankruptcy, returns in such cases 
 to be made by trustee in bankruptcy. 
 
 8. Railroad companies operating leased or purchased lines to include 
 all receipts derived therefrom, and if bonded indebtedness has been as- 
 sumed, may deduct interest thereon to an amount not exceeding its own 
 paid-up capital stock. If such subsidiary companies receive income in the 
 way of rentals, etc., return to be also made by such companies. 
 
 9. Corporations, etc., organized under the authority of the United 
 States or any State or Territory thereof, or Alaska, or the District of 
 Columbia, to include in their returns not only the income derived from 
 the business carried on within the confines of the United States, but in- 
 come received from business transacted in any foreign country as well. 
 
 10. Corporations having branch or subsidiary companies to include in 
 their returns the income of all such companies when no distinction is made 
 in operating and accounting by reason of the separate incorporation of 
 such subsidiary companies; otherwise a return by each corporation should 
 be made. 
 
 11. Foreign companies having several branch offices in the United States 
 should each designate one of such branches as its principal office and 
 should also designate the proper officers to make the required return. 
 
 12. Where a consolidation of two or more corporations has been ef- 
 fected during the year, and each or any such corporation subsequent to 
 such consolidation collects prior existing debts, each such corporation 
 should make separate return and include therein all such collected debts, 
 as also all income received during the year prior to the date of con- 
 solidation. 
 
 13. "Principal place of business" is held to mean the principal office 
 where the company keeps its books, from which the required return is 
 to be prepared, and not necessarily the place where the operating plant 
 is located. 
 
 14. As the law specifically provides that the tax imposed shall be 
 computed on the net income during each calendar year, returns of income 
 based on any period other than the calendar year cannot be accepted. 
 
 15. Full amount of stock, as represented by the par value of the shares 
 issued, to be regarded as the paid-up capital stock, except when such 
 stock is assessable on account of deferred payments, in which case the 
 
626 AUDITING 
 
 amount actually paid on such shares will constitute the actual paid-up 
 capital stock of the corporation. 
 
 i6. Capital stock held to include both preferred and common stock. 
 
 17. Surplus and undivided profits not to be included in capital stock. 
 
 18. Holding companies known as "voting trusts," receiving only divi- 
 dends on stock held, and having no capital stock, etc., not liable. 
 
 19. Mutual savings banks having no capital stock not liable to tax 
 imposed. (Opinion Attorney-General, February 14, 1910.) 
 
 20. Cooperative dairies not issuing stock and allowing patrons dividends 
 based on butter fat in milk furnished not liable. 
 
 21. Foreign steamship companies having no office in the United States, 
 whose vessels only occasionally touch at ports in the United States, not 
 regarded as doing business in this country within the meaning of the 
 statute. 
 
 22. Companies organized in Porto Rico and not engaged in business 
 in the United States not subject to tax. 
 
 23. Corporations owning sugar or other plantations and disposing of 
 the products thereof not entitled to exemption as agricultural organizations. 
 
 24. Corporations organized to sell provisions, etc., to stockholders and 
 others not exempted. 
 
 23. Corporations organized for the purpose of holding real estate to 
 make return of income derived from the property so held. 
 
 26. Corporations going into liquidation during any tax period may, 
 at the time of such liquidation, prepare a "final return" covering the busi- 
 ness done during the fractional part of the year during which they were 
 engaged in business, and immediately file the same with the collector of 
 the district in which the corporation has its principal place of business. 
 
 27. Corporations organized for the purpose of insuring against death, 
 or injury by accident, or against damage to property by hail, storm, or 
 lightning, however maintained, are held to be insurance companies, and 
 unless they may be properly classed as "fraternal beneficiary organizations 
 operating under the lodge system," must make returns of annual net in- 
 come. (T. D., 1738.) 
 
 28. Corporations engaged in agricultural or horticultural pursuits for 
 profit are liable under the law to make returns and to pay the special ex- 
 cise tax thereby shown to be due. Agricultural and horticultural associa- 
 tions specifically enumerated as exempt are held to be such associations 
 as county fairs or like organizations, not themselves engaged in such pur- 
 suits, but which, by means of awards, etc., are intended to encourage better 
 production, and no part of whose net income inures to the benefit of any 
 private stockholder or individual. (T. D., 1737.) 
 
 29. Fruit growers' associations whose purpose is to promote the mutual 
 benefit of their members in growing, harvesting, and marketing their 
 products, and which are not organized for profit and have no capital 
 stock represented by shares, and whose income is derived wholly from 
 membership fees, dues, and assessments to meet necessary expenses, are 
 not liable. 
 
CORPORATION TAX LAW 627 
 
 30. Corporations engaged in growing fruits, vegetables, and the like 
 products for profit, and distributing such profits among their members 
 on the basis of the capital invested, are liable and must make returns and 
 pay taxes, if any are found to be due. (T. D., 1737.) 
 
 31. Associations or trusts voluntarily formed by parties at interest and 
 not organized "under the laws of the United States or of any State or 
 Territory thereof, or of the laws applicable to the District of Columbia or 
 Alaska," are not corporations within the meaning and intent of the 
 law, and are not liable. (United States Supreme Court opinion in Amory 
 Eliot V. James G. Freeman, et al., No. 448.) 
 
 32. National banks do not come within any of the exemptions named 
 in the act. 
 
 33. "Agricultural organizations" held not to come within the statutory 
 exemption, unless their chief object is the promotion or advancement of 
 agricultural interest, and no part of the net income inures to the benefit 
 of their stockholders. 
 
 34. Mutual Hall Association regarded as an insurance company and 
 not as an agricultural association, and therefore liable to tax. 
 
 35. Exemption in favor of fraternal beneficiary associations does not 
 apply to mutual fire insurance companies. 
 
 36. Limited partnerships, if organized for profit and having a capital 
 stock represented by shares, although no "certificates of stock" are issued, 
 are liable to the tax imposed. (Opinion Attorney-General, February 14, 
 1910.) 
 
 Zy. Interest received on Government bonds to be included in gross in- 
 come. (Opinion Attorney-General, January 13, 1910.) 
 
 38. Returns should be signed and verified by two of the officers desig- 
 nated in the law. Signing of one person holding two such offices not 
 permitted. Agents for foreign steamship companies may sign the re- 
 quired returns if so authorized by their companies. 
 
 39. Returns not required to have corporate seal affixed. 
 
 40. Returns filed with deputy collector regarded as having been filed 
 with collector. 
 
 41. No form of protest prescribed. Any form of protest sufficient if 
 filed before payment of tax. Right of protest not to be denied. 
 
 Inventories, Accounts, etc. 
 
 42. Where an inventory or its equivalent was not taken at the close 
 of the year 1908, a supplemental statement showing such inventory ap- 
 proximately must be submitted with the return on the regular form. Such 
 supplemental statement shall be verified under oath by the treasurer or 
 principal financial officer submitting the same. (T. D., 1578.) 
 
 43. Profits realized on sale of real estate during the year, also increase 
 in value of unsold property, if taken up on the books of the corporation, 
 to be included in income. 
 
 44. Cost of manufactured articles, or articles in process of manufacture, 
 held to include original cost of materials used, plus cost of labor, etc. 
 
628 AUDITING 
 
 45. Mortgaged real estate should be inventoried at its full value and 
 amount of mortgage reported as indebtedness. 
 
 46. Receipts from sale of patent rights to be included in income. 
 
 47. No particular system of bookkeeping or accounting will be re- 
 quired by the department. However, the business transacted by corpora- 
 tions, etc., must be so recorded that each and every item therein set forth 
 may be readily verified by an examination of the books and accounts where 
 such examination is deemed necessary. 
 
 48. Any increase in the value of the capital assets, as determined by 
 a physical revaluation and taken cognizance of by the corporation in book 
 entries, is gain, and must be accounted for as income for the year in which 
 such increase is so recognized and recorded. 
 
 Deductions, Expenses, etc. 
 
 49. It is immaterial whether the deductions are evidenced by actual 
 disbursements in cash or whether evidenced in such other way as to be 
 properly acknowledged by the corporate officers and so entered on the books 
 as to constitute a liability against the assets of the corporation, etc., making 
 the return. 
 
 50. Mortgage indebtedness on real estate, if assumed by the corpora- 
 tion acquiring such real estate, to be included in the indebtedness of the 
 corporation. But if not so assumed and remains only as a lien on the 
 property, interest paid thereon may be deducted as a charge "made as 
 a condition to the continued use or possession of the property." (Opinion 
 Attorney-General, February 21, 1910.) 
 
 51. Cost of erecting building, if included in lease under which property 
 is held by company, is a proper deduction, to be prorated according to 
 time fixed by lease. 
 
 52. General expenses, such as coal, ship stores, etc., of foreign steam- 
 ship companies, to be prorated as provided in act for interest deductions. 
 
 53. Amount received by nursery companies from sales of trees, etc., 
 less amount expended for seedlings and young trees, to be included in 
 gross income. Amount expended for labor, salesmen, etc., to be deducted as 
 expenses. 
 
 54. Commissions allowed salesmen, paid in stock, may be deducted as 
 expense if so charged on books. 
 
 SS- Sales of stock and bonds are regarded as sales of capital assets 
 and should be so accounted for. (Art. 11, Reg. 31.) But proceeds derived 
 from sale of bonds used in defraying ordinary and necessary expenses are 
 a proper deduction in determining the company's net income. 
 
 56. Stock issued in payment of property purchased represents capital 
 investments and notes issued during the year represent indebtedness. 
 Corporate funds applied to the payment of outstanding notes not a proper 
 deduction in ascertaining net income. 
 
 57. Amounts expended in additions and betterments which constitute 
 an increase in capital investment not a proper deduction. 
 
CORPORATION TAX LAW 629 
 
 58. Dividends received by corporations on stock of other corporations 
 whose net income does not exceed $5,000 is nevertheless a proper deduction 
 under the law. (Opinion Attorney-General, January 24, 1910.) 
 
 59. Dividends received on stock of foreign corporations not subject to 
 tax not a proper deduction. 
 
 60. Dividends paid employees in lieu of wages not proper deduction as 
 expenses. 
 
 61. Royalties on patent rights to be reported as income. Allowance 
 for depreciation of patents expiring during year, however, will be al- 
 lowed. 
 
 62. In the case of lands bought prior to January i, 1909, and sold 
 during any subsequent year, the profits arising from such sale, if no ac- 
 counting of increased value of land was made in returns for previous 
 years, should be prorated in accordance with the number of years the land 
 was held by the corporation and the number of years the law was in 
 effect. 
 
 63. Banks paying taxes assessed against their stockholders because of 
 their ownership of the shares of stock issued by such bank cannot deduct 
 the amount of tax so paid in making their return for the special excise 
 tax on corporations. 
 
 64. Amounts paid for pensions to retired employees, or to their families 
 or ofhers dependent upon them, or on account of injuries received by em- 
 ployees, are proper deductions as "ordinary and necessary expenses"; gifts 
 or gratuities to employees in the service of a corporation are not properly 
 deductible in ascertaining net income. Donations made for purposes con- 
 nected with the operation of the property, when limited to charitable in- 
 stitutions, hospitals, or educational institutions, conducted for the benefit 
 of its employees, or their dependents, shall be proper as a deduction under 
 the same head. 
 
 65. Where allowances on account of salaries are deemed excessive 
 and for the purpose of evading the tax due, investigation will be made, 
 and if the facts warrant, prosecution will follow. 
 
 66. Interest paid on time deposits and deposits subject to check con- 
 stitutes a proper deduction from the amount of gross income during the 
 year. 
 
 67. Interest on portions of bonded or other indebtedness bearing dif- 
 ferent rates of interest may be deducted from gross income during the 
 year, provided the aggregate amount of such indebtedness does not ex- 
 ceed the paid-up capital stock of the corporation. 
 
 68. Interest paid during the year on notes given prior to January i, 
 1909, to be prorated. But interest on notes given in 1909, and payable 
 subsequent to December, 1909, unless charged on the company's books, 
 is not a proper deduction from the income of that year. 
 
 69. Interest, taxes, or other items allowable as deductions, accruing 
 prior to January i, 1909, are not allowable deductions from the gross 
 income of years subsequent thereto. 
 
 70. Unearned premiums set aside by insurance companies as reserve 
 
630 AUDITING 
 
 not to be included as income until earned, unless the same shall be entered 
 on the ledger as income during the year in which received. 
 
 71. Funds set aside by company for insuring their own property not 
 a proper deduction. 
 
 72. As the tax imposed is measured by and is not a tax upon the 
 net receipts of corporations, etc., interest received during the year on 
 Government bonds is not a proper deduction from such income in de- 
 termining the amount of tax due. (Opinion Attorney-General, T. D., 
 
 1583.) 
 
 73. State, county, or municipal taxes paid during the year a proper 
 deduction in ascertaining the net income of corporations. 
 
 74. Import duties or taxes, if included in arriving at cost of goods, 
 are not deductible under the head of taxes paid during the year. 
 
 75. Bad debts, if so charged off the company's books during the year, 
 are proper deductions. But such debts, if subsequently collected, must 
 be treated as income. 
 
 76. The net addition to reserves of insurance companies, required by 
 law, may be based on the highest amount of reserves required by any 
 State in which the insurance company does business. (T. D., 1727.) 
 
 77. Reserves for taxes cannot be allowed, as the law specifically pro- 
 vides that only such sums as are paid within the year for taxes can be 
 deducted. (T. D., 1727.) 
 
 78. Where a corporation or insurance company holds bonds which 
 were purchased at a rate above par, and a proportionate deduction of the 
 value of such bonds is made on its books each year so that the book value 
 shall be the redemption value of the bonds when they become due and 
 payable, the return of annual net income may show the depreciation on 
 account of amortization of such bonds. (T. D., 1727.) 
 
 79. Dividends declared by insurance companies are not deductible from 
 gross income under the guise of rebates or otherwise, and such dividends, 
 when applied to the payment of renewal premiums, or to shorten the en- 
 dowment or premium-paying period, or applied to purchase paid-up addi- 
 tions and annuities, must be considered and accounted for as income. 
 
 80. Railroad or other corporations which have leased their properties 
 in consideration of a rental equivalent to a certain rate of interest on its 
 outstanding capital stock and the interest on the bonded indebtedness, and 
 such rental is paid by the lessee directly to the stock and bondholders, 
 should, nevertheless, make a return of annual net income showing the 
 rental so paid as having been received by the corporation. 
 
 81. Salaries paid to an officer who is a stockholder, to constitute an 
 allowable deduction, must be a reasonable and fair compensation for the 
 services rendered, regardless of the amount of stock which such officer 
 may hold, and must have been authorized by the board of directors and 
 made a matter of record on the minute books of the corporation. 
 
 82. "Good Will" represents the value attached to a business over and 
 above the value of the physical property, and is such an entirely intangible 
 asset that no claim for depreciation in connection therewith can be allowed. 
 
CORPORATION TAX LAW 631 
 
 Publicity 
 
 95. A person who as trustee or in any other fiduciary relation has the 
 ownership or possessory right to stock in a corporation is a stockholder 
 in such corporation within the equity of the rule set down in Treasury 
 Decision No. 1665, governing the publicity of returns. (Opinion Attorney- 
 General, December 2T, 1910.) 
 
 . Few decisions have been rendered since the date of the syn- 
 opsis above given. Among the decisions since rendered w^as one 
 to the eifect that "Dividends declared by Insurance Companies 
 are the dividends referred to in section 38, act of August 5, 1909, 
 as not being deductible from gross income, and when such 
 dividends are applied to the payment of renewal premiums to 
 shorten the endowment or premium-paying period, to purchase 
 paid-up additions and annuities, etc., they must be included and 
 accounted for as income." 
 
 Two special decisions relative to the rate of depletion of 
 deposits and the return of cash investments to corporations with 
 respect to natural gas and petroleum properties have been ren- 
 dered. These two decisions are numbered T. D. 1,754 and 1,755, 
 respectively. 
 
 One of the most undesirable features of the corporation tax 
 law is that it requires all corporations, irrespective of their con- 
 venience or preexisting fiscal arrangements, to make their re- 
 turns and inventories as of December 31st of each year. With 
 the object of securing relief from the burden which is thus 
 unnecessarily put upon the shoulders of the tax payer, the 
 American Association of Public Accountants has been waging a 
 campaign to secure the passage of an amending bill which will 
 permit returns to be made as of the end of each individual fiscal 
 year. Many of the leading commercial and industrial bodies of 
 the country have indorsed the proposal and various bills have 
 been introduced in the House of Representatives and the Senate 
 with the object of bringing about the much-needed reform. 
 
 The Treasury Department itself, which for a long time was 
 opposed to the adoption of the fiscal year instead of the calendar 
 year, has now been converted, and at a hearing before the Ways 
 and Means Committee of the House on January 10, 1912, the 
 Commissioner of Internal Revenue stated that it was the opinion 
 of the Treasury Department that the law should be changed. 
 
632 AUDITING 
 
 PARTNERSHIP AND INDIVIDUAL EXCISE TAX 
 
 The following is the text of the bill introduced in the last 
 session of Congress, which extends the excise tax on met profits 
 to firms and individuals. Congress adjourned August 26, 1912, 
 without enacting the bill into law, but the same or a somewhat 
 similar measure may confidently be expected to become law 
 within the near future. 
 
 AN ACT 
 
 To extend the special excise tax now levied with respect to doing 
 business by corporations, to persons, and to provide revenue for the Gov- 
 ernment by levying a special excise tax with respect to doing business by 
 individuals and copartnerships. 
 
 Be it enacted by the Senate and House of Representatives of the 
 United States of America in Congress assembled. That every person, 
 firm, or copartnership residing in the United States, any Territory thereof, 
 or in Alaska or the District of Columbia, shall be subject to pay annually 
 a special excise tax with respect to the carrying on or doing business by 
 such person equivalent to one per centum upon the entire net income over 
 and above five thousand dollars received by such person from all sources 
 during each year; or, if a nonresident, such nonresident person shall like- 
 wise be subject to pay annually a special excise tax with respect to the 
 carrying on or doing business by such person equivalent to one per centum 
 upon the amount of net income over and above five thousand dollars re- 
 ceived by such person from business transacted and capital invested within 
 the United States and its Territories, Alaska, and the District of Columbia 
 during each year. The term "business,"' as herein used, is and shall be 
 held to embrace everything about which a person can be employed, and all 
 activities which occupy the time, attention, and labor of persons for the 
 purpose of a livelihood or profit. The word "person" wherever used in 
 this Act shall be held to include natural persons or individuals and firms 
 or copartnerships. 
 
 Sec. 2. That the term "business'' as herein used is and shall also 
 be held to embrace the act or acts of holding, receiving, caring for and 
 disbursing, either personally or through agents, the returns or profits of 
 investments of capital of whatever kind; and every person, firm, or co- 
 partnership residing as aforesaid holding the bonds, debentures, or other 
 evidence of indebtedness of any corporation or association organized under 
 the laws of either the United States or of any State, Territory, or Dis- 
 trict of the United States, or doing business therein, shall, upon the carry- 
 ing on or doing business by such person either personally or by agent, in 
 respect to the income therefrom as aforesaid, and upon the right to hold, 
 possess, manage, and control the principal and to collect the interest or 
 other income of said bonds or other evidence of indebtedness, be subject 
 
PARTNERSHIP TAX ACT 633 
 
 to pay annually a special excise tax equivalent to one per centum upon the 
 annual interest or income payable upon said bonds or other evidence of 
 indebtedness: Provided, That said tax shall not be paid upon the interest 
 or income derived from said bonds or other evidences of indebtedness 
 when the same is otherwise paid under the provisions of this Act by the 
 person holding or owning the same: And provided further. That said 
 tax shall not be paid by the holder or owner of said bonds or other evi- 
 dence of indebtedness except to the extent that the said interest or income 
 from the same shall when added to the other net income of said holder 
 or owner for the year exceed the net income of five thousand dollars 
 received by such person from all sources during each year. 
 
 Sec. 3. That in computing incomes the necessary expenses actually 
 incurred in carrying on any business, not including personal, living, or 
 family expenses, shall be deducted, and also all interest paid within the 
 year by such person on existing indebtedness; and all national. State, 
 county, school, and municipal . taxes, not including those assessed against 
 local benefits, paid within the year shall be deducted from the gains, profits, 
 or income of the person who has actually paid the same, whether such 
 person be owner, tenant, or mortgagor; also losses actually sustained dur- 
 ing the year, incurred in trade or arising from fires, storms, or ship- 
 wreck, and not compensated for by insurance or otherwise, and debts as- 
 certained to be worthless: Provided, That no deduction shall be made 
 for any amount paid out for new buildings, permanent improvements, or 
 betterments, made to increase the value of any property or estate: Pro- 
 vided further. That only one deduction of five thousand dollars shall be 
 made from the aggregate income of all the members of any family com- 
 posed of one or both parents and one or more minor children, or hus- 
 band and wife; that guardians shall be allowed to make a deduction in 
 favor of each and every ward, except that in case where two or more 
 wards are comprised in one family and have joint property interests the 
 aggregate deduction in their favor shall not exceed five thousand dol- 
 lars : And provided further, That in cases where the salary or other com- 
 pensation paid to any person in the employment or service of the United 
 States shall not exceed the rate of five thousand dollars per annum, or 
 shall be by fees, or uncertain or irregular in the amount or in the time 
 during which the same shall have accrued or been earned, such salary 
 or other compensation shall be included in estimating the annual gains, 
 profits, or income of the person to whom the same shall have been paid, 
 and shall include that portion of any income or salary upon which a tax 
 has not been paid by the employer, fiduciary, or other person, where 
 the employer, fiduciary, or other person is required by law to pay on the 
 excess over five thousand dollars: And provided further, That in com- 
 puting the income of any person there shall not be included the amount 
 received from any corporation, joint stock company or association, or 
 insurance company as dividends upon the stock of such corporation, joint 
 stock company or association, or insurance company, if the special excise 
 tax of one per centum now imposed by law has been paid by such cor- 
 
634 AUDITING 
 
 poration, joint stock company or association, or insurance company: And 
 provided further. That in computing the income of any person there shall 
 not be included the amount received from any firm or copartnership, if 
 the special excise tax of one per centum imposed by this Act has been 
 paid upon such amount by such firm or copartnership: And provided 
 further. That nothing in this Act contained shall apply to labor, agricul- 
 tural or horticultural organizations, or to fraternal beneficiary societies, 
 orders, or associations operating under the lodge system and providing 
 for the payment of life, sick, accident, and other benefits to the members 
 of such societies, orders, and associations and dependents of such mem- 
 bers, nor to domestic building and loan associations organized and operated 
 exclusively for the mutual benefit of their members, nor to any corporation 
 or association organized and operated exclusively for religious, charitable, 
 or educational purposes no part of the net income of which inures to the 
 benefit of any private stockholder or individual. 
 
 Sec. 4. That there shall be deducted from the amount of the net 
 income of each of such persons, ascertained as provided herein, the sum 
 of five thousand dollars, and said tax shall be computed upon the re- 
 mainder of said net income of such person for the year ending December 
 thirty-first, nineteen hundred and tv^elve, and for each calendar year there- 
 after; and on or before the first day of March, nineteen hundred and 
 thirteen, and the first day of March in each year thereafter, a true and 
 accurate return, under oath or afErmation, shall be made by each person of 
 lawful age, subject to the tax imposed by this Act, to the collector of 
 internal revenue for the district in which such person resides or has his 
 principal place of business, or, in the case of a person residing in a foreign 
 country, in the place where his principal business is carried on within the 
 United States, in such form as the Commissioner of Internal Revenue, 
 with the approval of the Secretary of the Treasury, shall prescribe, setting 
 forth specifically the gross amount of income from all separate sources 
 and from the total thereof, deducting the aggregate items or expenses and 
 allowance herein authorized, and likewise returning the amount of in- 
 come, gains, and profits of any minor or person for whom they act, but 
 persons having less than four thousand five hundred dollars net income 
 are not required to make such report; and the collector or deputy col- 
 lector shall require every list or return to be verified by the oath or af- 
 firmation of the party rendering it, and may increase the amount of any 
 list or return if he has reason to believe that the same is understated: 
 Provided, That no such increase shall be made except after due notice 
 to such party and upon proof of the amount understated; and in case 
 such person having a taxable income shall neglect or refuse to make and 
 render such list and return, or shall render a willfully false or fraudu- 
 lent list or return, it shall be the duty of the collector or deputy collector 
 to make such list according to the best information he can obtain, by the 
 examination of such person or any other evidence, and to add fifty per 
 centum as a penalty to the amount of the tax due on such list in all cases 
 of willful neglect or refusal to make and render a list or return; and in 
 
PARTNERSHIP TAX ACT 635 
 
 all cases of a willfully false or fraudulent list or return having been ren- 
 dered, to add one hundred per centum as a penalty to the amount of 
 tax ascertained to be due, the tax and the additions thereto as a penalty 
 to be assessed and collected in the manner provided for in other cases of 
 willful neglect or refusal to render a list or return, or of rendering a 
 false or fraudulent return: Provided further. That any person in his or 
 her behalf, or as such employer, or fiduciary, shall be permitted to de- 
 clare, under oath or affirmation, the form and manner of which shall be 
 prescribed by the Commissioner of Internal Revenue, with the approval of 
 the Secretary of the Treasury, that he, she, or his or her ward, employee, 
 or beneficiary was not possessed of an income of five thousand dollars, or 
 may declare that he, she, or his or her ward, employee, or beneficiary has 
 been assessed and has paid a special excise tax elsewhere for the same 
 year, under authority of the United States, measured by all his or her 
 income, gains, or profits, and upon all the income, gains, or profits for 
 which he or she is liable as such employer or fiduciary, as prescribed by 
 this law; and if the collector or deputy collector shall be satisfied of the 
 truth of the declaration, such person shall thereupon be exempt from 
 excise tax in the said district for that year; or if the list or return of any 
 person shall have been increased by the collector or deputy collector, 
 such person may be permitted to prove the amount liable to be assessed; 
 but such proof shall not be considered as conclusive of the facts, and no 
 deductions claimed in such cases shall be made or allowed until approved 
 by the collector or deputy collector. Any person feeling aggrieved by the 
 decision of the deputy collector, in such cases may appeal to the collector 
 of the district, and his decision thereon, unless reversed by the Com- 
 missioner of Internal Revenue, shall be final. If dissatisfied with the de- 
 cision of the collector, such person may submit the case, with all the 
 papers, to the Commissioner of Internal Revenue for his decision, and may 
 furnish the testimony of witnesses to prove any relevant facts, having 
 served notice to that effect upon the Commissioner of Internal Revenue, 
 as herein prescribed. 
 
 Such notice shall state the time and place at which and the officer 
 before whom the testimony will be taken; the name, age, residence, and 
 business of the proposed witness, with the questions to be propounded to 
 the witness, or a brief statement of the substance of the testimony he is 
 expected to give: And provided further. That the Government may at 
 the same time and place take testimony upon like notice to rebut the testi- 
 mony of the witnesses examined by the person taxed. 
 
 The notice shall be delivered or mailed to the Commissioner of Internal 
 Revenue a sufficient number of days previous to the day fixed for taking 
 testimony, to allow him, after its receipt, at least five days, exclusive of 
 the period required for mail communication with the place at which the 
 testimony is to be taken, in which to give, should he so desire, instruc- 
 tions as to the cross-examination of the proposed witness. 
 
 Whenever practicable the affidavit or deposition shall be taken before 
 a collector or deputy collector of internal revenue, in which case reason- 
 
636 AUDITING 
 
 able notice shall be given to the collector or deputy collector of the time 
 fixed for taking the deposition or affidavit. 
 
 Sec. S. That all assessments shall be made and all persons shall be 
 notified of the amount for which they are respectively liable on or before 
 the first day of June of each successive year, and said assessments shall 
 be paid on or before the thirtieth day of June, except in cases of refusal 
 or neglect to make such return, and in cases of false or fraudulent re- 
 turns, in which cases the Commissioner of Internal Revenue shall, upon 
 the discovery thereof, at any time within three years after said return 
 is due, make a return upon information obtained as above provided for, 
 and the assessment made by the Commissioner of Internal Revenue thereon 
 shall be paid by such person or persons immediately upon notification of 
 the amount of such assessment; and to any sum or sums due and unpaid 
 after the thirtieth day of June in any year, and for ten days after notice 
 and demand thereof by the collector, there shall be added the sum of five 
 per centum on the amount of tax unpaid, and interest at the rate of one 
 per centum per month upon said tax from the time the same becomes due. 
 
 Sec. 6. That it shall be the duty of all paymasters and all disbursing 
 officers under the Government of the United States, or persons in the em- 
 ploy thereof, when making any payment to any officers or persons as 
 aforesaid, whose compensation is determined by a fixed salary, or upon 
 settling or adjusting the accounts of such officers or persons, to deduct 
 and withhold the aforesaid tax of one per centum, and the pay rolls, 
 receipts, or accounts of officers or persons paying such tax as aforesaid 
 shall be made to exhibit the fact of such payment. And it shall be the 
 duty of the accounting officers of the Treasury Department, when auditing 
 the accounts of any paymaster or disbursing officer, or any officer with- 
 holding his salary from moneys received by him, or when settling or ad- 
 justing the accounts of any such officers, to require evidence that the taxes 
 mentioned in this Act have been deducted and paid over to the Treasurer 
 of the United States or other. officer authorized to receive the same. Every 
 person, firm, or corporation who pays to any officer, employee, or other 
 person a salary or compensation, interest, or other accrued profits, ex- 
 ceeding five thousand dollars for a taxable year, every lessee or mortgagor 
 of real or personal property who pays to the lessor or mortgagee interest 
 or compensation exceeding five thousand dollars for a taxable year, and 
 every trustee, executor, administrator, conservator, agent, or receiver, em- 
 ploying any person or paying any person business earnings, within the 
 meaning of this Act, exceeding five thousand dollars for any taxable year, 
 computed on the basis herein prescribed, shall make and render a return as 
 provided herein to the collector or a deputy collector of his district, and 
 shall deduct and withhold the tax herein imposed, and shall pay on said 
 return the tax of one per centum per annum as required by this Act: 
 Provided, That any officer, employee, or other person for whom return 
 has been made and the tax paid, as aforesaid, shall not be required to 
 make a return unless such person has other net income, but only one de- 
 duction of five thousand dollars shall be made in the case of any such 
 
PARTNERSHIP TAX ACT 637 
 
 officer or employee: Provided further, That salaries paid to State, county, 
 or municipal officers shall be exempt from the special excise tax herein 
 levied: And provided further,- Thsit interest upon the bonds or other ob- 
 ligations of a State or any political subdivision thereof and also the pro- 
 ceeds of life insurance policies paid upon the death of the person insured 
 shall not be included in computing the net income of a person subject 
 to the tax herein imposed: And provided further. That all property or 
 its value passing by will or by intestate laws or transferred by deed or 
 gift made or intended to take effect in possession after the death of the 
 grantor, donor, testator, or ancestor shall be exempt from the operation 
 of this law. 
 
 Sec. 7. That if any person, corporation, company, or association liable 
 to make the return or pay the tax aforesaid shall refuse or neglect to 
 make a return at the time or times hereinbefore specified in each year, or 
 shall render a false or fraudulent return, such person shall be liable to a 
 penalty of not less than fifty dollars and not exceeding five hundred dol- 
 lars. Any person, corporation, company, or association required by law 
 to make, render, sign, or verify any return who makes any false or fraudu- 
 lent return or statement with intent to defeat or evade the assessment 
 required by this Act to be made shall be guilty of a misdemeanor and 
 shall be fined not exceeding one thousand dollars or be imprisoned not 
 exceeding one year, or both, at the discretion of the court, with the costs 
 of prosecution. 
 
 Sec. 8. That it shall be the duty of every collector of internal revenue 
 to whom payment of any tax is made, under the provisions of this Act, 
 to give to the person making such payment a full written or printed 
 receipt expressing the amount paid and the particular account for 
 which such payment was made; and whenever such payment is made such 
 collector shall, if required, give a separate receipt for each tax paid by any 
 debtor on account of payments made or to be made by him to separate 
 creditors in such form that such debtor can conveniently produce the same 
 separately to his several creditors in satisfaction of their respective de- 
 mands to the amounts specified in such receipts; and such receipts shall 
 be sufficient evidence in favor of such debtor to justify him in withholding 
 the amount therein expressed from his next payment to his creditor; but 
 such creditor may, upon giving to his debtor a full written receipt, ac- 
 knowledging the payment to him of whatever sum may be actually paid, 
 and accepting the amount of tax paid as aforesaid (specifying the same) 
 as a further satisfaction of the debt to that amount, require the surrender 
 to him of such collector's receipt. 
 
 Sec. 9. That jurisdiction is hereby conferred upon the district courts 
 of the United States for the district within which any person summoned 
 under this Act to appear to testify or to produce books shall reside, to 
 compel such attendance, production of books, and testimony by appropriate 
 process. 
 
 Sec. 10. That all administrative, special, and general provisions of 
 law, including the laws in relation to the assessment, remission, collection. 
 
38 AUDITING 
 
 id refund of internal revenue taxes not heretofore specifically repealed 
 id not inconsistent with the provisions of this Act, are hereby extended 
 id made applicable to all the provisions of this Act and to the tax herein 
 iposed. 
 
 Sec. II. That the Act entitled "An Act to promote reciprocal trade 
 :lations with the Dominion of Canada, and for other purposes," approved 
 ily twenty-sixth, nineteen hundred and eleven, be, and is hereby, re- 
 eled: Provided, That from and after the passage of this Act the duty 
 1 chemical wood pulp shall be one-twelfth of one per cent per pound, 
 :y weight, if unbleached, and one-eighth of one per cent per pound if 
 cached, and the duty on printing paper as described in paragraph four 
 indred and nine of the Act approved August fifth, nineteen hundred and 
 ne, shall be one-tenth of one cent per pound if valued at not above 
 ree cents per pound, two-tenths of one cent per pound if valued above 
 ree cents and not above five cents per pound, and seven and one-half per 
 ntum ad valorem if valued above five cents per pound. 
 
 Passed the House of Representatives March 19, 1912. 
 
 Attest: South Trimble, 
 
 Clerk. 
 
 Passed the Senate with amendments July 26, 1912. 
 
CHAPTER XXXV 
 
 CERTIFIED PUBLIC ACCOUNTANT LAWS AND 
 EXAMINATIONS 
 
 The first Certified Public Accountant law was enacted by 
 the Legislature of the State of New York in 1896. Three years 
 later Pennsylvania followed, and in 1900 Maryland passed its 
 law. Since that time there has been a steady increase in the 
 number of States having C. P. A. laws, and in nearly every State 
 in the Union efforts have been made to secure the passage of this 
 necessary legislation. 
 
 The objections which have been raised by legislators have 
 been the arguments common to the ultraconservative, and in 
 those cases in which bills have not passed their failure has gener- 
 ally been due to an unwillingness on the part of legislators to be 
 convinced rather than to any lack of convincing argument. 
 
 To-day there are twenty-three States having on their statute 
 books laws providing for the regulation of professional account- 
 ants. In the following list the names of these States and the year 
 in which each law was enacted are given. 
 
 1896 New York 1907 Connecticut 
 
 1899 Pennsylvania 1908 Ohio 
 
 1900 Maryland 1908 Louisiana 
 
 1901 California 1908 Georgia 
 
 1903 Washington 1909 Massachusetts 
 
 1903 Illinois 1909 Missouri 
 
 1904 New Jersey 1909 Minnesota 
 
 1905 Michigan 1909 Montana 
 
 1905 Florida 1909 Nebraska 
 
 1906 Rhode Island 1910 Virginia 
 
 1907 Utah 1911 West Virginia 
 1907 Colorado 
 
 Among the States in which efforts are being made to secure 
 similar laws may be mentioned Alabama, Kentucky, Kansas, 
 North Carolina, Oklahoma, Oregon, Tennessee, Texas, and Wis- 
 consin. 
 
 639 
 
640 AUDITING 
 
 The vast majority of State laws specify that appUcants for 
 the degree of C. P. A. shall pass examinations in "theory of 
 accounts," "practical accounting," "auditing," and "commercial 
 law," and these topics are specifically mentioned in the model law 
 presented at the 1907 Annual Meeting of the American Associa- 
 tion of Public Accountants by the then committee on legislation. 
 Exceptions to the rule are found in the case of New York, Penn- 
 sylvania, Maryland, New Jersey, and Massachusetts. 
 
 In Pennsylvania the examinations are grouped under two 
 general headings, viz., "commercial law" and "general account- 
 ing." In the latter are included "theory of accounts," "practical 
 accounting," and "auditing." This grouping of subjects has 
 much in its favor, as it simplifies the work of the examiner, ren- 
 ders coordination of questions possible, and is less confusing to 
 the candidate. 
 
 In New York and Illinois it has been recognized from the 
 beginning that there should be an educational qualification. In 
 New York the candidate, before taking the examination, must 
 possess a high grade in the regents' system of qualifications. 
 Indeed, throughout the country it is becoming more and more 
 the conviction that the public accountant must have a broader 
 general education and a more scientific preparation than was 
 expected a few years ago. The work of the accountant covers 
 to-day a vastly wider field than that of his predecessors in the 
 latter part of the last century, and it may be said, generally 
 speaking, that the wider the accountant's general knowledge, the 
 greater will be his efficiency in the profession which he has under- 
 taken. 
 
 Another question which has been raised, and on which there 
 is a wide divergence of opinion, is the requirement of a certain 
 amount of professional experience before the candidate is exam- 
 ined. This experience may take the form of simple bookkeeping 
 or it may involve the service in the office of a public accountant 
 for one year or two or three, as the case may be, but it is becom- 
 ing increasingly felt that some degree of experience is of great 
 importance before the candidate applies for his degree as a Certi- 
 fied Public Accountant. As the profession grows in importance 
 the requirement of experience will, and should be, strengthened. 
 
 In the following pages are given recent examination papers 
 
C. p. A. QUESTIONS 641 
 
 in auditing prepared by the accountancy boards of a number of 
 representatives States. In cases in which there is no separate 
 paper on auditing and the subject is dealt with in the course of 
 a paper such as that on general accounting, the entire paper is 
 given, so that readers may form their own opinions as to the 
 desirability of the grouping of subjects and of treating these sub- 
 jects separately. 
 
 University of the State of New York 
 
 Thirty-third Accountant Examination 
 AUDITING 
 
 Wednesday, June 26, 1912 — 1.15 to 4.15 p. m. only 
 
 Answer 10 questions, but no more, selecting at least two questions from 
 each group. Each complete answer will receive 10 credits. Papers entitled to 
 75 or more credits will be accepted. 
 
 Group I 
 
 1. If you were sent to make the first audit of a concern, what are the 
 steps you would take? 
 
 2. What condition of office organization, above all others, leads to 
 fraud and defalcation by bookkeepers and cashiers? Support your opinion. 
 
 3. In making an audit of a concern doing a mercantile business, what 
 would you require to enable^ you to certify to the correctness of the in- 
 ventory of merchandise that they had prepared? 
 
 4. What means would you employ to verify the usual cash receipts of 
 the average social club? P'i^W •'**""" lM>-*if t-^wJ-ttf , 
 
 5. Give at length your views on the "ethics" of accountancy. 
 
 Gioup II 
 
 6. Assuming that you are a Certified Public Accountant and employed 
 as auditor by a corporation, state what you would consider it your duty 
 to do in order to safeguard your clients regarding the fire insurance that 
 they carry on their stock of merchandise. 
 
 7. A foreign agent of a life insurance company sends monthly the fol- 
 lowing data : a report showing his receipts and disbursements, with dates ; 
 vouchers supporting the disbursements; list of overdue premiums; a state- 
 ment of his daily cash balances in bank, supported by a certificate from his 
 bank as to his closing balances. How would you audit his report? 
 
 8. A company has acquired, at $90 per share, 100 shares of its own 
 
642 AUDITING - ..^ 
 
 capital stock, of the par value of $ioo per share. Its balance sheet shows 
 treasury stock $9,000. Is this correct? If so, why? If not, state how you 
 would adjust the books. 
 
 g. Describe briefly the way you 'carried out an audit which you planned 
 and conducted personally. 
 
 ID. In auditing the books of a corporation capitalized at $250,000 you 
 find that three years previously they acquired the business of a copartner- 
 ship included in which was an asset called good will valued at that time 
 at $25,000, since which the same has not been written down. The average 
 profits of the corporation for three years have been nine per cent on the 
 
 capitalization. How would you treat the item good will? Give reasons. 
 
 i-^ ■?, / 1'-' 
 
 Group III 
 
 11. What steps would you take to audit the Notes Receivable Purchased 
 and the Notes Receivable on Commission held by a commercial paper house, 
 to satisfy yourself that there had been no fraud by substitution? 
 
 12. The cashier of a concern is at the same time its bookkeeper. Dur- 
 ing his absence on vacation slight irregularities are discovered and you are 
 engaged to audit his books. He returns on the day you begin your audit 
 and admits a defalcation of $5,000. Knowing that his receipts were sup- 
 posed to be deposited daily in the bank, state the steps that you would 
 take to ascertain the truth of his admission. 3 O '-^ 
 
 13. The result of your count of the "cash on hand" at a large agency 
 on January i, 1912, discloses : 
 
 Bills $1,979 
 
 Coin ^419 
 
 Cash items supported by properly signed vouchers: 
 
 January 14, 1908 — Subagent Jones $200 
 
 July 20, 1909 — Subagent Thomas 140 
 
 August 20, 1909 — Subagent Vincent 75 
 
 September 30, 1910 — Subagent Nelson 230 645 
 
 Cash balance as per general ledger $3,108.19 
 
 Does this count complete your duty as an auditor? If you consider 
 that further steps are necessary state what you would do. 
 
 14. What instructions would you give to a junior accountant to whom 
 you had intrusted the audit of the account Investment in Bonds and Mort-„ 
 gages appearing on the books of a trust company? L|l-,(,"if*^) Tl(7i ils^ 
 
 15. You find that a concern whose books you are auditing has cap- 
 italized the amount of royalties that it would have had to pay on the sales 
 of a three years' period if it had not owned the patents. On the increase 
 of surplus thus obtained the directors have declared a stock dividend. 
 Would you consider yourself called on to criticize the action of the direc- 
 tors? If so, state what would be the character of your criticism.- 
 
 ( L\U x-3o\ .^. 
 
 { 
 
 -V'->---(®^' 
 
C. p. A. QUESTIONS 643 
 
 Pennsylvania State Board of Public Accountants 
 
 Examination Questions 
 GENERAL ACCOUNTING 
 
 Monday, November 20, 191 1, 9 a. m. to i p. m. 
 
 I. Describe fully any business enterprise for the purpose of giving 
 comprehensive information to a possible purchaser who is not very familiar 
 with the property or any phase of its organization, operations, or financial 
 condition or requirements, and who would expect, in case of purchase, to 
 use this information to have the business managed to the best advantage. 
 *^ 2. Outline a systein of accounting for a stock broker's office, including 
 provision for the daily balancing of all securities. 
 
 Monday, November 20, 1911, 2 p. m. to S p. m. 
 
 3. Describe fully the usual accounting system employed in a national 
 bank in one of the larger cities, with' deposits of $15,000,000 and upwards. 
 
 Explain fully how to make a thorough examination and verification 
 of each of the following: 
 
 Cash/ cash items, and exchanges. 
 
 Loans of all classes. 
 
 Collaterals. 
 
 Securities owned. 
 
 Deposits. 
 
 Earnings. 
 
 4. The Borough of Exeter decides to pave and curb Main and Broad 
 Streets, on the former of which is located the town hall and on the latter 
 the town high school. State concisely the usual method employed to finance 
 the expenditures involved in these improvements, and what accounts or 
 records would be required in connection therewith. 
 
 Tuesday, November 21, 1911, 9 a. m. to i p. m. 
 
 " 5. The books of the Mapes & Manning Company, manufacturers of and 
 
 dealers in farm implements, show for the past five years net profits as 
 follows : 
 
 1906 $177,000 
 
 1907 143,000 
 
 igo8 206,000 
 
 1909 16,000 
 
 igio 98,000 
 
 You are instructed by a banking syndicate to examine the accounts of 
 the company and report upon the profits during the above period. In the 
 course of your examination you ascertain the following facts: 
 
644 AUDITING 
 
 Current liabilities were not taken into the accounts, as follows : 
 
 January i, 1906 for New Buildings $42,000 
 
 Accrued Wages Si300 
 
 December, 31, 1906 Repair Charges 2,600 
 
 Accrued Wages 2,900 
 
 December 31, 1908 Merchandise Invoices 6,800 
 
 Current Expenses 5,400 
 
 December 31, 1910 Accrued Wages 3,200 
 
 Materials and Supplies 4,600 
 Shop Equipment 8,400 
 
 At December 31, 1910, the company engaged two real estate experts to 
 appraise its land and buildings. The lower of the two showed a present 
 value of $587,000, and this valuation was adopted by the Board of Directors, 
 who instructed the bookkeeper to charge Real Estate Account and credit 
 Profit and Loss at the above date with the difference between the fore- 
 going amount and the book figures of $560,000. 
 
 A mortgage of $200,000, bearing 5 per cent remained upon the prop- 
 erty during the whole of the period under review, and interest on this 
 mortgage was charged before arriving at the book profits. 
 
 Satisfactory provision was made in each year for depreciation of 
 buildings, machinery, etc. 
 
 Revise the profits for each year in accordance with the facts disclosed 
 by your examination, and draft the form of certificate you would be pre- 
 pared to give thereon to the bankers for prospectus purposes. 
 
 Assuming that after submitting this certificate to your clients they pre- 
 fer instead to publish a certificate showing the average profits for the 
 five-year period, what position would you take and what form of certificate 
 would you be willing to sign? 
 
 6. A manufacturing concern is required to carry a six months' supply of 
 a certain kind of raw material, and, as the material is not of the kind 
 that can be purchased every day, they must purchase it at any time it is 
 offered to them. For this reason the prices fluctuate sometimes very con- 
 siderably. When they purchase this material, they pay cash for same and 
 have the material shipped in as wanted. What method would you use in 
 arriving at the cost of this raw material used during any one month in 
 manufacturing? 
 
 Tuesday, November 21, 191 1, 2 p. m. to 5 p. m. 
 
 7. A textile mill, employing some 700 hands, operates five departments, 
 with a superintendent or head foreman in each. About 500 hands are paid 
 upon a piecework basis, 50 on a part piecework and part day rate, accord- 
 ing to the duties assigned to them from day to day; 100 are on a straight 
 
C. p. A. QUESTIONS 645 
 
 day-rate basis, while the remainder are paid weekly salaries, but no over- 
 time. Describe clearly and concisely the methods you would recommend 
 for assembling and recording the data entering into the weekly pay roll. 
 Also state how you would have the pay roll prepared and the wages, as 
 shown thereon, paid to the hands, having in view both economy in the 
 clerical work and the securing of proper safeguards against frauds. 
 
 8. (a) How should advancements which appear in the Inventory and 
 Appraisement of a decedent's estate be treated by the Executors in dis- 
 tributing the Principal to the heirs? 
 
 (6) In the absence of instructions in the will, what disposition should 
 be made of sale of "rights" or "warrants" by an Executor? 
 
 (c) An Executor of an estate in Pennsylvania forecloses a mortgage 
 owned by the Estate, and title is taken to the property, the property re- 
 maining in the Estate at the time of filing his account. How should the 
 transaction appear in his account? 
 
 Wednesday, November 22, 1911, 9 a. m. to i p. m. 
 
 9. A. B., desiring to incorporate his business, secures a charter under 
 the laws of the Commonwealth of Pennsylvania on December 28, 1910, 
 the A. B. Company being organized for the purpose of manufacturing 
 chemicals and for the sale of the products of such manufacture. The 
 capital stock of the company consists of 3,000 shares, of the par value of 
 $100 each, the subscribers being as follows : 
 
 A. B 2,996 shares 
 
 C. D I share 
 
 E. F I " 
 
 G. H I " 
 
 J. K I " 
 
 3,000 shares 
 
 A. B. advances from his own funds the minimum amount of cash 
 capital required by law. The balance of the subscription is to be paid for 
 in Formulae, Trade Marks, and Patents belonging to A. B. to the amount 
 of $150,000, and a sufficient amount of the tangible assets of A. B.'s busi- 
 ness, a Balance Sheet of which at January i, 191 1, is as follows: 
 Assets : 
 
 Real Estate $25,000 
 
 Machinery 30,000 
 
 Fixtures 15,600 
 
 $70,600 
 
 Inventories : 
 
 Manufactured Product 15,220 
 
 Materials 28,650 
 
 Coal 572 
 
 Prepaid Insurance 1,856 
 
 46,298 
 
646 AUDITING 
 
 Cash $12,106 
 
 Accounts Receivable 28,418 
 
 40,524 
 
 $157,422 
 Liabilities : 
 
 Bills Payable 2,000 
 
 Accounts Payable 3>i43 
 
 5. 143 
 
 Capital of A. B $152,279 
 
 (o) Prepare entries for opening the books of the A. B. Company. 
 
 (fc) Prepare appropriate entries for the books of A. B. 
 
 Lucidity and complete statement of all necessary particulars should 
 have your consideration. 
 
 10. The following is a financial statement of the Homestead Land Com- 
 pany on commencement of business, January i, 1908: 
 
 Assets Liabilities 
 
 Land $500,000 Capital Stock $100,000 
 
 Cash 70,000 Bonds Authorized .$500,000 
 
 Discount on Bonds S,ooo Less not sold 25,000 
 
 475.000 
 
 Total $575,000 
 
 Total $575,000 
 
 The land shown represents 10,000 acres, which were acquired at the 
 rate of $50 per acre. The bonds issued by the company are dated January 
 I, 1908, maturing January i, 1928, and bear interest at 5 per cent per 
 annum, payable July and January ist. Under these bonds the company is 
 required to pay into the hands of the Trustee, as a sinking fund for their 
 redemption, the sum of $50 for each acre of land for which the company 
 has received full payment and conveyed title. (Note that the company 
 has complied with this requirement during the year and the Trustee has 
 advised, at December 31, 1908, that he had in his possession the sum of 
 $153,500, of which sum $3,500 represented interest on the funds in his 
 hands.) 
 
 The object of the company is to divide its property into lo-acre plots, 
 which it sells at the rate of $75 per acre when paid for in cash, or $100 per 
 acre when the plots are sold on the installment payment plan. This latter 
 plan provides for the payment of $20 per acre in cash at the date of pur- 
 chase, and the balance to be covered by four notes of equal amounts, 
 maturing one, two, three, and four years after the date of purchase. The 
 first two notes not bearing interest, but the two latter to bear interest at 
 the rate of 5 per cent per annum. During the year ended December 31, 
 igo8, 300 plots were sold for cash and title conveyed to the various pur- 
 
C. p. A. QUESTIONS 647 
 
 chasers, also during the same year 300 plots were sold on the installment 
 plan ias outlined in the foregoing. 
 
 Expenses not subject to inference from the foregoing: 
 
 Administration $2,500 
 
 Salaries 5,ooo 
 
 Advertising S.ooo 
 
 Taxes accrued, not paid 2,500 
 
 Prepare a Balance Sheet at December 31, 1908, and a Profit and Loss 
 Account for the year ended on that date. 
 
 Wednesday, November 22, 191 1, 2 p. m. to 5 p. m. 
 tc- II. In a given trade, goods are purchased on terms of S per cent dis-_,i^i 
 count for cash in ten days, or net thirty days. In certifying a Balance 
 Sheet in this trade, how would you deal with the question of this discount t "^ 
 in stating the value of the inventory of merchandise on hand? Give your 
 reasons for the treatment you would advocate. 
 
 12. You are retained to make an examination of the accounts of a 
 hardware manufacturing company, and prepare a Balance Sheet and a 
 Statement of its Earnings for the past ten years, the examination to be 
 of sufficient scope to enable you to issue a certificate to the Balance Sheet 
 and also to give the assurance that the Statement of Earnings presented is 
 substantially correct. 
 
 Give an outline of your audit procedure, showing to what extent you 
 would carry your examination in respect to the several classes of assets 
 and liabilities, and if it were stated to you that depreciation of the plant 
 and equipment had been provided for through the inclusion in the manu- 
 facturing cost of expenditures for new additions and betterments, what 
 method would you take to ascertain the extent of such provision? 
 
 University of Illinois 
 
 EXAMINATION FOR CERTIFICATE AS CERTIFIED PUBLIC 
 
 ACCOUNTANT 
 
 Chicago, III., May 28, 29, and 31, 1912 
 
 AUDITING 
 
 Wednesday, May 29, 1.30 to 4.30 p. m. 
 
 The general intelligence with which the questions are answered will 
 be considered in the marking, as well as the technical accuracy of each 
 answer. 
 
648 AUDITING 
 
 Answer All of the following Eight Questions: 
 
 1. Distinguish between a "Continuous" and "Completed" audit, and state 
 what you understand by— (i) A Cash Audit; (2) A Financial or Balance- 
 Sheet Audit; and (3) A General Audit. 
 
 (S Credits.) 
 
 2. What general procedure would you follow in auditing the Receipts, 
 or debit side of the Cash Book, of a Manufacturing Company where the 
 transactions were not too numerous to render a complete detailed audit 
 impracticable, and state what features of the audit would you omit where 
 the transactions were too numerous to permit of a complete detailed audit? 
 
 (10 Credits.) 
 
 '^ 3. (a) Do you consider it important to vouch or otherwise examine 
 expenditures added to Plant, Property, and Equipment Accounts ; and if you 
 do, state what your object would be, and the character of the examination 
 you would make. 
 
 (6) State the points to be attended to in the audit of the Inventories 
 of a Manufacturing Corporation. 
 
 (I2j4 Credits.) 
 
 4. In the Balance Sheet of a concern under audit you find the Accounts 
 Receivable and Payable to be as follows: 
 
 Accounts Receivable — 
 
 Chicago (Head Office) Debtors $95,650.00 
 
 St. Louis Branch account 2,425.00 
 
 Atlanta Branch account 4,730.00 
 
 New Orleans Branch account 1,725.00 
 
 Accounts Payable — 
 
 Chicago (Head Office) Creditors $41,500.00 
 
 New York Branch account 7,200.00 
 
 Montreal Branch account 3,752.00 
 
 What adjustments in the Balance Sheet, if any, would be necessary in 
 order that an unqualified certificate might be given? 
 
 (7^ Credits.) 
 
 5. Criticize the following Balance Sheet from both the Auditor's stand- 
 point and that of the Company's Financial Position; assuming that the 
 Bonded Indebtedness outstanding is $200,000. 
 
 A. B. COMPANY— BALANCE SHEET— DECEMBER 31, 1911 
 
 Assets 
 
 Real Estate, Buildings, Plants, Machinery, Equipment, and other 
 
 permanent Investment, including Good Will $1,000,000 
 
 Investment in Stocks and Bonds at Cost (Market Value $60,000) . . 100,000 
 
C. p. A. QUESTIONS 649 
 
 Current Assets: 
 Inventories — 
 
 Raw Materials $170,000 
 
 Finished Stock at Selling Prices, less Discount 
 
 5 per cent 100,000 
 
 Consignments ( Selling Value) 50,000 
 
 Supplies (Estimated) 200,000 
 
 $520,000 
 
 Accounts and Bills Receivable, including Advances to Em- 
 ployees 125,000 
 
 Stocks in Treasury (Unissued) — 
 
 Preferred $150,000 
 
 Common 137,225 
 
 $287,225 
 
 Investments in Subsidiary Companies 225,500 
 
 Cash and Miscellaneous Items 50,500 
 
 $1,208,225 
 
 $2,308,225 
 
 Liabilities 
 
 Capital Stock: 
 
 Preferred Stock $500,000 
 
 Common Stock 750,000 
 
 Bonds and Bankers' Loans 575,000 
 
 Current Liabilities : 
 
 Accounts Payable $ 15,225 
 
 Other Indebtedness 231,000 
 
 Accrued Items 2,000 
 
 248,225 
 
 Reserves : 
 
 For Depreciation $50,000 
 
 Less — Renewal Expenditures written off 65,000 
 
 Balance (Debit) $15,000 
 
 For Bad Debts 20,000 
 
 Other Contingencies i 5,000 
 
 10,000 
 
 Surplus (less Dividends Paid) including appreciation in 
 Real Estate and other Capital Assets and Profit on 
 Inventorying Raw Materials at Market Prices 225,000 
 
 $2,308,225 
 (175^ Credits.) 
 
650 AUDITING 
 
 6. You find in the course of an annual examination as of December 31, 
 the following : 
 (i) A credit balance in the Cash Account of $625.00 
 
 (2) In the Credit Ledger a debit balance for Cash charged to Davis 
 
 & Co., on July 31 for ; . 375-00 
 
 (3) In the Debit Ledger a credit balance for Cash paid by Jones 
 
 & Co., on December 31 250.00 
 
 (4) A debit balance also in the Debit Ledger to Winslow & Co. : 
 
 July I, Mdse $ 50.00 Aug. 20, cash and discount. . .$ 50.00 
 
 Aug. 3, Mdse 60.00 Oct. 3 " " ••• 7S-0O 
 
 Sept. 15, Mdse 75.00 Dec. i " " ... 100.00 
 
 Oct. ID, Mdse 100.00 Dec. 31, Balance 60.00 
 
 $285.00 $285.00 
 
 December 31, Balance $60.00. 
 
 What would be your view of each of these items? 
 (7^ Credits.) 
 
 7. In auditing the accounts of a Corporation, you find that the Com- 
 pany has utilized its own Materials and Labor in the construction of ex- 
 tensive additions to its plant, and that it has charged up such work at 
 regular trade prices sufficient to yield to it a substantial Profit, which has 
 been credited to Profit and Loss Account. Do you see any objection to 
 this course? Explain fully the theory upon which your answer is based. 
 
 (10 Credits.) 
 
 8. A Company insures the life of its Manager for its own benefit in 
 the sum of $50,000, the annual premium being $1,250. Explain the method 
 you would adopt of treating the disbursement at the annual accounting 
 during the period the policy was in force. 
 
 (10 Credits.) 
 
 Answer Any Two of the following Five Questions: 
 
 9. (o) In auditing the Disbursements of a Company, what books and 
 documents would you call for; what would be your exact procedure, and to 
 what points would you pay particular attention? 
 
 (6) Under what conditions would indo^sed checks be regarded as 
 
 ADEQUATE VOUCHERS ? 
 
 (10 Credits.) 
 
 10. How far is an Auditor entitled to probe into matters beyond the 
 term which he is instructed to audit, and for what purposes should he do so? 
 
 (10 Credits.) 
 
C. p. A. QUESTIONS 651 
 
 • *^ II. In auditing the accounts of the following, what documents and 
 records would you expect to see other than the regular double entry set of 
 books? 
 
 (i) The Trust Estate of a deceased person. 
 
 (2) A private Partnership. 
 
 (3) A new Company which had not been previously audited. 
 
 (4) A Charitable Institution. 
 
 (10 Credits.) 
 
 12. In the course of audit of an Investment and Brokerage Corporation 
 you find that the Directors have written up the value of some of the 
 securities, which they contend is in harmony with current market values. 
 The accounts show that the dividend proposed to be paid has not been earned 
 unless the increment in value referred to is included as a Profit. What 
 is your view of the proposed procedure of the Directors? If you concur 
 with their proposed action, state your reasons; and if not, state the pro- 
 cedure, as Auditor, you would follow. 
 
 (10 Credits.) 
 
 13. (o) In the accounts of a Wholesale Dry Goods Company, under 
 what, if any, circumstances is it permissible to carry forward to a sub- 
 sequent period the whole or any portion of the Expenditures for Salesmen's 
 Salaries or Commissions and Traveling Expenses? 
 
 (b) In the accounts of a Lumber Company owning large tracts of 
 standing Timber, how should the book value of "Stumpage" be disposed 
 of? What do you understand by "Stumpage"? 
 
 (10 Credits.) 
 
 State of Massachusetts 
 
 Fourth Public Accountant Examination 
 
 AUDITING 
 
 Wednesday, June s, 1912, i p. m. to 5.30 p. m. 
 
 Answer questions 39, 40, 41, and 42, and 6 others, but no more. 
 
 39. State fully how you would verify the bank account of a concern 
 depositing with six banks, and making frequent transfers of funds between 
 them. 
 
,2 AUDITING 
 
 40. Of what value in auditing is a unit of production? 
 
 41. A client (A. B. Co.) presents you the following statement as of 
 muary i, 1912: 
 
 Assets Liabilities 
 
 ash •. $10,600.27 Notes payable r $20,000.00 
 
 ccounts receivable 30,219.73 Accounts payable 30,140.10 
 
 [erchandise 39,320.14 Profit and Loss 5,000.04 
 
 Machinery 10,000.00 Capital Stock 40,000.00 
 
 oans to directors 5,000.00 
 
 $95,140.14 $95,140.14 
 
 You are required on January 10, 1912, to make sufficient examination 
 id audit to certify the statement for credit purposes. ^ 
 
 State fully how, and to what extent, you would verify the different 
 5ms, and draw formal certificate covering same. 
 
 42. A corporation takes from its customers their notes in partial set- 
 ;ment of their accounts. Some of these notes are discounted by the cor- 
 )ration, and with its unlimited indorsement. Notes receivable account 
 
 credited with the notes discounted, and interest account is charged with 
 e discount. State (a) your procedure in auditing the notes receivable 
 ansactions ; (b) how you would ascertain what notes are not matured ; 
 id (c) how you would deal with the latter in the certificate of your 
 idit? 
 
 43. In auditing the accounts of a tax collector, what should be done 
 determine if he accounts for the interest on overdue taxes paid? 
 
 44. You are auditor of a manufacturing corporation which has been 
 jerating five years and which has, amongst other accounts, the follow- 
 g, viz. : Plant account, $700,000 ; Reserve for Depreciation, $200,000 ; 
 urplus, $100,000. The officers ask you to certify a statement embracing the 
 )ove items in the following form, viz.: "Plant," $700,000; "Surplus and 
 eserve accounts," $300,000. State (a) whether you approve same and 
 a) the reasons supporting your answer. 
 
 45. How would you audit the accounts of a Tax Collector? 
 
 46. The officers and directors of a Massachusetts corporation have 
 cecuted and submitted to you, for your signature as the auditor chosen 
 ider the provisions of the statutes, their Certificate of Condition, April 
 
 1912. At the same time, the treasurer asks you to prepare the corpora- 
 Dn's "Return" to the Tax Commissioner, April i, 1912, showing, therein, 
 iluations of the merchandise and accounts receivable which the treasurer 
 aims to be fair cash values, but which are less than the respective amounts 
 icluded in the Certificate of Condition. State what action you would 
 ke (a) regarding the Certificate of Condition; (b) regarding the tax 
 Return"; and (c) the reasons supporting your answers. 
 
 47. To what extent do you deem it necessary to verify the following 
 
C. p. A. QUESTIONS 653 
 
 in order that you may certify to the correctness of a Profit and Loss 
 statement : 
 
 Materials and Supplies. 
 
 Goods in Process. 
 
 Finished Goods. 
 
 Accounts Receivable. 
 
 48. Describe a complete audit of the Trust Department of a Trust 
 Company. 
 
 49. Your visit as auditor of The Iroquois Bank of Pittsfield happens 
 to be concurrent with that of the examiners from the Bank Qjmmissioner's 
 Office. State in detail what modifications, if any, you would feel justified 
 in making in the scope and thoroughness of your audit. 
 
 so. You are instructed to make a report on the earning capacity of a 
 manufacturing plant, as disclosed by its operations during a period of 
 five years. Inventories were taken at the beginning and end of this period, 
 and at yearly intervals between same. What would your procedure be in 
 the examination, and what salient features would you bring out in your 
 report ? 
 
 51. A corporation has on its books $210,000 of accounts receivable, of 
 which $49,000 are long overdue, and apparently worthless. The inventory 
 of finished goods, taken at contract price, less S per cent amounts to 
 $124,000, and from this sum has been deducted $45,000 "to provide for any 
 losses." 
 
 How would you deal with this state of affairs in reporting to the Bank 
 Commissioner on the condition of the corporation for savings bank loans? 
 
 52. The "system of internal checking"' of a savings bank calls for 
 regular observance by the Board of Investment, whether the records of 
 collateral received, and changes thereof, on loans, accord with the votes 
 of the Board. Under these conditions, and in the case of loans on col- 
 lateral security, state (a) whether you would write to each borrower to 
 send to you the details of the note, together with a list of the collateral 
 deposited therewith; (b) whether you would ascertain the market value 
 of the collateral; -(c) what action you would take if you thought that 
 the character of the collateral was inferior, or that the margin was in- 
 sufficient. State (d) whether you would restrict the extent of your general 
 audit because of a high degree of excellence in the "system of internal 
 checking"; (e) the reasons supporting your answers. 
 
 53. A corporation in closing its fiscal year has some 60 items of cur- 
 rent liabilities, which it enters on its books as follows: 
 
 (Sundry accounts) $53,827-34 
 
 Accounts payable $53,827.34 
 
 On the first day of the new year, the bookkeeper makes the following 
 entry: 
 
 Accounts payable $53,827-34 
 
 (Sundry accounts) $53,827-34 
 
 How should the auditor deal with this condition? 
 
654 AUDITING 
 
 The State Board of Accountancy of Ohio 
 
 AUDITING 
 Friday, December 8, 1911, at 9 a. m. (Time Allowance, Three Hours) 
 
 ui. (a) Describe briefly but in detail the several steps you would take 
 in making a complete and detailed audit of the books of account of a manu- 
 facturing corporation. 
 
 (6) Give a list of the books of such a corporation which in a de- 
 tailed audit the auditor should examine. 
 
 2. Under instructions calling for a complete audit and verification of 
 all entries, what supporting data would you require for the following? 
 
 (o) Purchases. (e) Cash Receipts. 
 
 (6) Returned Purchases. (_f) Cash Payments. 
 
 (c) Sales. (g) Journal Entries. 
 (rf) Returned Sales. 
 
 3. In the case of an unexplained absence of a bookkeeper who has 
 entire charge of the accounting for a corporation, state the steps that in 
 your judgment should be taken to determine: first, the actual existing con- 
 ditions; second, whether or not irregularities had been committed. 
 
 4. (o) You are called upon to audit the books of account of a con- 
 cern and discover that for the fiscal year under your inspection it has not 
 shown sufficient profit to justify the payment of any dividends. The man- 
 ager, in order to make a profit showing, has failed to set up the usual 
 reserves for depreciation of buildings, plants, machinery, tools, etc., nor has 
 he sufficiently allowed for losses in the collection of Accounts Receivable, 
 etc. In making your report of audit, what would you do under the cir- 
 cumstances? Give your reasons therefor fully in such form as you would 
 submit them in your report. 
 
 (6) In what way, if at all, would you report the fact that a trusted 
 office manager had overdrawn his salary account at various times, in no 
 case more than $300, all of which had been returned before the time of 
 the annual audit? State your reasons fully. 
 
 5. State the arrangement of a report in which it is desired to present 
 Balance Sheet with supporting schedules of Accounts Receivable, Accounts 
 Payable, Notes Receivable, Notes Payable, and Profit and Loss Account, 
 together with comments on the extraordinary features of the business. 
 
 6. (a) How would you account for the proceeds of sales to customers 
 without checking each entry? 
 
 (6) In passing upon the value shown in the inventory, how should the 
 auditor treat materials costing $10 per unit when the market price is $8 
 per unit, and when the market price is $12 per unit? State reasons fully. 
 
C. p. A. QUESTIONS 655 
 
 7. How should the following assets be valued for a balance sheet? 
 
 (o) Manufactured goods. 
 
 (6) Raw material. 
 
 (c) Accounts Receivable. 
 
 (d) Partially manufactured goods. 
 {e) Notes receivable. 
 
 (f) Stock, bonds, and similar investments. 
 
 (g) A building company engaged in constructbn work 
 under contract has a number of contracts in process 
 of completion. In auditing the accounts of such a 
 company, how would you compute the value of such 
 unfinished contracts as an asset in the Balance Sheet? 
 
 8. A firm having several branches maintains an account with each 
 branch in the ledger and charges all such accounts with goods sent the 
 agents for stock. When the inventory of stock is taken, the balance of 
 each branch account is treated as an ordinary Accounts Receivable and is 
 included in the general debts owing to the iirm. If you see any objections 
 to this method, say how you would deal with the accounts. 
 
 9. Does an auditor's duty in any way extend beyond the careful ex- 
 amination and certifying of the books and accounts submitted to him? 
 Discuss briefly different theories. 
 
 10. (a) The auditor of an incorporated company which has been ac- 
 customed to making investments in interest paying securities, in making 
 his statement to the directors presented a Balance Sheet showing a surplus 
 of $65,000. After discussion, the directors determined that they did not 
 wish to declare a dividend out of this surplus, and gave their auditor the 
 following order: 
 
 "Decrease this surplus by investing $30,000 in the S per cent bonds of the 
 X Y Z Railroad Company." 
 
 Presuming there was an item in the aforesaid Balance Sheet of cash 
 $75,000, what effect will the carrying out of the directors' order have upon 
 the surplus of $65,000? 
 
 (6) What is an audit? Make a definition. 
 
 Minnesota State Board of Accountancy 
 
 Examination April ii, 1912 
 
 AUDITING 
 
 Time Allowed, Six Hours 
 
 I. State the purposes of an audit. To what extent should an audit 
 deal with accounting system? With bookkeeping system? 
 
556 AUDITING 
 
 ''2. Distinguish between the "continuous" and the "completed" audit, 
 stating the advantages and disadvantages of each. 
 
 3. Describe the method of verifying cash on hand at the close of the 
 jeriod under review. 
 
 4. Discuss "the best method of auditing cash receipts." 
 
 5. Discuss "the best method of auditing cash payments." 
 
 6. How would you audit a pay roll? 
 
 7. What special matters should, be investigated in the audit of corporate 
 )ooks ? 
 
 8. What different considerations govern the valuation for balance sheet 
 jurposes of "fixed" and "current" assets? 
 
 9. What is the best procedure in verifying the existence and value of 
 and, buildings, stock-in-trade, investments in stocks and bonds, plant and 
 nachinery, work-in-progress ? 
 
 ID. Discuss "the proper method of treating discounts, freight, and haul- 
 ige on goods or equipment purchased," "on goods sold." 
 
 11. Discuss "the limitations of an investigation of a business on be- 
 lalf of a projected purchasing company." To what extent would fraud by 
 imployees of the vendor bear upon the subject? 
 
 12. In what respects would an investigation of a business on behalf of 
 I retiring or deceased partner differ from one on behalf of a projected 
 mrchasing company? 
 
 13. Discuss "the extent of the auditor's certification." 
 
 14. Discuss "the proper method of presenting the condition and earn- 
 ngs of a holding company which owns from 75 to 100 per cent of the stock 
 if a number of subsidiary corporations." 
 
 15. State the special features which pertain to the audit of the books 
 ind accounts of a building loan association. 
 
 16. State the special features which pertain to the audit of the books 
 md accounts of a street railway company. 
 
 17. State the special features which pertain to the audit of the books 
 md accounts of a fire insurance company. 
 
 v'i8. A mercantile concern sustains a partial loss by fire. The books 
 ;re modern, except no cost accounting is incorporated. The end of the 
 iscal year is December 31, when a physical inventory is taken; the fire 
 ccurred in October and was evidently a two-thirds loss, with full insur- 
 nce. While the adjusters are at work you are called in to satisfy the firm 
 s to their loss, so that they may be prepared for discussion with the in- 
 urance companies. 
 
 Outline your procedure and state how you arrive at the actual loss. 
 
C. p. A. QUESTIONS 657 
 
 Utah 
 
 Examination April 12, 1912 
 AUDITING 
 Time Limit, Three Hours 
 
 1. Explain the meaning of good will. When may it properly appear 
 upon the books of a company as a valuable asset? What principal factors 
 should be taken into consideration in placing a valuation on good will ? 
 
 2. Are stock dividends legitimate at any time? Would you consider 
 it justifiable at any time to pay a dividend with borrowed money? Give 
 reasons for your answers. 
 
 3. What are secret or hidden reserves? How may they be created, and 
 what do you think of their propriety? 
 
 4. For several years a corporation makes reserves of profits to pro- 
 vide for redemption of bonds and for building extensions. When the 
 bonds are redeemed and the extensions made, what disposition would you 
 make of the reserve accounts? 
 
 5. Under what headings would you generally classify the resources and 
 the liabilities in a balance sheet of a manufacturing company? 
 
 6. State the steps necessary to verify the cash receipts and payments 
 for a period, including the resultant cash balance. 
 
 7. In examining the mortgage loans of a bank, insurance company, or 
 other loan company, what papers and records would you examine, and to 
 what points would you give particular notice? 
 
 8. In auditing a corporation, what books and records besides the regular 
 financial account books would you want to examine ? In naming any book , 
 or record give fully your reasons for calling for it. 
 
 g. In what ways may a bookkeeper who is also cashier conceal thefts, 
 his books being kept by double-entry and in balance? 
 
 10. In preparing the balance sheet of a business at the close of a year, 
 how should you treat each of the following items : (a) bad and doubtful 
 debts, (b) premiums for fire insurance unexpired, (c) interest paid in 
 advance on notes payable discounted, (d) discount on accounts receivable, 
 (e) discount on accounts payable, (f) depreciation of plant. 
 
INDEX 
 
 FAGB 
 
 A 
 
 Abbreviations, stock broker's 368 
 
 Accident reserve of electric rail- 
 ways 438 
 
 Accommodation indorsements. ... 166 
 
 Account stated, when binding ... 44 
 
 Accountant's Manual, The, on in- 
 ventory of stock 311 
 
 Accounting as a qualification for 
 
 an auditor 24 
 
 Accounts payable 
 
 audit record of 246 
 
 verifying 149 
 
 Accounts receivable 
 
 audit record of 246 
 
 generally 94 
 
 schedule of 297 
 
 Accumulated dividends as a lia- 
 bility 179 
 
 Actions at law, expenses of 530 
 
 Adams, Prof. Hemy C. 
 
 on depreciation 329 
 
 on railroad accounts 430 
 
 Advantages of an audit 18 
 
 Advertisements, misleading ; mis- 
 use of reports in 239 
 
 Advertising 
 
 agencies 497 
 
 newspaper 398 
 
 register 257 
 
 value of 518 
 
 Agency accounts 
 
 of branches 301, 415 
 
 insurance 375 
 
 Agency expenses, statement of . . . 388 
 
 Agreement, partnership 41 
 
 Allowances 
 
 and rebates 186 
 
 and returns 285 
 
 Amateur auditors 34 
 
 PAGE 
 
 American Association of Public 
 Accountants 
 
 code of ethics of 56 
 
 schedule for municipal indus- 
 tries and public service cor- 
 porations submitted to 424 
 
 American Bankers' Association, 
 form of statement for bor- 
 rowers 220 
 
 American Electric Railway Ac- 
 countants' Association, clas- 
 sification of accounts by ... . 432 
 American Malting Co. case 
 
 (liabihty of directors for un- 
 authorized dividends) .... 273, 594 
 Amortization 
 
 corporation tax and funds for. . 389 
 
 generally 136 
 
 N. Y. Public Service Commis- 
 sion on 322 
 
 of premium and discounts on 
 
 bonds 300 
 
 Analytical mind as a qualification 
 
 of an auditor 27 
 
 Anticipation 
 
 of earnings and profits 188 
 
 on sales not delivered 192 
 
 Appleton V. American Malting Co. 
 
 (liabiHties of directors) 599 
 
 Apportionment between capital 
 
 and revenue or income. .435, 476 
 Appraisal 
 
 of assets 505 
 
 of public utilities 425 
 
 Appreciation in value of assets. . . 193 
 Appropriations and liabilities, dis- 
 tinguished 468 
 
 Architects 
 
 accounts of 486 
 
 certificates of 304 
 
 659 
 
66o 
 
 INDEX 
 
 PAGE 
 
 Arrears of dividends 179 
 
 Assessments 
 
 on capital stock 140 
 
 municipal 460 
 
 Assets 
 
 appreciation in value of 193 
 
 contingent 140 
 
 current 88 
 
 definitions of 88 
 
 and liability items 298 
 
 profit on sale of 193 
 
 verifying 88 
 
 writing down 143 
 
 Astrachan S. S. Co., Ltd., etc. 
 
 (auditor's alleged negligence) . . . 586 
 
 Attorney-general of U. S. on cor- 
 poration tax law 609 
 
 Audit 
 
 advantages of an 18 
 
 beginning an 66 
 
 certificate of 210 
 
 clerks 31 
 
 completed 241 
 
 continuous 241 
 
 fees 160 
 
 minor objects of 10 
 
 notebooks 242 
 
 purposes and advantages of an . 8 
 
 Auditing 
 
 accounting distinguished from . . i 
 
 theory not sufficient in 7 
 
 "Auditor" and "Accountant," 
 
 English distinction between.. 573 
 
 Auditor 
 
 amateur 34 
 
 charitable institutions and the. . 53 
 
 civil liability for negligence. . . . 574 
 
 criminal liability of 574 
 
 dismissal of, during annual en- 
 gagement 574 
 
 duties of 33, 56 
 
 as expert witness 50 
 
 fees of 69 
 
 in N. Y 71 
 
 legal duties and liabilities sum- 
 marized 588 
 
 PAGE 
 Auditor (Continued) 
 
 liabilities of 571 
 
 liability for libel 588 
 
 liability of, limited in certain 
 
 cases 577 
 
 the non-professional 34 
 
 not an insurer 38, 581, 584 
 
 official 36 
 
 official legal opinion on duties 
 
 and liabilities of 590 
 
 "privilege" of 588 
 
 professional 38 
 
 purpose of the 17 
 
 qualifications of the 24, 32 
 
 recovery against, for negligence 23 
 
 what not to report 238 
 
 simple language best for 208 
 
 staff 37 
 
 status under English law. . . .64, 573 
 
 and ultra vires acts 45 
 
 is he a valuer? 105 
 
 Audits, special 54 
 
 Automobile dealers 413 
 
 Automobiles, depreciation of 337 
 
 B 
 
 Bad debts and earnings 186 
 
 Bad debts register 84 
 
 Bad or doubtful accotmts 297 
 
 Balance sheet 
 
 of building and loan association 376 
 English Companies Act form . . . 393 
 
 form of 212 
 
 of holding companies 554 
 
 of Hf e insurance company ..... 384 
 
 of manufacturing concern 392 
 
 object of 175 
 
 omissions from 150 
 
 of taxicab company 442 
 
 Balance-sheet audit 82, 87 
 
 Baltimore and Ohio R. R., rail- 
 road accounting illustrated by 430 
 Bank balances, verification of . . . . 252 
 Bank building, valuation of 144 
 
INDEX 
 
 66i 
 
 PAGE 
 
 Bank of Liverpool case 
 
 (forgery) 552 
 
 Bank loans, audited accounts an 
 
 aid to 18 
 
 Bankers, examinations for 539 
 
 Banks 
 
 clearing house examiners for. . . 350 
 
 interest rules of 566 
 
 national and state, audit of . . . . 349 
 
 statements required by 216 
 
 "Blind" accounts of brokers 370 
 
 Board-minutes inspection 593 
 
 Bonded debt of municipalities. . . . 466 
 Bonding employees 
 
 advantages of audit in 21 
 
 necessity for 39 
 
 Bonds 
 
 auditing 156, 307 
 
 discount on 283 
 
 premiums and discounts on. . . . 300 
 
 valuation of 136 
 
 Book plates, value of 396 
 
 Bookkeepers, instructions for. ... 85 
 Bookkeeping as a qualification of 
 
 an auditor 24 
 
 Bookkeeping, loose-leaf 307, 507 
 
 Books and records 
 
 precautions in handling , 505 
 
 styles of 309 
 
 Borrower's statements. . . .217, 220, 222 
 
 Branch accounts 301, 415 
 
 Breweries 402 
 
 Budget of municipalities 455 
 
 Building and loan associations . . . 372 
 Buildings 
 
 depreciation of 332 
 
 payments on 304 
 
 Burleigh v. Ingram Clark, Lim. 
 
 (accountant's lien) 573 
 
 Business methods, familiarity with 77 
 Business statistics, auditor's col- 
 lection of 510 
 
 C 
 
 Calls and assessments on capital 
 stock 140 
 
 PAGE 
 
 Cancellation of vouchers 295 
 
 Capital 
 
 contingent liabilities and 165 
 
 expenditure 302 
 
 and income 
 
 in electric railways 435 
 
 in executors' accounts 476 
 
 insuflBcient 522, 544 
 
 payments, cash discounts on. . . 303 
 
 reserve for working 178 
 
 and revenue, distinguished 203 
 
 Capital stock 
 
 auditing 307 
 
 audit record of 245 
 
 in bank audit 354 
 
 calls and assessments 140 
 
 premiums on 176, 177, 300 
 
 and surplus 175, 301 
 
 unissued 139 
 
 Cash, audit of 
 
 in bank 91 
 
 on hand 92 
 
 Cash book 
 
 falsification of 254 
 
 stockbrokers' 366 
 
 tabular 254 
 
 Cash discounts 201, 261 
 
 "Cash items" 72 
 
 Cash payments 255 
 
 Cash receipts 253 
 
 Cash and securities, verifying, in 
 
 a bank 352 
 
 Cashier, duties of 83 
 
 Casualty companies 389 
 
 Census Bureau, U. S. 
 
 classification of municipal ex- 
 penses 467 
 
 water supply, uniform accounts 
 
 for systems of 450 
 
 Certificate of audit 210 
 
 (Certificate of auditor, on branch 
 
 ofiSce accounts 302 
 
 Certificates of deposit in bank 
 
 audit 354 
 
 Certificates and reports 207, 238 
 
 Certified cheques in bank audit. . . 354 
 
662 
 
 INDEX 
 
 PAGE 
 
 Certified public accountant laws 
 
 and examinations 639 
 
 Character as an asset 546 
 
 Charitable institutions, forms of 
 
 accounts for 482, 483 
 
 Charitable organizations 479 
 
 Charter-parties 431 
 
 Charts, use of 230 
 
 Chase, Harvey S., on profits of 
 
 public service corporations. . . 422 
 
 Checker, in restaurants 497 
 
 Cheques 
 
 deposit of 252 
 
 as a receipt 274 
 
 verification of 255 
 
 Chicago Association of Commerce, 
 subscriptions investigating 
 
 committee of 54 
 
 Churches 484 
 
 Circulation 
 
 "audits" 399 
 
 manipulation of records of 399 
 
 newspapers, revenue from 398 
 
 City accounts (see under Munic- 
 ipal) 
 
 Civil liability of auditors 574 
 
 Clearing house blotter 366 
 
 Clerical errors 14 
 
 Clerks, audit 31 
 
 Client 
 
 fixing responsibility of 66 
 
 staff of 67 
 
 Clubs 163, 485 
 
 Coal mines 403 
 
 Code of ethics for auditors 56 
 
 Collateral v. integrity 540 
 
 Collection charges 290 
 
 Collections 84, 262 
 
 Columnar cash book 254 
 
 Commission 
 
 errors of 16 
 
 salesmen's 287 
 
 of trustees 476 
 
 Commissioner of Internal Revenue, 
 
 corporation tax regulations of 618 
 
 PAGE 
 Companies (English) Act (see 
 English Companies Act) 
 
 Competition 52S 
 
 Completed audit 241 
 
 Compounded interest 5^4 
 
 Comptroller of the Currency, on 
 bank examinations by direc- 
 tors 358 
 
 Comptroller 
 
 defined 37 
 
 municipal 456 
 
 Compulsory reports 240 
 
 Confirmation of customers' ac- 
 counts 263 
 
 Consigned goods 94, 153, 269 
 
 Construction and equipment of 
 
 electric railways 435 
 
 Construction and maintenance 
 apportionment between, in rail- 
 roads 428 
 
 distinction between 422 
 
 Consumers' register, forms of . . . . 445 
 
 Contingent assets 140 
 
 Contingent fees 71 
 
 Contingent liabilities and capital. 165 
 
 Continuing partner 534 
 
 Continuous audit 
 
 of brokers' accounts 370 
 
 defined 241 
 
 Contractor's accounts 490 
 
 Contracts, value of uncompleted 
 
 487, 491 
 
 Controlling accounts 85, 251 
 
 Cooley, Prof. E. M., on causes for 
 
 depreciation 319 
 
 Cooley, Morgan L., "American 
 
 Audit Record," of 243 
 
 Copying devices ju 
 
 Copyrights 
 
 depreciation of 2,2,7 
 
 valuation of 130 397 
 
 Corporate publicity, tendency to. 49 
 Corporation 
 
 audit of . . 
 
 informal acts of oflScers of 4^ 
 
INDEX 
 
 663 
 
 PAGE 
 
 Corporation tax 
 
 depreciation and the 340 
 
 insurance companies and 389 
 
 the law 601 
 
 Corrections and erasures 507 
 
 Correspondent's accounts in bank 
 
 audit 353 
 
 Cost-keeping systems, misfit 33 
 
 Coupons 
 
 of bonds 307 
 
 unused tickets, etc 161 
 
 Cravens, George A., on deprecia- 
 tion of equipment 335 
 
 Credit 
 basis, character, capital, and 
 
 capacity 542 
 
 to customers 254 
 
 department 186 
 
 memoranda 410 
 
 purpose of 148 
 
 risks 544 
 
 Credit manager 
 
 functions of a 542 
 
 statements requested by 224 
 
 Credit purposes, investigation for. 542 
 
 Creditors, investigations for 539 
 
 Criminal Hability of auditor 574 
 
 Current assets 88 
 
 Customers' accounts 
 
 generally 94 
 
 manipulation of (see Fraud) 
 verification of 100, 263 
 
 Customs as to interest 566 
 
 D 
 
 Damages 
 
 as liabilities 161 
 
 liability for 438 
 
 "Dating" invoices 152 
 
 Decedents' estates, principal and 
 
 income of 205 
 
 Defalcations 53° 
 
 Defaulter, attitude toward 550 
 
 Deferred assets and accounts re- 
 ceivable 98 
 
 PAGE 
 
 Deferred charges to operation 
 
 116, 272 
 Deferred income, magazine sub- 
 scriptions as . . 400 
 
 Departmental accounts, in depart- 
 ment stores 412 
 
 Departmental profits 189 
 
 Department stores 410 
 
 Departments, checks on 313 
 
 Depositors' accounts in bank audit 355 
 
 Deposits 99 
 
 Deposits as liabilities 162 
 
 Depreciation (see also various 
 classes of business) 
 
 calculation of 326 
 
 the Corporation Tax Law and. . 340 
 
 by depletion 405 
 
 of different classes of property. . 331 
 
 by exhaustion 327 
 
 fixed percentage basis of 320 
 
 in gas plants 448 
 
 generally 317 
 
 investment of reserve for 329 
 
 of leaseholds 333 
 
 a local issue 329 
 
 machinery and equipment 124 
 
 in manufacturing concerns 390 
 
 methods of applying 320 
 
 in mtmicipal accounts 465 
 
 in Nipissing Mines Co. case.. . . 341 
 
 an operating expense 328 
 
 place of, in profit and loss ac- 
 count 197 
 
 "production" method of cal- 
 culating 326 
 
 of railroads 430 
 
 rate regulation and 420 
 
 reserve for 318. 
 
 sinking fund method of 321 
 
 sinking funds and 327 
 
 of taxicabs 440 
 
 of telephone plants 452 
 
 of vessels 431 
 
 Detailed audit, the 80, 241 
 
 Detailed or balance sheet audit. . . 79 
 "Development expenses" 426 
 
664 
 
 INDEX 
 
 PAGE 
 
 Dickinson, A. Lowe's 
 on depreciation by depletion. . . 405 
 on moral qualities of an auditor 30 
 profit and loss statement sug- 
 gested by 228 
 
 on profits of a corporation 365 
 
 on profits of public service cor- 
 porations : . . 420 
 
 on reorganizations 537 
 
 Dilapidations 333 
 
 Director, right of, to examine 
 
 books 47 
 
 Directors 
 
 compensation of 593 
 
 of corporations 46 
 
 liabilities of 141, 593 
 
 Discounts 
 
 allowing for 96 
 
 on bonds 283 
 
 on capital payments 303 
 
 cash 261 
 
 cash and trade 201 
 
 in department stores 153, 410 
 
 for prepayment 267 
 
 trade 267 
 
 Dishonored notes 102 
 
 Di\ddends 
 
 audit of 305 
 
 from capital 204, 580 
 
 cash or stock 202 
 
 as a liability 179 
 
 as principal or income 206 
 
 stock 306 
 
 stock and extraordinary cash. . . 206 
 unclaimed 163 
 
 Doctors' accounts 488 
 
 Doubtful accounts 
 
 ledger of 298 
 
 schedule of 297 
 
 DumbeU's Banking Co., Lim. 
 (criminal liability of auditor) . . 574 
 
 Duties of an auditor 34 
 
 Duties, vouching payment of ... . 290 
 
 E 
 Earnings, gross 185 
 
 PAGE 
 
 Economics, knowledge of, as a 
 
 qualification of an auditor. . . 27 
 Education, as a qualification of an 
 
 auditor 29 
 
 Educational institutions 479 
 
 "Efficiency engineer," the 308 
 
 Efficiency of organization 315 
 
 Efficiency theory in office work. . . 316 
 Electric light and power com- 
 panies 445 
 
 Electric railways 432 
 
 Electrotypes, woodcuts, etc., val- 
 uation of 128 
 
 Employees 
 
 bonds of 39 
 
 transactions with 409 
 
 Empties 286 
 
 English auditor 573 
 
 English Companies Act 
 
 balance sheet required by 394 
 
 compulsory reports under 240 
 
 on dividends and reserves. . . 203, 204 
 opinion on auditor's report 
 
 under 590 
 
 provisions as to auditors in. . . . 64 
 
 Entertaining, etc 288 
 
 Equipment, depreciation of 335 
 
 Erasures 507 
 
 Errors 
 
 in the books 533 
 
 detection of 12 
 
 frequency of 17 
 
 kinds of 13 
 
 of principle 545 
 
 Estates 
 
 (see executors and trustees, 475) 
 
 Ethical duties of an auditor 56 
 
 Ethics, code of professional 56 
 
 Evidence, books as 536 
 
 Examination questions for C. P. 
 
 A 641 
 
 Ex-clearing-house blotter 367 
 
 Executors and trustees 475 
 
 Expenditures, extraordinary 283 
 
 Expenses accrued; profit and loss 
 
 account and 200 
 
INDEX 
 
 66s 
 
 PAGE 
 
 Expenses 
 
 in bank audit 355 
 
 extraordinary 283 
 
 and losses 195 
 
 and purchases 274 
 
 Experience, general, as a qualifica- 
 tion for an auditor 26 
 
 Expert witness, auditor as an ... . 50 
 Express arid freight expenses. . . . 292 
 Extraordinary expenditures 283 
 
 F 
 
 Failures in business. 543 
 
 Federal bank supervision, con- 
 demnation of method of 37 
 
 Federal control, knowledge of 
 legislation on, as a qualifica- 
 tion of an auditor 27 
 
 Federal excise tax on corporations 601 
 
 Fees of auditor 69 
 
 inN. Y 71 
 
 Filing auditors' papers 77 
 
 Filing systems, essential features' 
 
 of 310 
 
 Financial enterprises, audit of . . . . 348 
 
 Finished goods, value of in 
 
 Fire insurance companies 379 
 
 Fire loss, advantages of audit in. . - 20 
 
 Firm or individual, audit of a. . . . 40 
 
 Firm insurance 43 
 
 First National Bank v. Davis 
 
 (usurious interest) 564 
 
 Fixed assets 117 
 
 Fixtures, landlord's 336 
 
 Flax crops, depreciation of land by 331 
 Floy, Henry 
 
 on appraisal of public utilities. . 425 
 
 on depreciation 321 
 
 Fluctuation 
 
 and depreciation 317 
 
 profits on 517 
 
 reserve 3^4 
 
 Footings and postings, verifica- 
 tion of 248 
 
 Foreign branches 417 
 
 Foreign exchange 417 
 
 PAGE 
 
 Forgan, James B., on bank di- 
 rectors' responsibility 351 
 
 Forgeries 506 
 
 Foster's Valuation of Public Utili- 
 ties (quoted) 339 
 
 Foundry charts 235, 236 
 
 Fraud 
 
 audit not an insurance against 
 
 38, 581, 584 
 
 detection of 11 
 
 in investigations 506 
 
 in sales accounts 515 
 
 in trading business 407 
 
 the "trusted employee" and. . . 548 
 
 Fraud, instances of 
 
 in the Bank of Liverpool case. . 551 
 
 in bankruptcy cases 546 
 
 in banks 357 
 
 defalcations 530 
 
 in insurance company 380 
 
 in the Mill wall Dock case 551 
 
 in railroads 429 
 
 in real estate agency 493 
 
 in stock broker's office 371 
 
 Freight 
 
 and express expenses 292 
 
 generally 160 
 
 in manufacturing concerns 390 
 
 Fund and other permanent in- 
 vestments 136 
 
 Furniture and fixtures 
 
 depreciation of 336 
 
 valuation of 126 
 
 Future delivery, sales for 192 
 
 G 
 
 Gambling 279 
 
 Gas Companies 44/ 
 
 "Going concern" and "scrap" 
 
 valuations 1 19 
 
 Gold mines 406 
 
 Good will 
 
 depreciation of 338 
 
 treasury definition of 630 
 
 valuation of 131 
 
 Goods in process no 
 
56 
 
 INDEX 
 
 PAGE 
 
 rraft" and legal expenses 284 
 
 :oss profits 314 
 
 larantees as contingent liabili- 
 ties 169 
 
 H 
 
 salth companies 389 
 
 3at and power companies 445 
 
 siding companies 553 
 
 3man v. Quilter (dismissal of 
 
 auditor) 574 
 
 arses 
 
 depreciation of 336 
 
 valuation of 127 
 
 Dspitals, audits of 479 
 
 atels 496 
 
 Duse of Lords, committee re- 
 port (civil liability of auditor) 574 
 iitchinson and McEUieny, Jr., 
 etc., V. Curtiss and The Amer- 
 ican Malting Co. 
 (director's liability for unau- 
 thorized dividends) 595 
 
 I 
 lagination as a qualification of 
 
 an auditor 27 
 
 mprest" system 280 
 
 come 
 
 extraordinary stock dividends 
 
 and 206 
 
 net and gross, defined 615 
 
 verification of 258 
 
 come and expenses 
 
 audit of 247 
 
 in prior periods 247 
 
 come from investments, verifi- 
 cation of 265 
 
 .come, verification of in bank 
 
 audit 355 
 
 idorsements as liabilities 166 
 
 istallment accounts, reserve for 
 
 loss on 397 
 
 istallment contracts 103 
 
 istitution or similar organization, 
 auditor of an 53 
 
 PAGE 
 
 Insufficient capital 522 
 
 Insurance 
 
 firm 43 
 
 policies as guides to title 89 
 
 premiums 291 
 
 sufficiency of 545 
 
 on vessels 43' 
 
 Insurance companies 
 
 audit of 378 
 
 corporation tax and 389 
 
 reserve, as a liability 174 
 
 Integrity v. collateral 54° 
 
 Interest 
 
 accrual of 205 
 
 on bank deposits 267 
 
 and collection charges 290 
 
 methods of calculating 563 
 
 payable 158 
 
 receivable, verification of 266 
 
 Interim audits 242 
 
 Internal audit in department 
 stores 410 
 
 Internal checks 
 
 in bank audit 356 
 
 system of 83 
 
 Internal Revenue, Bureau of: rul- 
 ing on bad debts 187 
 
 International Harvester Co.: rule 
 
 as to profits on forward sales 192 
 
 Interstate Commerce Commission 
 classes of accounts for electric 
 
 railways 433 
 
 development of the 419 
 
 failure of,'=;to obtain analysis of 
 property^accounts 118 
 
 Inventories 
 
 audit record of 246 
 
 basis of value in 104 
 
 of department store 413 
 
 finished goods in lii 
 
 generally 84, 299, 519 
 
 goods in process in no 
 
 perpetual 311 
 
 of retail merchants 409 
 
 secret reserves and 143 
 
 supplies, stores, etc., in 113 
 
INDEX 
 
 667 
 
 PAGE 
 
 Inventories (Continued) 
 
 verification of 107 
 
 Inventory, the turnover and the. . 112 
 
 Investigations 502 
 
 Investment companies 362 
 
 Investment securities, inventory 
 
 of 113 
 
 Investments 
 
 ascertaining value of 365 
 
 of trustees 476 
 
 Invoices, purchase 276 
 
 Irish Woolen Mill Co., Lim., v. 
 Tyson 
 
 (auditor's negligence) 278, 583 
 
 J 
 
 Jones V. Terre Haute & Richmond 
 R. R. Co. 
 (interest of stockholders in cor- 
 poration) 305 
 
 Journal vouchers 293 
 
 Judgments 157 
 
 K 
 
 Kingston Cotton Mill Co., In re 
 
 (inflation of inventory) 108 
 
 (liabiHty of auditor) 577 
 
 Kirkbride & Sterrett's, "The Mod- 
 em Trust Company," on bank 
 interest 566 
 
 L 
 
 Land, depreciation of 331 
 
 Land and buildings, valuation of. 119 
 
 Land and development companies 494 
 
 Landlord's fixtures 336 
 
 Lawless v. Anglo- Egyptian Cotton 
 & Oil Co., Lim. 
 
 (auditor's liability for libel) .... 588 
 
 Lawyers' accounts 489 
 
 Leake, P. D., on depreciation 317 
 
 Leaseholds 
 
 depreciation of 333 
 
 valuation of 122 
 
 Leases, investigation of 519 
 
 PAGE 
 Ledgers 
 
 columnar 315 
 
 generally 84 
 
 self-balancing 315 
 
 stockbrokers' 367 
 
 subsidiary 314 
 
 Leeds Estate Bldg. & Investment 
 Soc'y, Lim., v. Shepherd 
 
 (auditor's duty) 580 
 
 Legal expenses 160 
 
 Legal expenses and "graft" 284 
 
 Legislation, proposed, for com- 
 pulsory audits 58 
 
 Liabilities 148 
 
 of auditors 571 
 
 contingent 165 
 
 of directors 141 
 
 outstanding 298 
 
 Liability and asset items 298 
 
 Libel, auditor's liability for 588 
 
 Lien of accountant 573, 574 
 
 Liens and hypothecations 89, 227 
 
 Life insurance companies 382 
 
 Liverpool & Wigan Supply Ass'n, 
 Lim., case 
 
 (auditor's negligence) 579 
 
 Loans 
 
 by officers to corporation 46 
 
 record of brokers' 368 
 
 London & General Bank, In re 
 
 (auditor's duty) 580 
 
 London Oil Storage Co., Lim., v. 
 Seear, Hasluck & Co. 
 
 (auditor's negHgence) 586 
 
 Loose-leaf records 309, 507 
 
 Lots, sale of building 273 
 
 Lybrand, William M. 
 
 on holding companies 554, 556 
 
 on intercompany profits 190 
 
 on profit and loss of subsidiaries 559 
 
 M 
 Machinery 
 
 depreciation of 334 
 
 purchase of 305 
 
 valuation of 124 
 
68 
 
 INDEX 
 
 PAGE 
 
 lagazines, publishers of 397 
 
 lail books 279, 293 
 
 lail, safeguarding incoming 84 
 
 lailing department 311 
 
 Iain, Frank W., on incompetent 
 
 auditors 32 
 
 laintenance and asset accounts, 
 
 secret reserves and 142 
 
 lanipulation of accounts 12 
 
 (see also Fraud) 
 lanuf acturing and trading profits, 
 
 anticipation of 188 
 
 lanuf acturing concerns 390 
 
 largia record 367 
 
 larking records 506 
 
 lartin v. Isitt 
 
 (auditor's responsibility) 587 
 
 lartindale, Joseph B., on propor- 
 tion between capital and 
 
 other assets 89 
 
 lassachusetts act of 1909, as to 
 
 interest 569 
 
 lay, George O., on expenses of 
 
 seasonal business 282 
 
 laynards, Lim., v. Maynards and 
 others 
 
 (auditor's liability) 579 
 
 Memorandum books 258, 259 
 
 Memorandum," goods out on. . . 269 
 Mercantile agencies, forms for 
 statements of financial condi- 
 tion 222 
 
 Merchants, wholesale 407 
 
 Metz Fund, on municipal ac- 
 counting 459, 469 
 
 .Mileage account 288 
 
 MiHwall Dock case 
 (fraudulent manipulation of ac- 
 counts) 551 
 
 M^ilwaukee Three-Cent Fare case, 
 depreciation rates quoted in. . 339 
 
 .Minerals, depreciation of 345 
 
 /lines 
 
 depreciation of 338 
 
 leases and royalties on 347 
 
 valuation of 140 
 
 PAGE 
 
 Minimum rents in mining accounts 403 
 
 Mining 403 
 
 Mining accounts, minimum rents 
 
 in 403 
 
 Minors, as beneficiaries of estates. 478 
 Minute book, contingent liabili- 
 ties shown by 171 
 
 Misappropriation of money or 
 
 goods II 
 
 (see also Fraud) 
 
 Misfit, cost-keeping systems 33 
 
 Montgomery, Robert H., on profits 
 
 of public service corporations 420 
 Moral qualities, auditor's need of. 30 
 Mortgages 
 
 generally 155 
 
 upon coal and ore lands 405 
 
 Municipal Accounting, Handbook 
 
 of 469 
 
 Municipal accounting 455 
 
 Municipal accounts. Exhibits i to 
 
 8 471-474 
 
 Municipal ownership of water- 
 works 449 
 
 Municipal revenues 457 
 
 Municipal industries, schedule of 
 
 revenue and expense for 424 
 
 Municipal statements 463 
 
 N 
 
 National Association of Credit 
 Men, statement recommended 
 
 by 225 
 
 National bank examiners 349 
 
 Negligence of auditor, recovery on 
 
 ground of 23 
 
 Net profits defined 598 
 
 New works in place of old 142 
 
 New York Clearing House; in- 
 terest, custom as to 568 
 
 New York Firemen Ins. Co. v. Ely 
 
 (usury) 569 
 
 New York National City Bank, 
 on bank examinations by di- 
 rectors 358 
 
INDEX 
 
 669 
 
 PAGE 
 
 New York Public Service Commis- 
 sion, on amortization 322 
 
 New York State, proposed "Busi- 
 ness Companies Act" for. ... 59 
 New York State Bankers' Associa- 
 tion, standard form of borrow- 
 ers' statement 217 
 
 New York statute as to interest . . 569 
 New York Stock Corporation Law 
 
 on dividends from capital. . . 204 
 New York Third Ave. Ry. Co. 
 
 (amortization) 322 
 
 Newspapers 
 
 manipidation of circulation re- 
 cords by 399 
 
 publishers of 397 
 
 Newton v. Birmingham Small 
 Arms Co., Lim. 
 (auditor withholding informa- 
 tion) 588 
 
 Nipissing Mines Co. case 
 
 (depreciation) 341 
 
 Niven, John B., on profits of pub- 
 lic service corporations 422 
 
 Non-professional auditors 34 
 
 Notebooks, audit 242 
 
 Notes, confirmation of in batik 
 
 audit 353 
 
 Notes discounted, as liabilities. . . 165 
 Notes payable 
 
 concealing personal loans.. .154, 155 
 
 vouchers of 305 
 
 Notes receivable loi, 299 
 
 O 
 
 Obsolescence 
 
 depreciation due to 319 
 
 generally 125, I99 
 
 importance of provision for 330 
 
 Office methods 308 
 
 Office methods with branch records 416 
 
 Officers of corporations 45 
 
 Official auditors 36 
 
 Ofisetting errors 16 
 
 Omission, errors of I5 
 
 Ordef and receiving records 151 
 
 PAGE 
 
 Order books 260 
 
 Organization expenses 281 
 
 Outside enterprises 
 
 liabilities in 168 
 
 loans 266 
 
 Outstanding accounts 297 
 
 Outstanding discounts 96 
 
 Outstandings 
 
 confirmation of 263 
 
 valuing 95 
 
 Overdue accounts, valuation of. . . 96 
 
 Overextension of business 167 
 
 P 
 
 Packages, valuation of 126 
 
 Participations and imderwritings. 193 
 
 Partition of estate 478 
 
 Partner, investigation for a re- 
 tiring 534 
 
 Partners' salaries 531 
 
 Partners' withdrawals 305 
 
 Partnership, advantages of audit 
 
 to 20 
 
 Partnership agreements, detailed 
 
 consideration of 41 
 
 Partnership and individual excise 
 
 tax, proposed 632 
 
 Pass-book 84 
 
 Pass-books, in bank audit 354 
 
 Patent Htigation, investigation in. 547 
 Patents 
 
 depreciation of 337 
 
 valuation of 129 
 
 Patterns, drawings, lasts, etc., 
 
 valuation of 127 
 
 Pay roll 
 
 book 287 
 
 chart 235 
 
 in department stores 411 
 
 in manufacturing concerns 390 
 
 municipal 461 
 
 padding prevented by compara- 
 tive statistics 237 
 
 system necessary 84 
 
 vouchers for 279 
 
570 
 
 INDEX 
 
 PAGE 
 
 Pennsylvania, proposed legislation 
 in, for compulsory audits. ... 58 
 
 Percentage of profits 232 
 
 Periodical audits, responsibility of 
 
 auditor in 587 
 
 Perpetual inventory 311 
 
 Petty cash 
 
 imprest method of 280 
 
 vouchers for 279 
 
 'Petty expenses" 280 
 
 Postage or mail books 279 
 
 Postage, vouchers for 292 
 
 'referred stock accumulated divi- 
 dends as a liability 179 
 
 Preliminary expenses, treatment of 281 
 'remiums on capital stock.. . . 177, 300 
 'remiums and discounts on bonds 300 
 Premiums paid on securities by 
 
 trustees 477 
 
 'revious audits, procedure on fol- 
 lowing 79 
 
 'rincipal, method of calculating . . 563 
 'rindpal and income 
 
 distinction between 203, 476 
 
 distinction in decedents' estates 205 
 
 'rindple, errors of 13 
 
 'rivate ledger, audit record of . . . . 245 
 
 'Privilege" of auditor 588 
 
 'rofessional auditors 38 
 
 'rofessional ethics, code of 56 
 
 'rofit and loss account 181 
 
 'rofit and loss account of building 
 
 and loan association 377 
 
 'rofit and loss statement 228 
 
 'rofits 
 
 accountant's definition of 184 
 
 anticipating 188 
 
 charts (gross and net) 232 
 
 contracts on maximum 189 
 
 departmental 189 
 
 disposition of 202 
 
 economic definition of 183 
 
 on fluctuations 517 
 
 gross 314 
 
 insurance 530 
 
 legal definition of 182 
 
 FACE 
 
 Profits (Continued) 
 
 on sale of assets 193 
 
 of subsidiary companies 190 
 
 and "surplus" distinguished. . . . 184 
 Program of audit of broker's office 368 
 Promissory notes (see Notes) 
 
 Promoters, disreputable 502 
 
 Promoters' expenses 281 
 
 "Proof sheet" of subsidiary ledgers 314 
 
 Protested notes receivable 299 
 
 Public Service Commissions 
 
 orders of affecting a business. . . 533 
 
 powers of 418 
 
 Public service corporations 
 
 profits of 420 
 
 schedule of revenue and expend- 
 iture for 424 
 
 Public utilities 
 
 audit of 418 
 
 deposits required by 162 
 
 PubUc utihty companies, depre- 
 ciation rates of 339 
 
 Publicity, corporate; tendency to. 49 
 
 Publishers of books 394 
 
 Publishers of magazines and news- 
 papers 397 
 
 Purchase invoices 276 
 
 Purchase records 250 
 
 Purchase returns 294 
 
 Purchases and expenses 274 
 
 Purchases and sales charts 233 
 
 Q 
 
 Qualifications of the auditor. . . .24, 32 
 
 of assistants 31 
 
 as expert witness 50 
 
 Quick assets 88 
 
 R 
 
 Railway 
 
 steam 427 
 
 street' 432 
 
 Rate of interest 565 
 
 Real estate 
 
 accounts 492 
 
 depreciation of 345 
 
 payments on 303 
 
INDEX 
 
 671 
 
 PAGE 
 
 Realizations from profit and loss.. 269 
 Reckitt, Ernest 
 
 on holding companies 558 
 
 on profits of public service cor- 
 porations 420 
 
 on secret reserves 147 
 
 Reconstruction expenditures of 
 
 electric railways 436 
 
 Records, special business 256 
 
 Renewals and repairs 284 
 
 Rent 160 
 
 Rents of manufacturing concern.. 391 
 
 Rents receivable 97, 268 
 
 Reorganizations, investigations of 537 
 
 Repairs and maintenance 320 
 
 Repairs and renewals 284 
 
 Reports (see also Investigations) 
 
 compulsory 240 
 
 restrictions on use of 239 
 
 scope of 209 
 
 scope of in bank audit 356 
 
 Reports and certificates 207 
 
 Reserve for working capital 178 
 
 Reserves 172, 195 
 
 Reserves, secret 141 
 
 Residuals, sale of 447 
 
 Restaurants 497 
 
 Retail merchants 408 
 
 "Returned Purchases" book 295 
 
 Returns 185 
 
 Returns and allowances 285 
 
 "Revenue" statement 228 
 
 Royalties 
 
 adjustment of 532 
 
 authors' 394 
 
 S 
 
 Salaries, checking 287 
 
 Sale of a business, advantages of 
 
 audit in 22 
 
 Sale or purchase of a business, 
 
 investigation upon the 508 
 
 Sales 
 
 charts 231 
 
 checking 84 
 
 goods received for 270 
 
 PAGE 
 
 Sales (Continued) 
 
 not delivered 271 
 
 profit on 412 
 
 records 251 
 
 verification of 259, 515 
 
 Salesbook 84 
 
 Salesmen's commissions 287 
 
 Savings accounts, employees' .... 163 
 
 Savings banks, auditing 360 
 
 Seasonal balances in department 
 
 stores 412 
 
 Seasonal business, expenses of . . . . 282 
 Secret reserve 
 
 auditor's attitude as to 146 
 
 in bank audit 356 
 
 discussion of 141 
 
 fluctuation as a 317 
 
 Securities 
 
 inspection of 374 
 
 as stqck-in-trade 113 
 
 verifying, in a bank 352 
 
 Self-balancing ledgers 315 
 
 Selling campaigns as deferred as- 
 sets 282 
 
 Sells, Elijah W., on profits of pub- 
 lic service corporations 420 
 
 "Settlement sheet" in theaters. . . 499 
 
 Shipping companies 430 
 
 Ships, depreciation of 337 
 
 Short & Compton v. Brackett 
 
 (accountant's liability) 579 
 
 Smking funds 
 
 accoimts 177 
 
 depreciation and 327 
 
 discussion of 135 
 
 municipal 462 
 
 Small tools, valuation of 125 
 
 Smith V. Sheard 
 
 (auditor's negligence) 587 
 
 Societies, building and loan 372 
 
 Special audits 54 
 
 Speculative securities companies.. 364 
 
 Staff auditors 37, 82 
 
 Stamps, postage and other 116 
 
 Standard Oil Co. of Indiana, stock 
 
 dividend of 306 
 
INDEX 
 
 PAGE 
 
 ate Bank of N. C. v. Cowan 
 
 (interest) 568 
 
 atement of earnings and ex- 
 penses of taxicab company. . . 441 
 atement of financial condition, 
 
 sample 3 
 
 ationery 
 
 for auditor 74, 212 
 
 controlled financial 458 
 
 ationery house "auditing" 308 
 
 atistics, value of comparative . . 237 
 
 eam railroads 427 
 
 ock 
 
 charging, at sale price 409 
 
 dividends 306 
 
 and extraordinary cash divi- 
 dends 206 
 
 on hand 311 
 
 record 367 
 
 subscriptions 103 
 
 ock accounts, in branches 416 
 
 ock in trade (see Inventories) 
 ockbrokers 
 
 audits of accoimts 365 
 
 interest, customs as to 567 
 
 ockholders and public, protec- 
 tion of: advantages of audit 
 
 in 21 
 
 ocks and bonds, depreciation of 344 
 
 reet railways 432 
 
 ibcontractor's accounts 492 
 
 ibscription earnings account of a 
 
 magazine 400 
 
 ibscription record 257 
 
 ibsidiaries, profits of 190 
 
 ibsidiary ledgers, controlling. . . 314 
 ippUes, stores, etc., inventory of 113 
 
 irety companies 389 
 
 arplus 179 
 
 irplus accoimt of life insurance 
 
 company 386 
 
 irplus and profits distinguished. 184 
 ispense accounts 
 (see Contingent liabilities, 1^5, 
 and Outstanding accounts, 
 297) 
 
 PAGE 
 
 System 
 
 on computation of good will . . . 132 
 
 foundry charts from 235 
 
 Systems of accounts, criticisms of. 525 
 Systems, office 308 
 
 T 
 
 Tabular cash book 254 
 
 Tabular ledger 315 
 
 Taft's Commission on Economy 
 and Efficiency, Pres.: sugges- 
 tions of 310 
 
 Tax rate, fixing the 455 
 
 Taxes 
 
 adjustments of 532 
 
 auditing 307 
 
 discussion of 158, 460 
 
 secret reserves to diminish 142 
 
 Taxicab companies 438 
 
 Teele, Arthur W., on railroad ac- 
 counts 430 
 
 Telephone companies 450 
 
 Temporary investments 115 
 
 Terminology of reports, simplicity 
 
 advisable in 208 
 
 Theaters 498 
 
 Theatrical companies 500 
 
 Theory of auditing, value of 25 
 
 Ticket sales of electric railways. . . 434 
 
 Timber, removal of 345 
 
 Timber lands 
 
 depreciation of 338 
 
 valuation of 140 
 
 Time of interest 565 
 
 Title guarantee companies 389 
 
 Tools, small: depreciation of 336 
 
 Tract development 493 
 
 Trade creditors 151 
 
 Trade discounts 201, 267 
 
 Trading business, statement of 
 
 earnings and expenses of a. . . 514 
 Trading — wholesale merchants . . . 407 
 
 Traffic earnings of railroads 428 
 
 Traveling expenses and commis- 
 sions 160, 288 
 
INDEX 
 
 673 
 
 PAGE 
 
 Treasury Department 
 
 on corporation excise tax 614 
 
 decision 1742 on depreciation. . 344 
 decisions on corporation tax. . . 624 
 
 on depreciation 318 
 
 depreciation defined by the. . . . 340 
 
 interest, rule as to 568, 569 
 
 Treasury stock 138 
 
 Trial balance 296 
 
 Trust companies 361 
 
 Trustees and executors 475 
 
 Turnover, the 112, 516 
 
 U 
 
 Ultra vires acts 45 
 
 Unclaimed dividends 163 
 
 Underwritings and participations. 193 
 Unfilled contracts as contingent 
 
 liabilities 170 
 
 Unfinished work, architects': val- 
 uation of 487 
 
 Unissued capital stock 139 
 
 Unit costs or earnings 230 
 
 Unit period of interest 568 
 
 United States Steel Co., inter- 
 company profits of 191 
 
 Unusual items, elimination of . . . . 528 
 Usury 
 
 (see Interest, 563) 
 
 V 
 Valuation, as "'going concern" and 
 
 "scrap" 119 
 
 Verification of outstandings 100 
 
 Visualizing transactions 2 
 
 Vouchers 
 
 cancellation of 295 
 
 cheques as 274 
 
 generally 84 
 
 PAGE 
 
 Vouchers (Continued) 
 
 missing 278 
 
 not always conclusive 81 
 
 for petty cash, pay roll, etc. . . . 279 
 useless checking of 277 
 
 W 
 Wages (see also Pay roll) 
 
 discussion of 159, 288 
 
 Wagons, automobiles, etc., valua- 
 tion of 127 
 
 Wagons, depreciation of 337 
 
 Wasting assets 139, 205, 338 
 
 Water companies 449 
 
 Water rates, etc 159 
 
 Weiss, William F., on stock divi- 
 dends and income 206 
 
 Whinney, Frederick; testimony be- 
 fore committee of House of 
 Lords on auditor's liability. . 575 
 
 Wholesale merchants 407 
 
 Wickersham, G. W., on corpora- 
 tion tax law 609 
 
 Wilde and others v. Cape and 
 Dalgleish 
 (auditor and accountant dis- 
 tinguished) 573 
 
 Wildman, John R., on trade dis- 
 counts 201 
 
 Wilkinson, George, on "Auditing 
 
 Insurance Accounts" 381 
 
 Wisconsin Railroad Commission, 
 telephone accounting system 
 
 of 452 
 
 Work in progress 
 
 profit on 187 
 
 valuation of contractors' 490 
 
 Working papers 
 
 discussion of 73 
 
 in investigations 503 
 
;-^3a