OF THE 
 
 University of California. 
 
 Class 
 
Digitized by the Internet Archive 
 
 in 2007 with funding from 
 
 IVIicrosoft Corporation 
 
 http://www.archive.org/details/auditingpracticaOOdickrich 
 
AUDITING 
 
 A PRACTICAL MANUAL 
 FOR AUDITORS 
 
 By 
 
 LAWRENCE R. DICKSEE, M.Com., F.C.A. 
 
 (of the firm of SeLlaRS, DICKSEE ca CO.) 
 
 Formerly Professor of Accounting at the University of Birmingham, 
 
 cow of the London School of Economics and Political Science (University of London) 
 
 Editedlby 
 
 ROBERT H. MONTGOMERY, C.P.A. 
 
 (ofthc firm of LYBRAND, ROSS BROS. Ca. MONTGOMERY) 
 Attorney at Law 
 
 AUTHORIZED AMERICAN EDHION 
 
 Rel>ised and Enlarged 
 
 ^brIa 
 
 OF THE 
 
 UNIVERSITY 
 
 OF 
 
 IFOKN^ 
 
 RONALD PRESS CO. 
 NEW YORK 
 
 1909 
 

 
 Copyright, 1909 
 
 by Robert H. Montgomery 
 
 All Rights Reserved. 
 
 
CONTENTS 
 
 PAGE 
 
 Statement by the Author of the English Edition, . . 4 
 
 Preface to the American Edition, 5 
 
 Preface to the Second American Edition, 8 
 
 Introduction by A. Lowes Dickinson 11 
 
 I. — Introduction, 17 
 
 II. — Methods of Account, 55 
 
 III. — Special Considerations in Different Classes of 
 
 Audits, 90 
 
 IV. — The Same (Continued) 132 
 
 V. — The Same (Continued), 158 
 
 VI. — From Trial Balance* to Balance Sheet, ... 168 
 
 VII. — Form of Accounts and Balance Sheets, . . . 208 
 
 VIII. — What are Profits? 246 
 
 IX. — The Attitude of the Auditor, 266 
 
 X. — The Liabilities of Auditors, 290 
 
 XI. — Investigations, 315 
 
 XII. — Interest, 342 
 
 Appendix A. Legal Liability of Auditors, Legal 
 
 Decisions, &c., 356 
 
 Appendix B. Professional Ethics, 380 
 
 Appendix C. American Malting Case, 386 
 
 Appendix D. Forms of Accounts, 396 
 
 Appendix E. C. P. A. Examination Questions, ... 510 
 
 Appendix F. Extract from "Tretyce off Housebandry," 537 
 
 Appendix G. United States Corporation Tax Law of 1909 540 
 
 202587 
 
AUTHORIZATION. 
 
 To avoid misunderstanding I have thought it desirable to 
 append a note to][this volume, pointing out that it has been 
 issued by arrangement with me, and that the various altera- 
 tions and amendments that have been effected, with a view to 
 making the work more^suitable to the needs of American prac- 
 titioners and accountant students, have all been submitted to 
 me and have met with my entire approval. 
 
 The numerous extracts from Acts of Parliament that appear 
 in the English Edition have been omitted, and the somewhat 
 voluminous reports of British legal decisions have been ma- 
 terially condensed ; but the alterations in the body of the work 
 are only such as appeared to be called for under the cir- 
 cumstances, and while condensation has taken place in some 
 directions, in others the scope of the work has been con- 
 siderably elaborated. 
 
 I trust that the production of this Americanized Edition of 
 my work will add to the popularity that it has already earned 
 in the States during the past seventeen years. 
 
 LAWRENCE R. DICKSEE. 
 
 CoPTHALL House, 
 London, E. C, 
 England. 
 24th September, 1909. 
 
OF THE 
 
 UNIVERSITY 
 
 OF 
 
 PREFACE TO THE AMERICAN EDITION. 
 
 It cannot be expected that any hard'and fast rules will ever 
 prevail, nor is it desirable that the personal element in an 
 audit should be superseded by instruction prepared in advance, 
 but Jt must be admitted that the experiences of one profes- 
 sional Auditor are of great value to others. It is the object of 
 this work, therefore, to state as concisely as possible, the 
 results of Mr. Dicksee's experience supplemented by sugges- 
 tions from leading English and American accountants, and it 
 is believed that some portion of this book, at least, will be 
 found valuable to every American practitioner and student* 
 
 Much of the matter herein contained is taken verbatim 
 from Mr. Dicksee's English edition, which for many years 
 has been the standard work on Auditing both in Great Britain 
 and America. The principal changes, therefore, are those 
 which are cau sed by the numerous differences existing between 
 accountancy nomenclature, laws and customs of Great Britain 
 and the United States. 
 
 The interchange of thought which^^has followed the various 
 meetings of the English Societies, and which has been of great 
 value to the profession at large, had no counterpart in the 
 United States until the holding in September, 1904, of the 
 Congress of Accountants at St. Louis. Discussion of the 
 papers read on various accountancy topics did much to em- 
 
 5 
 
6 PREFACE TO THE AMERICAN EDITION. 
 
 phasize the importance of a better understanding among ac- 
 countants, particularly along the lines of uniform methods of 
 preparing and stating accounts. These suggestions covered 
 not only municipal and public service corporation accounts, 
 but embraced general methods as well. 
 
 We find ourselves, therefore, at the very threshold of what 
 may be called a new era in the profession in the United States, 
 and we are fortunate in having the benefit of the best English 
 practice as a guide to our broadened field. We must recog- 
 nize, however, the wide differences between our laws and cus- 
 toms, and, while the essential principles underlying all prop- 
 erly conducted audits are the same, yet it may be found here- 
 after that more radical modifications in Mr. Dicksee's text will 
 be in order. 
 
 References made herein to American customs are based on 
 my general practice and observations covering a number of 
 years, but no claim is made, of course, that the field has been 
 sufficiently covered to warrant the statement that the last 
 word has been said on any subject of which mention is made. 
 On the contrary, it can only be hoped that the necessity for a 
 somewhat better understanding as to "good practice" than 
 has heretofore existed will be recognized. 
 
 I take this opportunity to express my indebtedness to 
 several members of the profession for valuable suggestions 
 received. In particular I desire to express my thanks to 
 Arthur Lowes Dickinson, M.A., F.C.A., C.P.A., and to my 
 partner, William M. Lybrand, C.P.A. 
 
 As a fitting conclusion, nothing better expresses my thought 
 than the last clause of the Preface of Mr. Dicksee's first 
 English Edition : — 
 
PREFACE TO THE AMERICAN EDITION. 7 
 
 "As I have no claim to completeness in this work, so also 
 do I wish to disclaim any assumption of absolute finality; and, 
 accordingly, I shall consider myself greatly indebted to my 
 readers for any suggestions and opinions with which they may 
 be pleased to favor me, which, I need hardly add, shall re- 
 ceive every attention upon the publication of a new edition." 
 
 ROBERT H. MONTGOMERY. 
 
 43 Exchange Place, 
 
 New York. 
 2Sth August, 1905. 
 
PREFACE TO THE SECOND AMERICAN 
 
 EDITION. 
 
 During the four years which have elapsed since the publica- 
 tion of the first American edition of this work, four thousand 
 two hundred and fifty (4250) copies have been printed. 
 
 Its reception was very gratifying and it is to be hoped that 
 the present edition will be received as kindly. 
 
 The entire text of the first edition has been revised, but no 
 material changes have been made in the general principles 
 which, as enunciated by Mr. Dicksee and again reprinted, 
 represent the best thought of the profession here and abroad. 
 
 Within a few years there has been a considerable advance 
 with respect to standard forms of accounts and it seemed 
 wise to reproduce a number of them in this volume. 
 
 Other new matter also appears, all of which is submitted 
 with the hope that it may prove of interest to members of 
 the profession and of practical assistance to students. 
 
 I am indebted to Walter A. Staub, C. P. A., for his services 
 in connection with this edition, particularly with reference 
 
 8 
 
PREFACE TO THE SECOND AMERICAN EDITION. 9 
 
 to the chapter on Interest and the Discussion of the Corpora- 
 tion' Tax Law. 
 
 I wish to repeat the statement which will be found in the 
 preface to my first edition, viz.: "I shall consider myself 
 greatly indebted to my readers for any suggestions and 
 opinions with which they may be pleased to favor me." 
 
 ROBERT H. MONTGOMERY. 
 
 165 Broadway, 
 
 New York. 
 2d December, 1909. 
 
OF THE 
 
 UNIVERSITY 
 
 OF 
 
 INTRODUCTION. 
 
 BY ARTHUR LOWES DICKINSON, M.A., F.C.A., C.P.A. 
 
 The publication of an American edition of Mr. L. R. 
 Dicksee's work on Auditing is further evidence of the grow- 
 ing importance to the community of a correct understanding 
 of the principles of Accounting; and the fact that this edition 
 has received the support of educational authorities throughout 
 the country is full of promise for the future of the still young 
 profession of the Public Accountant. 
 
 Bookkeeping is a simple science, and complete mastery of 
 its principles does not call for any very high order either of 
 intelligence or of education. Bookkeeping, however, is only 
 one, and perhaps the smallest, of the necessary qualifications 
 for the Public Accountant who would succeed in his profession. 
 
 The question is daily asked — What is a Public Accountant ? 
 And the answer that best defines his place in the world of 
 Commerce may, perhaps, be expressed as follows: A Public 
 Accountant is a person skilled in the affairs of Commerce and 
 Finance, and particularly in the accounts relating thereto, 
 who places his services at the disposal of the community for 
 remuneration. This definition calls for three main qualifica- 
 tions : — 
 
 (i) Skill in the affairs of Commerce and Finance. 
 
 (2) Special skill in the Accounts relating thereto. 
 
 (3) The application of this skill to the affairs of the com- 
 
 munity, and not merely of one Corporation or Firm, 
 for remuneration. 
 
 II 
 
12 INTRODUCTION. 
 
 In Great Britain the Public Accountant has during the past 
 quarter of a century worked out his own salvation, and is 
 regarded as a skilled Commercial and Financial Advisor, not 
 only on accounts, but upon general business matters. While 
 he is^frequently appointed to such positions of Trust as Liqui- 
 dator, Receiver, &c., which in this country are either awarded 
 for political reasons or to Lawyers, his main duties consist in 
 the audit of the accounts of Corporations, Firms and Indi- 
 viduals, and it is to this branch of the subject that the present 
 volume mainly relates. 
 
 The Public Accountant acting as a Professional Auditor 
 must be familiar with the general principles of Commercial 
 and Common Law, including that relating to Corporations, 
 Bankruptcy and Trusts; he must be acquainted with Econo- 
 mic and Banking principles; and with those underlying the 
 valuations of property of all kinds. But his knowledge of all 
 these subjects is a means to an end, and that end is the applica- 
 tion thereof to that one subject of Accounts in which his skill 
 specially lies ; while on the more complicated Legal, Economic 
 or Valuation questions he must, and does, consult those other 
 business Advisors who have special skill in these matters. 
 There is probably no other profession, not even excepting 
 that of Law, which requires of its members, if they would suc- 
 ceed, a higher standard of education, experience and general 
 business knowledge. 
 
 Within recent years the degree of Certified Public Account- 
 ant has been created by certain States. The future value to 
 the Profession of this degree is exactly what its members make 
 it, and no more. The holders are placed in a privileged 
 position, which is of value only so far as by their own honesty 
 and ability they can maintain a standard superior to those 
 who have not so qualified. The future is with the rising 
 generation, and the various Schools of Commerce connected 
 with Universities all over the country are doing excellent 
 work in the provision of educational facilities. As the 
 educational standard is raised, as the class of college men from 
 
IXTRODUCTIOX. 1$ 
 
 whom the legal profession is at present so largely recruited 
 is attracted to the profession of Public Accountant, so will 
 the standard be raised to a yet higher level, and the profession 
 will gradually obtain that full and complete recognition 
 already obtained in England, but as yet very grudgingly and 
 •only to a small degree accorded in America. 
 
 The moral qualities called for are so high that it should 
 place the profession 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 train- 
 ing to that end enable him to ascertain it. No legal quibbles 
 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, 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. 
 
 While differences of opinion on matters of principle must 
 always exist, perhaps they exist to a less extent in Account- 
 ancy for the reason that most of its problems when attacked 
 with intelligence admit of being carried back to elementary 
 first principles. The faculties requisite for such a mental 
 exercise are the result of thorough training and long experience 
 coupled with a mind naturally gifted with analytic powers; 
 and having regard to the variety of problems which arise, the 
 first principles or admitted facts necessary to their solution are 
 
14 INTRODUCTION. 
 
 themselves very numerous. The best preliminary training 
 would seem to consist in the acquirement of a thorough knowl- 
 edge of these principles or facts throughout the domain of 
 Mathematics, Economics, Banking, Law and Commerce; the 
 practical application of these principles to the special science 
 of Accounting naturally follows, and the present volume may 
 be described as an elementary text-book on the practical side 
 of the question. If the student would avail himself thoroughly 
 of it, he must analyze every proposition therein to its elements, 
 search out the economic, legal or commercial reasons for it, 
 and so fit himself to pass judgment upon the actual facts which 
 may come before him in his wider practice in the Commercial 
 world. 
 
 The Public Accountant so trained who will apply his whole 
 mental energies to the problems before him, and arrive at a 
 solution unbiased by any outside influence, and confident in his 
 own ability, and above all integrity, need have little fear of 
 the pains and penalties described in the Chapter on the Audi- 
 tor's responsibility. 
 
AUDITING. 
 
CHAPTER I. 
 
 INTRODUCTORY. 
 
 AUDITING (up to the Trial Balance). 
 
 PRELIMINARY CONSIDERATIONS. 
 
 Before touching on matters of detail it may be well to ob- 
 serve that the sole purpose of this book is to treat of an audit 
 from the standpoint of the professional auditor and the student 
 who have mastered the principles of bookkeeping, and it is, 
 therefore, not deemed necessary to discuss nor define "Audit- 
 ing'* in the abstract. 
 
 It is obvious, too, that the preliminary stages of arranging 
 for the work, settling upon its scope, and the general attitude 
 of the auditor are all matters which appear for examination 
 more logically in later chapters. 
 
 For some years it has been the custom of leading firms of 
 accountants, both in England and America, to use a small 
 note book for each audit on which they are engaged. 
 
 The form usually preferred consists of a book with printed 
 instructions of a general nature in front, followed by several 
 blank pages for special instructions applicable to the particular 
 audit, and for memoranda to be written up during successive 
 audits. 
 
 Specially ruled pages are then provided. Each page is used 
 to record the work done on one book or class of accounts, and 
 enough sheets should be bound in each book to allow for 
 recording the memoranda of the audit of a large undertaking. 
 The pages are printed and ruled somewhat as follows: 
 
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AUDITING (up to THE TRIAL BALANCE). IQ 
 
 The most convenient book is one in which each page is 
 ruled with twelve double columns, thus providing for the 
 record of a year's work where the audits are made monthly, 
 six years' work where they are made semi-annually, etc. The 
 columns are arranged so that the date of completing each 
 part of the work may be recorded as well as the initials of 
 the audit clerk. 
 
 Since the issue of the first American edition of this work, the 
 Accountancy Publishing Co. has published an " Audit Note- 
 Book," the demand for which is sufficient to prove that the 
 use of such a book is very general among the profession. 
 
 On the other hand, it has been suggested " that if a com- 
 petent clerk is sent to undertake an audit (and none but com- 
 petent clerks should be sent), it is much the better way to 
 leave him unfettered with printed instructions, but allow him 
 to go thoroughly into the whole system in operation, and from 
 the nature of such system, and from what he sees, let him 
 outline his own method of procedure. By this means there is 
 not so much danger of his getting into a semi-careless groove 
 of working, and, moreover, he feels that more responsibility 
 is placed upon him, which acts as an incentive to do the work 
 more thoroughly than would be the case were he working to 
 * rule of thumb.' " There is, doubtless, something to be said 
 upon this side of the question; but if so much be left to the 
 clerk, it is a little difficult to see what the principal is expected 
 to do himself. In any case, however, the book is useful as a 
 record of the routine work performed and of the queries raised 
 in the course of audit. It is believed that, in point of fact, 
 some sort of audit note-book is almost invariably used by 
 most accountants at the present time. 
 
 The printed instructions cannot be more than a mere out- 
 line of an auditor's duties, but they can be so framed as to 
 be of material assistance to the audit clerks. 
 
 The following instructions are modelled after a set used in 
 an English office for many years, and will be found extremely 
 
20 AUDITING. 
 
 suggestive. Various modifications of these instructions appear 
 in most audit note-books. It is understood, of course, that no 
 attempt is made to lay down any hard and fast rules. 
 
 INSTRUCTIONS FOR AUDIT. 
 
 1. In commencing a new audit obtain a list of all the books kept, and 
 of all persons authorized to receive or pay money and order goods. 
 
 2. In the case of a corporation, examine the by-laws and board 
 minutes respecting the receipt and payment of money, and the drawing 
 of cheques, notes, &c. 
 
 3. Ascertain and take note of the general system upon which the 
 books are constructed, and the plan of checking the correctness of 
 the accounts paid, and whether they are paid exclusively or generally 
 by cheques. 
 
 4. Report if the accounts and vouchers have been systematically 
 checked and certified; and note any discrepancies. 
 
 5. Compare the cancelled cheques with the cash payments. Compare 
 a portion of the items of deposits, as detailed in cheque stubs or copy- 
 book, with the receipt side of the cash book, to determine whether all 
 items deposited have been properly entered. Prove the reconciliation 
 of the cheque book balances at the end of the period with the bank pass 
 books, and see that the latter are frequently balanced and examined. 
 
 6. Note any unusual or extraordinary payments or receipts. 
 
 7. In regard to the payments for wages and petty cash, note any 
 unusual items, and see that vouchers for all other payments are kept 
 and produced. 
 
 8. In all cases where branch establishments are included in one 
 business, you will be careful to examine into the mode of bringing the 
 returns of operations, accounts, and expenses to the head office. 
 
 9. Examine the purchase and sales books, and see that the proper 
 returns of purchases and sales are made by each department; that the 
 purchase and sales books are properly entered up; that the invoices 
 are properly checked as to quantities and prices; satisfy yourself that 
 every liability of the year is brought into the accounts. 
 
 10. Ask for special instructions as to how far the postings and foot- 
 ings of the individual ledgers and the footings of the books of original 
 entry are to be verified. 
 
 11. All the postings in the nominal or general ledgers must be 
 checked. The mode of the journalizing must be carefully examined 
 and its correctness tested. 
 
AUDITING (up to THE TRIAL BALANCE). 21 
 
 12. Verify the trial balances of all ledgers, being careful not to omit 
 the comparison of the totals of those of subsidiary ledgers with the 
 controlling accounts in the general ledger trial balance. 
 
 13. Examine the bills receivable and bills payable books, and note 
 any item of past due, renewed or protested notes, and make list of 
 same and of the collateral security, if any. 
 
 14. Examine the entries and transfers passed through the journal, 
 and check the postings; and although you are not held responsible for 
 the details of classification, it is desirable you should make any sug- 
 gestions required, and note any discrepancies, especially in relation to 
 the division thereof on account of capital and revenue accounts 
 respectively. 
 
 15. Ask for special instructions as to examination of capital stock 
 and mortgage bond accounts. 
 
 16. In the accounts of stock-taking see that all stock sheets and 
 returns are duly signed by the heads of departments, and that the same 
 are correctly carried forward to the general inventory account; and 
 ascertain and note whether goods finished or in progress are taken at 
 cost price or otherwise; also in large concerns report whether an 
 independent clerk has verified the stock returns in regard to prices 
 and quantities. 
 
 17. In checking the profit and loss account, note whether the usual 
 and proper deductions have been made for wear and tear and 
 depreciation. 
 
 18. Take care that in the balance sheet no additions are made to 
 expenditure on capital account, except such as are authorized or 
 passed upon by some responsible person, and note the distinction be- 
 tween new works and mere replacements. 
 
 19. Ascertain the correctness of the cash balances, promissory notes, 
 and other securities in hand. Take note of any items or memoranda 
 carried as cash. 
 
 To sum up, then, the matter may be stated thus: — At the 
 commencement of an audit the principal should if possible, go 
 over the ground personally, and decide what w^ork requires 
 to be done. A list of such work (together with any other 
 special notes that may seem desirable) should be entered in 
 the audit note-book, which should be ruled in columns, so 
 that the initials of a clerk against any item may clearly show 
 that he is responsible for the correctness of that item for the 
 
22 AUDITING. 
 
 period named at the head of the column. As heretofore 
 mentioned, it is practicable to keep books ready printed which, 
 with but slight alteration, will answer the purposes of any 
 audit; but there will usually be some special circumstances 
 connected with each audit that distinguish it from others, and 
 these circumstances will usually involve some modification of 
 the customary routine obtaining to that class of accounts. 
 
 Some sort of definite system is undoubtedly preferable to 
 leaving things too much in the hands of the audit clerk, as 
 there is, in the latter case, always a danger, either of dis- 
 satisfying the client, or else of leading him to prefer a change 
 of principals to a change of clerks, if one of the two be in- 
 evitable. For this reason, if for no other, the principal 
 should always endeavor to keep the reins of every audit in 
 his own hands, or, at least, out of the exclusive control of any 
 one audit clerk; for, although objection may legitimately be 
 taken to the latter being kept at a continual game of " General 
 Post," it cannot be denied that it is a mistake to invariably 
 send the same clerks to the same audits. 
 
 THE OBJECT AND SCOPE OF AN AUDIT. 
 
 The next point to be considered is the object and extent of 
 an audit. The object of an audit may be said to be threefold: 
 
 (i) THE DETECTION OF FRAUD. 
 
 (2) THE DETECTION OF TECHNICAL ERRORS. 
 
 (3) THE DETECTION OF ERRORS OF PRINCI- 
 PLE. 
 
 On account of its intrinsic importance the detection of fraud 
 is clearly entitled to be considered an " object " in itself, al- 
 though it will be obvious that it can only be concealed by the 
 commission of a technical error or of an error of principle. 
 It will be appropriate, therefore, to combine the search after 
 fraud with search for technical and fundamental errors; but 
 it can never be too strongly insisted that the auditor may find 
 fraud concealed under any item that he is called upon to verify. 
 
AUDITING (up to THE TRIAL BALANCE). 23 
 
 His research for fraud should therefore be unwearying and 
 constant. 
 
 It has been asserted by some that the whole duty of the 
 auditor is to ascertain the exact state of his client's affairs 
 upon a certain given date. This is, in effect, the same thing 
 as saying that he is only responsible for the correctness of 
 the balance sheet. Even if this be the case — and it is open 
 to considerable doubt, as the extent of an auditor's duties de- 
 pends entirely upon the terms of the express or implied con- 
 tract between himself and his client — the balance sheet cannot 
 well be verified without a proper examination of the revenue 
 account, which in its turn involves a complete examination of 
 the books. 
 
 The detection of fraud is a most important portion of the 
 auditor's duties, and there will be no disputing the contention 
 that the auditor who is able to detect fraud is — other things 
 being equal — a better man than the auditor who cannot. 
 Auditors should, therefore, assiduously cultivate this branch 
 of their functions — doubtless the opportunity will not for long 
 be wanting — as it is undoubtedly a branch that their clients will 
 most generally appreciate. 
 
 Before dealing with the various methods to be adopted to 
 insure the detection of errors, it will perhaps be not out of 
 place to inquire what is the extent to which an auditor is ex- 
 pected to carry his research. This will naturally vary accord- 
 ing to the circumstances of each individual case ; but even 
 allowing for this, the greatest diversity of opinion obtains, some 
 claiming that an auditor's duty is confined to a comparison of 
 the balance sheet with the books, while others assert that it is 
 the auditor's duty to trace every transaction back to its first 
 source. Between these two extremes every shade of opinion 
 may be found; and, among others, the opinion of most prac- 
 tical men. Were the auditor's functions limited to a certifica- 
 tion that the balance sheet submitted to him was in accordance 
 with the books, it would be difficult to conceive why the 
 
24 AUDITING. 
 
 amateur auditor should have been found so lamentably want- 
 ing: on the other hand, it cannot be denied that (except in 
 concerns of comparative insignificance) a minute scrutiny of 
 every item would be quite impossible to the auditor — nor in- 
 deed is such a detailed audit often necessary, although it is in 
 the highest degree desirable that every undertaking should 
 possess the means of enabling the staff to make such an exam- 
 ination for itself. 
 
 In undertakings where the transactions are too numerous 
 to justify checking every entry, it is usually possible to test 
 the accuracy of the bulk of the work by aggregates which 
 appear in subsidiary books and ledgers, and which are repre- 
 sented in the general or private ledger by controlling accounts. 
 
 This is a matter that will be dealt with at some length later 
 on, and its further consideration may be postponed until that 
 time. 
 
 It is in the highest degree necessary that the auditor, before 
 commencing his investigation, should thoroughly acquaint him- 
 self with the general system upon which the books have been 
 kept. 
 
 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, but in this country the list is in nearly all cases 
 either not supplied at all or else it is made by the auditor 
 himself during the progress of the audit. Such a practice is, 
 indeed, very desirable. It cannot be too strongly insisted, how- 
 ever, that such a list can only be of any real utility when the 
 auditor thoroughly grasps the uses, and the possible abuses, 
 of which each book is capable. Numerous instances have 
 been known of an audit entirely failing' through neglect of this 
 precaution. 
 
 Having thoroughly made himself master of the system, the 
 auditor should look for its weakest points. " Where is fraud 
 most likely to creep in ? '* he should ask himself ; and, if he 
 
AUDITING (up to THE TRIAL BALANCE). 25 
 
 can find a loop-hole, let him be doubly vigilant there. But 
 never let him for a moment suppose that, because he sees no 
 opportunity for fraud, none can exist. To the intelligent 
 auditor who has grasped his system thoroughly, it is gen- 
 erally practicable to dispense with a considerable portion of the 
 mechanical means of checking. To what extent this can be 
 done with safety must always remain a question for each 
 auditor's own intelligence and experience to answer, and it 
 may be added that probably he must take the risk of any conse- 
 quences that may ensue; but — so far as the matter can be 
 explained in a general treatise — its solution will be sought after 
 in these pages. 
 
 Before leaving this subject, it may, perhaps, be well to add 
 that, under the expression " mastery of the general system," 
 perusal of the partnership agreement, the charter and by-laws 
 of a corporation, recorded contracts and agreements, State 
 laws, and any and all other documents that, per se, affect the 
 general constitution of the concern, are included. 
 
 ADVANTAGES OF AN AUDIT. 
 
 The question has been raised from time to time as to what 
 advantages may be reasonably expected from a proper profes- 
 sional audit of accounts. In addition to those mentioned, 
 as coming under the head of the primary objects of auditing, 
 it may be pointed out that the proprietor or proprietors of a 
 business will not only have the advantages of having placed 
 before them an accurate statement of their affairs, together 
 with a profit and loss account showing how this position has 
 been arrived at, but that they would also have available certified 
 accounts as to profits which cannot fail to be of the greatest 
 convenience, in the event of their wishing to sell the business 
 to a private trader, or firm, or to an incorporated company, 
 or in the event of one of the partners dying or wishing to 
 retire, or for the purpose of submitting a statement to banks 
 as a basis for loans. One of our most eminent New York 
 bankers in an address to a bankers' convention advised those 
 
26 AUDITING. 
 
 present to require prospective borrowers to furnish statements 
 prepared by Certified Public Accountants, and at the conven- 
 tion of the American Bankers' Association, held at Denver, 
 Colorado, in the autumn of 1908, the Committee on Credit 
 Information reported, urging " that every member exert his 
 influence to have all paper purchased from note brokers pre- 
 sented with accompanying statements audited by Certified Pub- 
 lic Accountants . . ." and to that end asked that the Asso- 
 ciation, by the adoption of the Committee's report, " recom- 
 mend that its members in purchasing commercial paper from 
 note brokers, give preference to such names as furnish accom- 
 panying statements audited by Certified Public Accountants. 
 . . . " Under each of these circumstances the importance 
 of a thoroughly reliable statement of profits cannot well be 
 over-estimated, and the convenience it affords — as well as the 
 enhanced price which can be obtained in the event of a sale — 
 will under all normal circumstances more than compensate for 
 any slight expense which the audit may have originally in- 
 volved. It is, of course, quite clear that one of the reasons 
 an enhanced price may be obtained is that in considering an 
 ordinary statement of profits, no matter how carefully it may 
 be prepared it is usual to " discount " the results, while an 
 audited statement can be safely taken at its face. So far as 
 private firms are concerned, an efficient audit possesses the 
 further advantage that, by reason of its insuring a periodical 
 preparation of reliable accounts, it tends to minimize the risk 
 of partnership disputes, with all their attendant annoyance 
 and expense. Accurate accounts are also of great value to both 
 sides in compensation cases. 
 
 In the case of corporations the audit assumes a slightly 
 different aspect. The company auditor is not expected to act 
 as the financial adviser of the undertaking — a position that is 
 frequently thrust upon him in connection with private audits — 
 his duty being rather that of an auditor appointed in the inter- 
 ests of an inactive partner. It devolves upon him to examine 
 the accounts of their stewardship, prepared by the active part- 
 
AUDITING (up to THE TRIAL BALANCE). 27 
 
 ner — i. e., the directors — and to state whether in his opinion 
 those accounts are correct, and fully and fairly disclose the 
 position of affairs, or in what respects they fail to do so. 
 
 In addition, it may be pointed out that an auditor, through 
 gross negligence, failing to discover fraud or embezzlement 
 on the part of the employees of the client, may possibly be 
 held liable in damages for the amount lost as a result of his 
 negligence. While no cases bearing on the specific liability 
 of auditors have been decided by any of the higher courts 
 in the United States, the law is very well settled in England 
 that auditors are liable for gross negligence. The leading 
 English cases are cited in Appendix A to this work, and in 
 the absence of American decisions our courts can be expected 
 to follow them. If they do not, however, they will seek 
 analogous cases on our own books, and, as will be more fully 
 explained in a later chapter, our courts are reasonably sure 
 to hold auditors strictly accountable. 
 
 This liability involves, of course, a corresponding benefit to 
 the persons in whose favor the liability accrues, and is conse- 
 quently a factor that ought not to be lost sight of in weighing 
 the advantages of an audit. It is, however, hardly necessary 
 to add that the auditor does not insure the honesty of his 
 clients' employees. 
 
 There does not seem to be any general realization on the 
 part of many auditors of the responsibilities they assume when 
 they undertake to audit the accounts of large concerns for an 
 extremely small fee — frequently fixed in advance — and which 
 on its face does not allow for more than a mere skimming of 
 the aflFairs of the company. It would, therefore, be no great 
 calamity to the profession as a whole to have an American 
 decision definitely settling this vexatious question. 
 
 Needless to say, there is no desire on the part of any Ameri- 
 can practitioner to be the first victim, and it is hoped that 
 with a more general knowledge of the full duties and respon- 
 
28 AUDITING. 
 
 sibilities of professional auditors the standard will be raised 
 to a point where no severe consequences can follow. 
 
 METHOD OF AUDIT. 
 
 A comparison of the relative merits and disadvantages of 
 completed and continuous audits is worthy of more attention 
 than it has hitherto attracted. 
 
 THE CONTINUOUS AUDIT sometimes includes the 
 preparation of the periodical accounts by the auditor's staif. 
 Its advantages may be said to be : ( i ) The examination occurs 
 sooner, and consequently any errors committed are more 
 quickly detected and rectified; (2) the periodical visits of the 
 auditor keep the bookkeeper closer up to his work; (3) a more 
 detailed audit is practicable; (4) the audit can be completed 
 soon after the closing of the books, without unduly hurrying 
 the examination. On the other hand, there is always a danger 
 of items that have been checked by the auditor being altered 
 (either ignorantly or fraudulently) before the final audit; and 
 it is therefore necessary that the clerk in charge of a continu- 
 ous audit be very wide awake, and have a very clear idea of 
 the system under which he is working. 
 
 It has been found a good plan to adopt a special " tick " 
 for the verification of all figures upon which a correction ap- 
 pears; as, if this plan is adopted, a correction made after the 
 tick has been affixed will be more readily discovered. It goes 
 without saying that the difference in the two ticks should be 
 as slight as possible, and the bookkeeper should not be told 
 what the difference implies. 
 
 THE COMPLETED AUDIT (by which is meant the audit 
 begun after the trial balance has been completed) obviates this 
 difficulty to a certain extent, and, if the books remain in the 
 auditor's sole custody during the duration of the audit, entirely ; 
 but the drawbacks it presents (which are, naturally, the advan- 
 tages of the continuous audit) render its adoption impractica- 
 ble, except in small concerns or in partial audits, unless the 
 
AUDITING (up to THE TRIAL BALANCE). 2g 
 
 books can be so arranged that very little detailed checking has 
 to be done by the auditor. 
 
 The risks involved in leaving the books in the hands of the 
 bookkeeper during the audit are undoubtedly very consider- 
 able; but, so long as these difficulties are not lost sight of, 
 there is but little doubt that common-sense and a general alert- 
 ness will save the auditor from this — as well as many another 
 — danger. Moreover, where the auditor himself closes the 
 books — and this will not infrequently be the case in small audits 
 conducted continuously — it should be difficult for fraud on the 
 part of the staff to altogether escape detection. 
 
 It would be well to mention here the extreme importance of 
 completing each item of the audit as soon as possible after 
 it is begun. Extensive frauds have escaped detection because 
 the auditor checked the balances of a ledger one day and 
 the additions of such balances on the next — some of the items 
 having been altered in the meantime. It will be obvious that 
 had the additions been checked on the same day as the extrac- 
 tion of the balances, and a note taken of the total, the fraud 
 would have been impossible. 
 
 What may be described as the " ideal " audit is one com- 
 bining the two modes of investigation just described. It is 
 sometimes attained in England by the employment of two in- 
 dependent auditors, one performing a continuous and the other 
 a completed audit ; but more frequently the continuous audit is 
 done by " staff " auditors, or by the client's ordinary employees 
 under a good system of internal check. 
 
 CALLING BACK POSTINGS. 
 
 Having now cleared the ground of various preliminary con- 
 siderations, the manifold points arising in the course of an 
 ordinary audit will be dealt with. 
 
 It has been seen that, in every instance, it will be necessary 
 for at least some of the postings to be called over; and inas- 
 much as by that means the auditor will at once acquaint him- 
 
30 AUDITING. 
 
 self with the nature of the transactions that have occurred, 
 the calling back of such postings will form an appropriate 
 starting-point for examination. Many persons prefer to start 
 with an examination of the vouchers, and, if the vouchers 
 are rich in detail, it will frequently be desirable to take them 
 first; but when — as is often the case — they are mostly bare 
 receipts for so much money, it will generally be best to start 
 with the postings. 
 
 It is well to commence with the posting of the cash book, 
 even when all the postings are to be checked, as by this means 
 a general idea of the business done is most quickly grasped; 
 which is very desirable. As a general rule the postings should 
 be called back from the ledger, as it is not only more rapid 
 as a rule, but in cases where cash credits have been made in 
 the ledger without a corresponding debit to cash the fraudu- 
 lent entries are more quickly discovered. The calling over 
 of postings can hardly be too carefully done, and although the 
 work is decidedly mechanical — and, consequently, somewhat 
 somniferous — it must be most conscientiously performed. In 
 particular, care must be taken not to pass any item already 
 ticked, unless it be certain that it has inadvertently been ticked 
 in the regular course of audit; and also any items remaining 
 unticked after the calling over is completed should receive most 
 careful attention. Inexperienced clerks are apt to " suppose '* 
 they ought to have ticked an item, or to '' suppose " they ticked 
 such-a-one instead of such-another. Either " supposition" 
 may cause a fraud to remain undetected, or (which will, per- 
 haps, appeal to the youthful mind more powerfully) may keep 
 him late at his work night after night, while the senior audit 
 clerk hunts up and down for an error in the trial balance. 
 When the error is discovered to be a mistake in the posting 
 that was passed in calling back, it is possible that the unfortu- 
 nate junior will be even more sorry that he ever ventured to 
 " suppose." 
 
 Where it is intended to check every posting, it is a good 
 plan, after the cash postings have been checked, for the remain- 
 
AUDITING (up to THE TRIAL BALANCE). 3I 
 
 ing postings to be called back from the ledger into the jour- 
 nals, etc. ; and it will probably save time, while going through 
 the ledgers, to check the additions and balances at the same 
 time, and so finish each ledger at a sitting. This method, how- 
 ever, is not always convenient, or even possible, and much must 
 therefore be left to the discretion of the clerk in charge. 
 
 Where there are subsidiary books from which very few 
 postings are made to the ledgers, they can be exhausted before 
 going through the ledger a second time to clean up. For 
 instance, with a journal having but a few entries the first item 
 can be called from the journal to the ledger, and then all sub- 
 sequent journal entries in that same ledger account will be 
 called back; after they are completed the second item in the 
 journal should be taken up, and so on until the journal is 
 exhausted. 
 
 It is not always easy to impress upon the clerks the import- 
 ance of so gauging the work that both men will be busy prac- 
 tically all the time, and if this is not watched closely we may 
 find one clerk going through an entire ledger for an entry or 
 two while the other clerk sits patiently or sleepily by doing 
 nothing ! 
 
 BAD OR AMBIGUOUS FIGURES should always receive 
 close attention, as it not infrequently happens that they are 
 posted as one figure, and added up as another. Corrections, 
 too, require careful attention. Erasures should always be 
 strictly prohibited ; and where hand-made paper is used for 
 books, they should be keenly watched for, as a clean erasure 
 may easily have been made. It is very important that the 
 room used by the auditors be well lighted, or mistakes may 
 easily occur. Where a correction has been made, care must be 
 taken to insure that the addition and posting have both been 
 altered. In a continuous audit this is especially important, 
 but — as it has already been noticed — it need not now be dilated 
 on. 
 
 It may seem almost superfluous to say that the clerk calling 
 back should always speak clearly, but experience teaches that 
 
32 AUDITING. 
 
 this is a matter that frequently does not receive the considera- 
 tion it deserves. Such a mistake as $200.25 being posted 
 $225.00 should be guarded against by always mentioning the 
 word " cents " in calling back such an amount. It is import- 
 ant that the clerk calling should learn to " pull with " the one 
 who is turning over folios. This is a habit much more readily 
 acquired by some juniors than others — in many respects it 
 resembles the art of accompanying in music — and the senior 
 who has found a youngster to suit him will not willingly make 
 a change, as the economy of nervous force consequent upon 
 perfect accord is very considerable. 
 
 VERIFYING ADDITIONS. 
 
 In all cases it is desirable, although it is not always prac- 
 ticable, that all the additions should be verified. In every 
 case, however, the additions of the private ledger, general 
 ledger, cash books, sales books, petty cash books and payrolls 
 will require to be verified in detail unless the auditor can satisfy 
 himself as to their accuracy by intelligent and comprehensive 
 tests. This should always be done when the other work con- 
 nected with the same book is being done ; for if the designing 
 bookkeeper has power to make alterations meanwhile he can 
 afford to laugh at every safeguard against fraud. 
 
 It is hardly necessary to add that the verification of addi- 
 tions though purely mechanical is most important work. It is 
 especially necessary that the " carried forwards " be checked 
 on to the following page, as errors frequently occur here. 
 Also when verifying the additions of a book with several col- 
 umns of figures it is important to see that the distinction be- 
 tween the various columns is preserved when carrying forward 
 totals from one page to another. 
 
 THE PREVIOUS BALANCE SHEETS. 
 
 While the junior clerk is checking additions, the senior will 
 have time to see to many matters which require his attention. 
 
AUDITING (up to THE TRIAL BALANCE). 33 
 
 Foremost among these will be the comparison of the ledgers 
 with the last balance sheet — unless, indeed, the principal has 
 already dealt with this point. 
 
 It is very generally conceded that no auditor can be made 
 liable for the acts or omissions of his predecessor in office; 
 but this rule must, of course, be strictly applied, and an 
 auditor who adopts and perpetuates the mistakes of his pre- 
 decessor would not on this account alone escape the conse- 
 quences of his own negligence. It is important, therefore, 
 to carefully scrutinize those items which, in the ordinary 
 course, are brought forward as balances from one year to 
 another. In so far as their correctness cannot be tested by an 
 examination of the accounts under review, the present auditor 
 is doubtless not responsible; but in cases where a careful in- 
 vestigation of the current accounts would have disclosed an 
 error in the previous accounts it might well be held that the 
 discovery ought to have been made and that failure to make 
 it was the result of negligence. It is not thought necessary 
 to pursue this subject in detail. It may be pointed out, how- 
 ever, that the mere existence of a ledger account headed 
 " Reserve," with a balance to the credit thereof, should not 
 be taken as conclusive evidence that a corresponding amount 
 of profits available for distribution has been transferred to 
 Reserve; while it would be only prudent to see that proper 
 depreciation had been written off all wasting assets in prior 
 years, as well as in the year under review. 
 
 It need, perhaps, hardly be added that it is important that 
 the auditor should see that he begins his investigation at the 
 exact point where the previous investigation left off — that is 
 to say, the opening balances of the period under review should 
 in all cases be checked and agreed with the previous balance 
 sheet. This applies whether or not the accounts for the 
 previous period were checked by the same auditors. Under 
 normal circumstances this checking of the opening balances 
 would probably be done as a matter of course, but the ques- 
 tion as to its necessity might sometimes arise where it is the 
 
34 AUDITING. 
 
 custom to start an entirely new set of books with each financial 
 year — ^more especially if the auditing is done at the account- 
 ant's office, and not at the client's place of business. By way 
 of showing the extreme importance of adopting this some- 
 what obvious precaution, it may be added that, some few years 
 since, a case of somewhat extensive fraud, extending over a 
 long period of years, transpired, which might have been dis- 
 covered at any time, had the auditors checked the starting 
 balances with the previous year's books. 
 
 VOUCHERS. 
 
 Much might be written, and indeed, has been written, upon 
 the important subject of vouchers; it is, however, impossible 
 to treat the matter exhaustively in the space at disposal. 
 
 The present work would, however, be incomplete without 
 some mention of the matter, which, for convenience sake, will 
 be dealt with under the following heads: 
 
 (a) Receipts. 
 
 (b) General Payments. 
 
 (c) Petty Cash. 
 
 (d) Wages. 
 
 (e) Bank Account, &c. 
 (/) Journal Entries, &c. 
 
 Each of these involves, for its complete consideration, the 
 question as to the form of accounts employed, but the relative 
 merits of the various forms available will mostly be more con- 
 veniently dealt with at a later period. In general terms it 
 may be said that the process of " vouching " consists of obtain- 
 ing evidence (usually documentary) that the transactions re- 
 corded in the books are facts. 
 
 (a) RECEIPTS.— It is part of the auditor's duty to ascer- 
 tain, as far as possible, that all cash received has been entered 
 to the debit of the cash book. The usual mode of verification 
 available will be a comparison of the details of the bank de- 
 
AUDITING (up to THE TRIAL BALANCE). 35 
 
 posits, but unless the entries which purport to be a copy of the 
 deposit slips are verified at bank they cannot be depended 
 upon, for numerous instances have been disclosed where cash- 
 iers have systematically kept the " details of deposits " copy- 
 book, or stubs in agreement with the cash book while the 
 actual deposit tickets contained different items but identical 
 totals. 
 
 The reason for this is obvious, i. e., the covering up and 
 " carrying " of collections from customers, the current receipts 
 being used to cover past items not credited. Many of these 
 defaults run on for years in establishments where the cashier 
 has access to the customers' ledgers, and where collections are 
 not looked after sharply by anyone else. 
 
 Some years ago an article appeared in The Journal of Com- 
 merce, written by Mr. D. J. Tompkins, of the Guarantee Com- 
 pany of North America, with reference to customers' accounts, 
 which we reproduce. 
 
 "As an officer of one of the older guarantee companies, the writer 
 has had over twenty years' experience of claims under fidelity bonds 
 on defaulting employees. Three-fourths of the defaults by treasurers 
 and cashiers accrue by embezzlement of remittances received, and 
 then by concealing the theft by the ' lapping ' system, so-called. For 
 instance, the defaulter embezzles a cash payment by A and defers entry 
 of such payment on cash book until, on receiving remittance from B, 
 he puts B's check into cash-drawer and into bank and then enters A's 
 payment on cash book, but likewise defers entry of B's remittance 
 until the arrival of Cs remittance enables him to enter B's payment in 
 similar way. He has to continue this system until the end, or until the 
 shortage is made good. The more items stolen, the greater the number 
 of accounts that must be tampered with to conceal default. 
 
 " The result is that as sundry amounts paid in by customers have 
 not yet been entered by cashier on cash book, and hence not posted by 
 bookkeeper to credit of their accounts on ledger, their balances appear 
 on ledger at amounts larger than actually due by them. Manifestly, 
 therefore, no audit can be complete or conclusive as to the existence of 
 a default without the auditor's verification of the ledger balances by 
 communication with agents and customers. 
 
 "However, it is not often necessary to thus verify all such accounts 
 to determine with reasonable certainty if such default exists. If de- 
 
36 
 
 AUDITING. 
 
 fault exists in any appreciable amount its concealment by 'lapping' 
 will involve the existence of irregularities in a considerable number 
 of such accounts; and if there be, say, one hundred accounts on the 
 ledger, let the auditor select ten or fifteen accounts that are fairly repre- 
 sentative and verify those. The result will indicate as to tlie necessity 
 of verifying the remainder. 
 
 " Again, there is another means of more certainly determining, right 
 inside the office, whether this lapping system is in vogue to conceal 
 existing default. If, as should be, the employee is required to make 
 and retain on file in the office a carbon duplicate deposit slip showing 
 items deposited in bank each day, the auditor should compare the indi- 
 vidual items so shown deposited with the items on cash book for same 
 day. Let him make such comparison for three or four days of each 
 month. If he finds that such individual items correspond, except for 
 explainable differences, he may feel reasonably assured of the absence 
 of any evidence of 'lapping.' But if he finds frequent variances be- 
 tween such items — if, for instance, he finds on certain days such dis- 
 crepancies as shown by the following, viz.: 
 
 Receipts as per Cash Book. 
 
 Sept. 5. — Brown $149.70 
 
 Smith 205.00 
 
 Jones 310.00 
 
 Roberts 180.00 
 
 Moore 45.00 
 
 Thomas 22.50 
 
 Total $912.20 
 
 Deposits as per Slip. 
 
 Check $300.00 
 
 275.00 
 
 " 160.00 
 
 " 121.70 
 
 " 45.00 
 
 Currency 10.50 
 
 $912.20 
 
 — in such case the auditor should realize that here exists the indica- 
 tion of 'lapping' — the deposit of checks in different amounts from 
 the receipts entered on cash book — ^the availing of a deposit of remit- 
 tances of certain customers to enable the cashier to enter credit to 
 other customers for amounts previously received and entry of which 
 had been deferred — the sure sign of default. True, occasional dis- 
 crepancies of this kind may be natural and legitimate, but if such dis- 
 crepancies occur frequently the auditor should know that a thorough 
 verification of all accounts should be at once begun. If a carbon 
 ■duplicate of the deposit slip be not retained in the office, the auditor 
 should make such comparisons from copies of some of the original 
 slips made by him at bank. 
 
 "Since railroad auditors, under pressure from guarantee companies, 
 liave begun to test outstandings in the accounts at large freight sta- 
 tions, defaults , which formerly ranged from $10,000 and upwards in 
 
AUDITING (up to THE TRIAL BALANCE). 37 
 
 such accounts have now dwindled to an average of only $2,000 or 
 $3,000. Only a similar test of ledger accounts will curtail the large 
 amount of defaults now so frequently sustained by insurance, manu- 
 facturing and commercial concerns." 
 
 After all, the only satisfactory verification of customers' 
 accounts is by direct confirmation, and many auditors now 
 advocate the issue of a circular to the customers, requesting a 
 verification of their accounts as quoted. In many wholesale 
 houses and manufacturing establishments this method is per- 
 fectly feasible, but in retail businesses and in some manufac- 
 turing concerns the number of accounts involved renders it 
 impracticable to verify all the accounts in this manner. In such 
 cases tests may be made by sending the requests for confirma- 
 tion to a certain percentage of the customers. The auditor 
 must not communicate with his client's customers on his own 
 responsibility, but must have the authorization of his client for 
 doing so. As a rule it is preferable to conduct the verification 
 in the client's name, provision being made — through the use 
 of a special post-office box or otherwise — for the return of 
 the customers' confirmations direct to the a/uditor. This 
 method of verifying the accounts receivable is especially desir- 
 able in cases of grave irregularity when some special inquiry 
 becomes absolutely necessary in order to ascertain the actual 
 position. It need hardly be added that the mere statement 
 by a customer that he has paid his account cannot always be 
 regarded as conclusive. 
 
 Cash sales require very careful scrutiny, and the method 
 of internal check adopted should always be ascertained, and, 
 as far as possible, perfected. Where practicable, it is most 
 desirable that the clerk who writes up the cash book should 
 not be the one who receives the money. 
 
 Special items of receipt will be more conveniently dealt with 
 when considering the audit of various kinds of accounts. 
 
 (b) GENERAL PAYMENTS, other than those for wages 
 and petty cash, should (where possible) be invariably made 
 
38 AUDITING. 
 
 by cheque, payable to " order." Even where the amount is 
 small this method of payment will, in the vast majority of 
 cases, be simpler, as well as safer, than cash payments. Such 
 payments by cheque hardly require vouching, but it should 
 nevertheless be done, nor will the process be difficult. Re- 
 ceipts can readily be obtained for all ordinary payments, 
 which should be numbered consecutively (the numbers of the 
 cheques are very useful for this purpose sometimes), as should 
 also the items in the cash book. 
 
 A receipt on the payee's own printed form is very much bet- 
 ter evidence that he has received the amount stated than a 
 receipt on the form of the payer, although, doubtless, a uni- 
 form style of voucher will save the auditor's time slightly. 
 From both points of view, it is not desirable that payers should 
 provide their own form of receipt ; be this as it may, however, 
 the practice exists, and will probably continue to do so. 
 
 Where the cheque-voucher is used, the detailed examination 
 of the original purchase invoices can frequently be dispensed 
 with, if not wholly at least to a considerable extent, but in all 
 cases where it is proposed to omit the inspection of the original 
 invoices enough of them should be examined to satisfy the 
 auditor that proper precautions are being taken with respect 
 to cash discounts, freight allowances,, short weights, &c., &c. 
 
 Some special payments cannot be vouched in the regular 
 way {e. g., the purchase of securities), but satisfactory evi- 
 dence that the payment was actually made, and value received, 
 should always be obtained. 
 
 (c) PETTY CASH.— Whatever system of petty cash be 
 adopted, the vouching of petty cash, as a whole, will be the 
 only possible real verification of the payments made from cash 
 to petty cash, and the whole matter may be appropriately con- 
 sidered here. The actual inspection of petty cash vouchers 
 may, or may not, be undertaken by the auditor, as he thinks 
 fit. In the former case, a responsible person must certify the 
 whole of the items en bloc; and in the latter case, a similar 
 
AUDITING (up to THE TRIAL BALANCE). 39 
 
 person must pass each separate voucher. Important frauds 
 are hardly likely to occur in petty cash; but, as likely as not, 
 petty peculations will arise, if an efficient supervision be not 
 exercised. No auditor can properly supervise the petty 
 cashier, and it is well to acknowledge the fact fully ; he may, 
 however, see that every payment has been duly authorized 
 by the responsible head, that the payments made by the cashier 
 have been duly acknowledged, that the footings of the petty 
 cash book are correct, and that the balance unspent is in hand. 
 Beyond this he should not attempt to go. 
 
 Some clients have a very bad habit of making comparatively 
 large payments through petty cash. This should be discour- 
 aged as far as possible. Some have a still worse habit of 
 allowing the petty cashier to receive small amounts; this is 
 a very bad system, and should be most vigorously contested. 
 All receipts should be banked, no matter how trifling in 
 amount, and a clerk in charge of cash receipts should never 
 be in charge of cash payments if it can be avoided. 
 
 {d) WAGES. — Instances of fraud in the payment of wages 
 are among the most frequent of those that come under the 
 notice of an auditor; but, from the very nature of the case, 
 direct evidence of proper payment is all but impossible. Sig- 
 natures might be, and frequently are, required from each man 
 receiving wages; but some men can only sign by means of 
 affixing their " mark," while many others would not be above 
 " going shares " with the paying clerk in anything they could 
 get over their due. Circumstantial evidence is thus the best 
 available for the auditor, and this will consist in a good 
 system of payment, which renders fraud improbable by reason 
 of the number of persons concerned in the preparation of the 
 pay-sheet and the subsequent payment. Particulars of time 
 worked, or piece-work done, should be certified by the fore- 
 men; the calculations of wages worked by one office clerk, 
 and checked by another; the cash for the wages made up by 
 the cashier, and the wages paid by him or his deputy in the 
 presence of a factory manager. Where possible, a cheque 
 
40 AUDITING. 
 
 should always be drawn for the exact amount of wages re- 
 quired. The auditor should inquire as to the particular sys- 
 tem adopted, and should ascertain that it is really carried out ; 
 sometimes it might be well for him to unexpectedly put in an 
 appearance when the wages were being paid. The additions of 
 the pay rolls should be verified, and a week or two's wages 
 taken at random and compared with the original time books 
 or time clock records. 
 
 (e) BANK ACCOUNT, &c.— All deposits with the bank 
 should be checked off against the pass book. The composi- 
 tion of a few such payments may be advantageously compared 
 with the items which they purport to represent, and any irregu- 
 larity carefully followed up. The credit side of the cash book 
 should also be checked with the paid cheques, and any dis- 
 agreement of the names should receive careful attention. The 
 bank balance must, of course, be verified, and if the auditor 
 has not himself received the pass book from the bank, he 
 should make a point of either obtaining the bank's certificate 
 showing the balance as of the date of the account, or take 
 it back to the bank, in person; otherwise he will run the risk 
 of never having seen the real pass book at all. A list of the 
 cheques outstanding should be retained, and it should be ascer- 
 tained afterwards, either by a second writing-up of the pass 
 book or by inquiry of the bank, whether the amounts agree. 
 If the time of the proposed audit is known, fraud may easily 
 be committed and the cash inflated by drawing a cheque at 
 the last moment which will be " outstanding." 
 
 The English clearing houses clear the same day, which cuts 
 off the kiting of " outstandings " so prevalent in America and 
 encouraged by our ** next morning " clearing. 
 
 Another fact which deserves mention is that the English 
 system of bank pass books is superior to ours, at least from 
 the auditor's standpoint. 
 
 The introduction of adding and listing machines in Amer- 
 ican banks is responsible for the practical abolition of the old 
 
AUDITING (up to THE TRIAL BALANCE). 4I 
 
 custom of writing the cheques in detail in the pass book. The 
 consequences of this is that many investigations are greatly- 
 hampered by the lack of details, which at one time were al- 
 ways available, but which are now recorded on loose sheets 
 of paper. These lists are almost invariably destroyed, and 
 cannot, as a rule, be found when needed. 
 
 Still another " labor saving " custom which has crept in is 
 the mere writing of the word " Balance " in the pass book, 
 neither the footing of the deposits nor the aggregate of the 
 paid cheques being shown. 
 
 In view of the numerous defalcations which have arisen 
 through manipulation of bank accounts, including the use of 
 duplicate pass books, it might properly be brought to the at- 
 tention of the banks that the interests of their patrons arc not 
 being properly safeguarded. 
 
 The ideal way would be to have each deposit accompanied 
 by a duplicate ticket, to be initialed by the receiving teller and 
 returned to the depositor; to have the cheques written up in 
 detail in the pass books and properly identified by their num- 
 bers or by dates. 
 
 This suggestion, of course, will not appeal to bankers, who 
 are constantly trying to reduce rather than to increase ex- 
 penses, but it would, nevertheless, be a great protection to 
 their customers. Such a system is in general use in England, 
 and judging by the dividend rates of most American banks 
 its adoption here would not increase expenses to such a point 
 as would materially affect profits. 
 
 In a continuous audit, the vouching should always be kept 
 as close up to date as possible, while the bank and {all) cash 
 balances should be verified at every visit. A cash balance will 
 sometimes be found to consist largely of " I O U's " ; this 
 should always be discouraged as far as possible. In any event, 
 the " I O U's " should be initialed by someone in authority. 
 
 (/) JOURNAL ENTRIES, &c.— The modern journal be- 
 ing the book of first entry in which comparatively unusual 
 
42 AUDITING. 
 
 transactions are recorded, it becomes just as important that 
 the journal entries should be fully vouched as it is that those 
 relating to cash receipts and payments should be subjected 
 to the same scrutiny. If the correctness of all entries passed 
 through the journal be taken for granted, there is absolutely no 
 limit to the amount of falsification that might be committed 
 with impunity. Improper journal entries might be made with 
 one of two objects — namely, (i) to conceal defalcations, as, 
 for instance, when customers are improperly credited with the 
 amount embezzled, and a corresponding debit made to Allow- 
 ance or Bad Debts; (2) to fraudulently exaggerate the profits 
 of the undertaking — e. g., by crediting nominal accounts and 
 debiting real accounts with payments that cannot properly be 
 capitalized. It is impossible to deal in detail with the vouch- 
 ing of journal entries, on account of the unlimited nature of 
 the transactions that might be recorded in this book; it may 
 be stated, however, that only the evidence of some disinter- 
 ested party — or that being unobtainable, the evidence of some 
 person absolutely above suspicion — should be accepted as a 
 voucher, and in the case of all important entries the auditor 
 should take steps which will enable him to form a definite 
 opinion of his own with regard to the matter. 
 
 A practical consideration in connection with vouching is 
 with regard to the actual marks an auditor should make to 
 indicate that this work has been performed. In the first place, 
 the voucher should be so marked that it cannot be afterwards 
 used as a voucher in support of another entry; and, in the 
 second place, the entry that has been vouched should be so 
 marked that the auditor can afterwards readily ascertain what 
 items remain unvouched. With regard to the marking of the 
 vouchers, the following methods are in use: — 
 
 ( 1 ) A large "tick " across the. face of the voucher. 
 
 (2) The audit clerk's initials, or the letter " E." 
 
 (3) A rubber stamp bearing the name of the firm — either 
 with or without the clerk's initials. 
 
 (4) The auditor's initial cut out by using a conductor's 
 punch. 
 
AUDITING (up to THE TRIAL BALANCE). 43 
 
 As the main object is to so disfigure the voucher that it can- 
 not be again used in support of another entry, it is not very 
 material which of these be employed. It may be remarked, 
 however, that initials necessarily take longer to make than a 
 tick or an impression from a rubber stamp. The third method 
 is, it is thought, generally to be preferred, as indicating clearly 
 who is responsible for the cancellation. In other cases the 
 record in the audit note-book ought to be sufficient for this 
 particular purpose. An additional reason for preferring the 
 third method is that it is the neatest, and as vouchers still con- 
 tinue to form a part of the client's business records after ex- 
 aminations thereof — as well as the possibility of their being 
 produced in court as evidence in litigation — the desirability of 
 using the neatest method is obvious. With regard to the 
 marking of the entries in the books as being vouched, some 
 firms employ a distinct " V," which has the advantage of be- 
 ing clearly distinguished among various classes of ticks, and 
 so enabling a list of missing vouchers to be more readily com- 
 piled. Sometimes, however, an imperfect voucher is accepted, 
 and in such case it seems desirable that a special form of mark 
 should be employed, so as to guard against the real voucher 
 being produced in support of another entry. 
 
 Where the auditor suspects irregularities that he is unable 
 actually to detect, he may frequently gain his point by feigning 
 laxity in his method of vouching; this will often serve to in- 
 duce that carelessness on the part of the defaulter that is nec- 
 essary for his detection and exposure. The author, who has 
 had a considerable experience of frauds of all kinds, has found 
 this method work out admirably ; it is, however, necessary that 
 it be practiced with discretion, if one wishes to avoid the 
 charge of being actually lax. 
 
 BILLS OF EXCHANGE. 
 
 A few words on the subject of bills, or as they are usually 
 called " notes," will not be out of place. 
 
44 AUDITING. 
 
 NOTES PAYABLE will present but little difficulty; the 
 returned note forms, of course, the voucher for the payment 
 of notes matured, while the notes running (as shown by the 
 notes payable book) will explain the balance of the notes pay- 
 able account in the ledger. 
 
 Notes payable are frequently written on special forms with 
 stubs attached, in which case it is important to see that all 
 are accounted for. It is not likely that they will be numbered 
 by the stationer, as a business man usually does not care to 
 publish generally the number of notes he issues. 
 
 Cases have been know^n where notes payable for large sums 
 have been negotiated without any entry therefor in the books, 
 and special care should be taken to cover this point. Of 
 course, where no grounds for suspicion have arisen during the 
 audit, it may not be thought advisable to make any special 
 examination along this line ; but if any doubts have presented 
 themselves it is well to make inquiry at all of the banks with 
 which the client is connected as to the aggregate of loans ob- 
 tained therefrom, and to make such further inquiries as may 
 be feasible. 
 
 NOTES RECEIVABLE require more careful considera- 
 tion. The notes receivable book should be dealt with seriatim; 
 all notes matured or discounted should be traced into the cash 
 book, and, if protested, back to the debit of the customer. All 
 notes protested, or still running and undiscounted, should be 
 in hand, and this fact must be verified. 
 
 Discount deducted from notes discounted should be looked 
 into to a certain extent, although not necessarily exhaustively ; 
 also, the important question of the liability upon notes under 
 discount, and the value of notes protested, must not be lost 
 sight of. Both these points require to be considered when 
 the provision for bad and doubtful debts is dealt with. 
 
 Protested notes should never be allowed to remain in the 
 notes receivable account of the ledger, but should be imme- 
 
AUDITING (up to THE TRIAL BALANCE). 45 
 
 diately charged back to the debtor in the event of their non- 
 payment when due. 
 
 CONSIGNMENTS. 
 
 It is very desirable that all points connected with consign- 
 ments be thoroughly verified, and for this purpose letter-files, 
 copy letter-books, and accounts current should be freely con- 
 sulted. There is, however, nothing particular in the nature 
 of the transactions (save the question of foreign currency, 
 which is dealt with elsewhere) that calls for special comment 
 here. 
 
 THE TRIAL BALANCE. 
 
 It should be the auditor's aim, so far as possible, to carry 
 each department of his investigation right up to the trial bal- 
 ance at the same sitting. Of course, in a large audit, this can 
 very rarely be accomplished; but the auditor must always 
 remember that there is material danger in leaving any portion 
 unfinished in the hands of bookkeepers or cashiers, who — for 
 all he can know to the contrary — may manipulate the figures 
 during the course of the audit. 
 
 The auditor, therefore, should endeavor to fix everything 
 up as he goes along, and where he cannot finish the same day, 
 he will do well to keep possession of the books and documents 
 until he can. In fact, he should, so far as possible, keep every- 
 thing in his own hands until the audit is completed as far as 
 the trial balance. Having once secured a trial balance that he 
 knows has not been tampered with, the auditor may cease to 
 trouble himself about the materials from which it was built 
 up — they may be manipulated and altered up and down, but 
 he holds in his own hand the key of the whole position. Nor 
 need the course indicated cause offense, or even excite sus- 
 picion, if carried out with tact. It is generally an easy mat- 
 ter to hang on to a list of balances, and even where it is not 
 practicable to retain uninterrupted possession of a book until 
 it is finished, a few notes and private marks will often serve 
 
46 AUDITING. 
 
 the purpose. It is not a difficult matter to acquire a " tick," 
 which, while looking much the same as any other, can be in- 
 stantly distinguished from a forgery. A man forging ticks 
 will be much less careful as to their form than a man forging 
 initials, and can thus be more often detected. It is not a bad 
 plan to carry about one's own colored ink, and to take care 
 that it is a different make from that in general use at the offices 
 where the audit is conducted. The auditor, however, must be 
 careful not to talk about these things; and he should also be 
 careful not to leave his ink about. It is often a great advan- 
 tage to employ ink of a different color to that used at the pre- 
 ceding audit. 
 
 BALANCING. 
 
 In the foregoing paragraph it has been assumed that an 
 exact balance has been arrived at by the bookkeepers before 
 the auditor commences his investigation. This, of course, is 
 as it should be, for clearly it is no part of the auditor's duties 
 (as such) to balance the books. The question arises, how- 
 ever, as to whether an auditor is ever justified in passing ac- 
 counts that do not exactly balance. Obviously, accounts that 
 do not balance cannot, in the nature of things, be entirely 
 accurate; but so long as the auditor is satisfied that the dis- 
 crepancy arises from one error, and not from the combined 
 effect of numerous errors, and so long as the difference is so 
 small as to have no practical effect upon the ultimate result, the 
 absence of an accurate balance may sometimes be disregarded. 
 Here, as elsewhere, however, much depends upon circum- 
 stances; a nominal or private ledger — or indeed, any ledger 
 with less than, say, 500 accounts — ought certainly to balance 
 exactly; on the other hand, it may be impracticable to insist 
 on an absolute balance with a large individual ledger — hence 
 the importance of these balances being tested at frequent 
 intervals, say, monthly at least. 
 
 METHODS OF BALANCING.— In private audits it not 
 infrequently happens that the auditor is requested to balance 
 
AUDITING (up to THE TRIAL BALANCE). 47 
 
 the books. The detection of errors in balancing is thus a mat- 
 ter with which an auditor occasionally has to deal, although it 
 does not in any sense form part of the actual audit itself. 
 There are two modes of seeking for errors in balancing: — 
 
 I. By localizing the error. 
 II. By tabulating the ledger accounts. 
 
 LOCALIZING THE ERROR.— This is, of course, best 
 accomplished by framing the system of accounts upon such 
 lines that each separate ledger is " self -balancing." Where 
 this has been done, it is a very simple matter to see in which 
 ledger or ledgers the discrepancy arises, and the field is at 
 once narrowed accordingly. It may easily happen, however, 
 that the various ledgers have not been framed upon self-bal- 
 ancing principles ; even then it does not necessarily follow that 
 the error cannot be localized. If the cash book be in tabular 
 form, or if there be separate subsidiary cash books, the equiva- 
 lent of a controlling account can almost always be con- 
 structed; transfers from one ledger to another may compli- 
 cate matters, but unless such transfers are much more numer- 
 ous than is usual, they will hardly present any very seriou? 
 difficulty. On the other hand, it is not often practicable to 
 apply this method if it necessitates an analysis of the cash 
 book. 
 
 When the books of original entry have not been in the first 
 instance so formulated as to readily lend themselves to the 
 construction of self-balancing ledgers, one of the many " proof 
 and balance " systems may be used. There are so many of 
 these offered, and their claims so varied, that space will not 
 permit going into details. 
 
 An auditor will frequently be asked to point out the best 
 method of preventing errors from remaining undiscovered 
 until after the trial balance is taken off, but so much depends 
 on the person using one of these " systems " that it is usually 
 advisable to recommend to him that he give several of them 
 a practical test and choose the best himself. 
 
48 AUDITING. 
 
 TABULATING THE LEDGERS.— This is a method 
 which is sometimes adopted where the number of ledger ac- 
 counts is not large, and, where practicable, it is extremely 
 thorough. It consists of making an abstract of every ledger 
 account upon sheets, which are virtually tabular ledgers. 
 When the abstract has been completed, the checking of the 
 cross-additions proves the extraction of the ledger balances, 
 while a comparison of the longitudinal totals with the opening 
 balances, day book totals, total of cash received, &c., will 
 show in which direction the error lies. Thus, if the total 
 " Goods Sold " does not agree with the total " Sales Account " 
 in the general ledger, there is clearly an error in the postings 
 or the additions of the sales books. Many accountants, how- 
 ever, and among them the authors, prefer to carefully re-check 
 the ledger, item for item, rather than adopt such a laborious 
 process of localizing the error — especially when it is remem- 
 bered that even when the abstraction of the ledger has been 
 completed, the localization has been directed, not to one ledger 
 account, but to one subsidiary book. 
 
 From the authors* point of view, the chief value of the 
 tabulation of the ledgers is in the event of it being necessary 
 to convert books previously kept upon single entry into double 
 entry: this is a feat which is sometimes necessary when ex- 
 amining the books of an undertaking about to be converted 
 into a corporation, or when endeavoring to frame a deficiency 
 account in cases of insolvency. 
 
 AUDIT OF CORPORATIONS. 
 
 The chief points arising in the course of the audit of a cor- 
 poration that do not occur in the audit of a private firm may 
 be divided under the following heads : — 
 
 (a) The audit of capital stock and bond accounts. 
 
 (b) The audit of dividend and interest accounts. 
 
 (c) Compliance with the various statutory requirements. 
 
AUDITING (up to THE TRIAL BALANCE). 49 
 
 (a) THE AUDIT OF CAPITAL STOCK AND BOND 
 ACCOUNTS.— The main points are: (i) Does the stated 
 amount of issued capital represent a valid allotment to bona 
 Me applicants? To ascertain this, the auditor must see that 
 the amount is within the authorized issue, that the various 
 classes of shares (if there be classes) are in accordance with 
 the certificate of incorporation, that the minutes of allotment 
 are in order, that the allottees have agreed to become share- 
 holders to an extent not less than the amount of their respec- 
 tive allotments, that the aggregate number of shares actually 
 issued to the various allottees is equal to the total number 
 stated to have been issued, and that the required deposit has 
 been paid. (2) Has the amount stated to have been paid up 
 been actually received in cash, or else for property under a. 
 valid contract? 
 
 PREMIUMS received on the issue of shares should prefer- 
 ably be credited to a special Premiums Account, or Capital Sur- 
 plus, and it is thought better that they should thus be shown 
 as a separate item upon all succeeding balance sheets. There 
 is, however, no law to forbid such premiums being credited 
 to Reserve, or even to Profit and Loss Account. 
 
 Where a commission is paid on the underwriting or placing 
 of shares, it is usual to anticipate this by first issuing the stock 
 at par to a syndicate, because in most of the States stock can- 
 not be validly issued at less than par. In some instances, how- 
 ever, where the company's stock sells at a premium, stock is 
 sold above par, and a commission is paid to an underwriting 
 syndicate. 
 
 In this case the commission should be charged against the 
 premium, and the net surplus carried to special Premiums or 
 Capital Surplus Account. 
 
 At subsequent audits it should be ascertained that the capi- 
 tal stock ledgers balance ; the author never heard it contended 
 that a full examination of the stock ledger was part of an 
 ordinary audit. 
 
50 AUDITING. 
 
 Bonds, however, are not subject to the same restrictions as 
 $tock, and can be issued at a discount. Where bonds were 
 issued for construction purposes it was, until comparatively 
 recently, usual (particularly among railroads and public serv- 
 ice corporations) to capitalize the entire discount on the theory 
 that it really represented actual additional cost of property for 
 which the proceeds of the bond sale were used. In fact, prior 
 to July I, 1907, when the Interstate Commerce Commission's 
 revised classification of accounts went into effect this practice 
 had the sanction of that Commission. 
 
 It is, however, becoming recognized that discount on bonds 
 is after all only an adjustment of the interest rate — whether 
 due to insufficient security of principal or to a nominal rate of 
 interest lower than the ruling market rate is immaterial — and 
 that such discount should be charged off to Revenue. If a 
 corporation has advisedly issued a four per cent, bond on a 
 six per cent, basis, why should the Revenue Account not show 
 this state of affairs? Certainly, if the par of the company's 
 credit were six per cent, and the bonds bore six per cent, and 
 were issued at par, no one would question the propriety of 
 charging the entire six per cent, against Revenue annually. 
 
 The scientific method of dealing with the discount (termed 
 amortization) is to write it off in instalments during the life 
 of the bonds, so that the aggregate of the discount and the 
 nominal interest charged to Revenue Account is the actual 
 amount of interest paid on the proceeds of the bonds. Where, 
 however, an extremely conservative management chooses to 
 write off the discount over a much shorter period than the 
 life of the bonds, or even in one year, no valid objection could 
 well be raised. In this connection it may be of interest to note 
 that the Public Service Commission of the State of New York 
 (Second District), in the uniform systems of accounts recently 
 prescribed for the various classes of public service corpora- 
 tions under its jurisdiction, expressly forbids the charging of 
 discount on bonds to any account representing the cost of 
 property, and directs the discount to be amortized or, if de- 
 sired, written off in a shorter period than the life of the bonds. 
 
AUDITING (up to THE TRIAL BALANCE). 51 
 
 In view of recent decisions of the courts, it is a grave ques- 
 tion as to whether they would uphold the custom of capitaliz- 
 ing the discount, and if the question at issue happened to be 
 the liability of directors for the payment of dividends out of 
 capital, the chances would probably be very much against the 
 directors. 
 
 When bonds are sold above par the premium should be 
 credited to a Reserve or Suspense Account and distributed to 
 the credit of Revenue over the life of the bonds. This course, 
 which is the converse of amortizing the discount on bonds, re- 
 sults in the Profit and Loss Account being debited with the 
 interest actually paid on the bonds, i. e.y the difference between 
 the nominal interest and the premium received. 
 
 It might also be permissible to use the entire amount of the 
 premium in reducing the book value of intangible assets or 
 absorbing depreciation of fixed assets caused by decreases in 
 values not resulting from the ordinary operations of the busi- 
 ness. Objection, however, should be raised to treating the 
 entire premium as a current earning of the year in which 
 received. 
 
 The trustee of the bonds and the registrar of the capital 
 stock (if registered) should be communicated with and their 
 certificates of the amounts of bonds and stock outstanding 
 compared with the corresponding accounts on the books of the 
 corporation. 
 
 (6) THE AUDIT OF PAYMENTS FOR DIVIDEND 
 AND INTEREST is not usually a difficult matter. A list 
 of stockholders should be handed to the auditor, showing 
 the number of shares held by each stockholder on the day the 
 dividend was declared, and the amount of dividend due. The 
 footings of this list should be checked, and the totals agreed 
 with the amounts of shares issued and dividends payable re- 
 spectively; it must also be seen that the rate of dividend is 
 correctly calculated in toto. A few of the larger amounts, 
 taken at random, may be advantageously compared with the 
 stock ledger, and the calculations checked; but it is not 
 
52 AUDITING. 
 
 generally essential that the whole list be exhaustively verified. 
 Many large concerns draw one cheque for the whole amount 
 of the dividend, and pay it into a separate banking account, 
 against which the dividend cheques are issued. Where this 
 method is adopted, it is a comparatively simple matter to 
 vouch the payments and verify the amount of outstanding 
 dividends — which latter will, of course, agree with the balance 
 of the pass book. Where dividends are paid in cash, or by 
 cheque upon the ordinary banking account, the vouching be- 
 comes merged in the vouching of the general payments. The 
 outstanding dividends will not be so easily traced, but will 
 present no special difficulty that requires particular mention 
 here. 
 
 It is also usual to draw one cheque for the whole amount 
 of each coupon on a bond issue, and the unpaid coupons will 
 be represented by the balance of the pass book. The paid 
 coupons should be cancelled and pasted in a book, and sub- 
 mitted for inspection. Non-compliance with these precau- 
 tions might easily result in part of the coupons being paid a 
 second time, and the failure to preserve them may ultimately 
 result in the trustee declining to satisfy the mortgage of record. 
 
 The old-fashioned manila leaved invoice book can be used 
 advantageously in filing coupons by using one page for each 
 bond; by taking care that the pages of the book correspond 
 with the bond numbers, almost instant reference may be had 
 to missing coupons. 
 
 In the case of all companies most of the following statis- 
 tical books are practically indispensable, whether required by 
 statute or not : — 
 
 Subscriptions and allotments book. 
 
 Stockholders' and registered bondholders' address books. 
 
 Call books. 
 
 Stock ledger. 
 
 Bond ledger. 
 
 Transfer book. 
 
AUDITING (up to THE TRIAL BALANCE). 53 
 
 Strictly speaking there is nothing to audit in these various 
 books — ^because they are statistical books merely, and not 
 books of account — but the auditor should satisfy himself that 
 the records are kept in the prescribed form, and, prima facie, 
 correctly. In addition, he will do well to ascertain that all 
 mortgages that require recording have been properly attended 
 to. 
 
 (c) COMPLIANCE WITH THE CHARTER AND BY- 
 LAWS, BOARD MINUTES, &c.— Under this heading it is 
 difficult to profitably draw attention to any specific points. It 
 may be mentioned, however, that it is not merely expedient, 
 but also absolutely necessary, that the auditor should carefully 
 peruse such of these documents as may relate to any particular 
 audit, with a view to modifying his course of action accord- 
 ingly. The special points to which it will be necessary for him 
 to direct attention are, so far as the capital is concerned, as 
 to whether it has been duly authorized ; so far as the accounts 
 are concerned, that any special points raised in these documents 
 are borne in mind when considering the method upon which 
 the accounts have been framed; and, so far as the question 
 of profits available for dividend is concerned, as to whether 
 all stipulations as to certain profits being carried to reserve, 
 or applied to the future redemption of bonds by the creation 
 of sinking funds, &c., have been properly dealt with. 
 
 It is most important that the minute books of the board of 
 directors, committees, &c., be submitted to the auditor in all 
 cases. 
 
 This matter is dealt with further on and need not be con- 
 sidered in detail here. 
 
 In the case of certain companies it is also desirable that 
 particular attention should be directed to the various contracts 
 connected with the original formation of the company. The 
 prospectus should be very carefully scanned, with a view to 
 seeing that any special provisions laid down therein are also 
 included in the regulations of the company and have been 
 
54 AUDITING. 
 
 acted upon. It is naturally difficult, if not actually impossible, 
 to speak exhaustively in this connection; but it may be men- 
 tioned that, supposing a prospectus states, as it sometimes 
 does, that the officers will not taken any salaries unless the com- 
 pany has made profits, or until a certain dividend has been 
 paid to stockholders, then, whether or not a similar provision 
 is contained in the company's by-laws, it is necessary that 
 the auditor should see that it has been complied with in the 
 accounts which come before him for certification. On this 
 point, however, nothing more than general hints can be given. 
 
CHAPTER II. 
 
 METHODS OF ACCOUNT. 
 
 (Suggested in the Course of Audit.) 
 
 It is not Strictly any part of the auditor's duty to offer 
 suggestions or issue instructions as to the system of accounts 
 to be adopted, but on account of his experience in such mat- 
 ters he is usually asked to do so. This more frequently 
 occurs during a first audit than thereafter, because the major- 
 ity of business men in deciding on an audit for the first time 
 are influenced largely by a feeling that an independent exam- 
 ination of their accounts will result in improved methods and 
 helpful suggestions. It is a not at all undesirable state of 
 affairs, but care should be taken not to promise too much. It 
 may easily happen that a client, who is given reason to expect 
 that his expenses will be cut down as a result of an auditor's 
 investigations, finds himself with a larger pay-roll and heavier 
 expenses through the introduction of books and methods which 
 are necessary to so record the transactions that savings may 
 be made in other departments; although the ultimate saving 
 may more than offset the increased expenses. The bookkeep- 
 ing staff may object to the audit, as they still do in so many 
 cases in the United States, and it may be hard for the auditor 
 to have his suggestions properly carried out. The auditor 
 cannot hope to be of any permanent value unless he masters 
 the entire system of accounts and by his very knowledge com- 
 pels recognition. In this connection the " entire system " does 
 not mean merely the financial books comprising the ledgers and 
 the books from which postings are made thereto, but the sta- 
 tistical and original entry books, such as receiving and ship- 
 ping books or records, salesmen's orders, stock records, cost 
 
 55 
 
56 AUDITING. 
 
 accounts, and various other books and records which, because 
 they usually are not called for by an auditor, receive scant 
 attention from others. The suggestions in the following chap- 
 ters will, therefore, not be amiss in the present connection; 
 but it will, of course, be understood that the various questions 
 now about to be considered are, for the most part, largely mat- 
 ters of individual opinion. The views stated in the following 
 paragraphs are those of the authors, but supplemented by 
 various views expressed by recognized authorities, and it is by 
 no means suggested that they should all be unquestioningly 
 taken on trust by the readers of this book. Circumstances 
 notoriously alter cases, and in no state of existence is this 
 more true than in the realm of accounts. 
 
 The above remarks will serve to explain the modus oper- 
 andi, not only with regard to the forms of accounts sug- 
 gested here below, but also in the following chapters, where 
 various important questions of principle are considered. 
 
 GENERAL SYSTEM OF INTERNAL CHECK. 
 
 This is a matter that may very profitably engage the careful 
 attention of the auditor, for not only will a proper system 
 of internal check frequently obviate the necessity of a detailed 
 audit, but it further possesses the important advantage of caus- 
 ing any irregularities to be corrected at once, instead of con- 
 tinuing until the next visit of the auditor, which — even m the 
 case of a continuous audit — is clearly a consideration. It is 
 very probable that the auditor will be asked to make any sug- 
 gestions that may occur to him for the improvement of the 
 existing system of accounts, or in the case of a new under- 
 taking he may be invited to prepare a system for the use of 
 his clients. In the latter case at least the work is naturally no 
 part of the regular audit, and should command a special fee, 
 but in the former case it would not usually be regarded as an 
 extra unless the alterations suggested and adopted were of a 
 radical nature. 
 
METHODS OF ACCOUNT. 57 
 
 In devising any system of internal check, there are three 
 matters to be specially borne in mind: first, the person in 
 charge of the cash should never be in charge of any ledger, 
 or, at least, of any individual ledger; secondly, each separate 
 ledger should be made self-balancing, or at least should be so 
 arranged that it can be separately balanced, and where this is 
 for any reason not altogether practicable, it is absolutely essen- 
 tial that those ledgers which are not checked in detail should 
 be so arranged that they may be collectively balanced separately 
 from those ledgers that are ; thirdly, where the individual led- 
 gers are numerous and are not checked in detail by the auditor, 
 the clerks in charge should be frequently changed about, so that 
 if there is any irregularity it is impossible for it to remain long 
 undetected without implicating the whole staff. With a system 
 of accounts arranged upon these lines, a detailed audit is fre- 
 quently not necessary in its entirety ; but it is always desirable 
 that the auditor should satisfy himself that the system has 
 actually been carried out as originally designed, and sections 
 of the work should be fully checked at unexpected times. 
 
 INSTRUCTIONS AS TO GENERAL SYSTEM OF 
 ACCOUNTS. — It is sometimes desirable that the head book- 
 keeper should be placed in possession of written instructions 
 containing an outline of the system to be followed. These 
 written instructions will naturally vary very considerably ac- 
 cording to circumstances, and it is impossible to give here more 
 than the barest outline of what may be required. The follow- 
 ing points are, however, important ones, which will generally 
 require to be included: — 
 
 (i) All cash received to be paid into bank daily. The 
 cashier to have no control over any of the ledgers. 
 
 (2) All payments other than petty cash payments to be 
 made by cheque, whatever the amount. 
 
 (3) The petty cash book to be kept upon the imprest system 
 under the supervision of the cashier. The clerk in charge of 
 
58 AUDITING. 
 
 the petty cash must on no account be allowed to receive any 
 moneys for sundry cash receipts. 
 
 (4) Vouchers to be obtained for every payment. 
 
 (5) The cash and bank balances to be verified daily, and 
 the reconciliation recorded in a special balance book. 
 
 (6) All ledgers to be rendered self -balancing, and all indi- 
 vidual ledgers to be balanced monthly. 
 
 (7) An adequate system of stock accounts and cost accounts 
 to be provided. 
 
 (8) All invoices for purchases to be passed by the receiving 
 department, by the buyer of the department concerned, and by 
 the accounting department, before being entered in the pur- 
 chases book or voucher record. 
 
 (9) Statements for payments to be passed by some respon- 
 sible person, preferably one of the partners, or the manager. 
 
 (10) The calculations of all sales to be checked in the 
 accounting department before the ledgers are posted. 
 
 (11) Each time the sales ledgers are balanced a Hst of all 
 
 accounts more than days overdue to be submitted to the 
 
 head bookkeeper, and by him to one of the principals for 
 further instructions. 
 
 (12) A thoroughly efficient system of calculating and pay- 
 ing wages to be introduced, and closely adhered to. 
 
 (13) So far as may be possible, the duties of every member 
 of the staff should be varied from time to time. 
 
 (14) Every member of the staff should be required to take 
 a vacation at least once a year. 
 
 (15) No member of the staff should be allowed to perform 
 what are (for the time being) the duties of another. 
 
 (16) The minute books to be fully entered up, and kept 
 indexed to date. 
 
METHODS OF ACCOUNT. 59 
 
 (17) All exceptional transactions to be reported to the 
 board at the next meeting for approval or further instructions. 
 
 (18) The various books required by the State laws to be 
 kept written up, and the necessary returns to be made to the 
 proper officers from time to time. 
 
 COST ACCOUNTS. 
 
 Every system of bookkeeping, worthy of the name, that 
 purports to record the transactions of a manufacturer, will 
 provide some method of ascertaining the cost of the articles 
 produced, while many systems recording transactions of a 
 purely trading nature (i. e., buying and selling ow/y) will like- 
 wise find a proper system of costing most advantageous. This 
 branch of an auditor's work has received more attention in the 
 last few years than in the previous twenty, and it is believed 
 that in the United States at least a very considerable advance 
 has been made, although those giving the matter serious atten- 
 tion form a small minority. 
 
 It is not considered practicable to treat of this subject in 
 a treatise on auditing, but the importance of proper cost ac- 
 counts can hardly be overestimated, and should be emphasized 
 whenever an opportunity affords. 
 
 There does not seem to be any logical reason for the general 
 practitioner to feel that cost accounting is so complicated that 
 be had better keep his hands off, thus opening the way for the 
 so-called cost-specialist. 
 
 The results of the latter's work have not always been 
 happy; in numerous instances where an elaborate cost system 
 has been installed, without regard to the commercial or general 
 system of accounts, the results of the business, as actually 
 stated in the latter, are so at variance with the results produced 
 by the cost books as to give rise to well deserved criticism. 
 
 A sane system of cost accounts necessarily works harmo- 
 niously with and directly into the commercial books, and the 
 
60 AUDITING. 
 
 proper person to bring about this result is the auditor, whose 
 experience is general, rather than one whose vision is limited. 
 
 The most absurd development of the recent agitation, how- 
 ever, is the stationery house which manufactures ready-made 
 " systems " in its factory, and " guarantees " the wildest results 
 — such as a daily balance sheet and profit and loss account. 
 All you have to do is to make over your whole business 
 methods to suit their printed forms and they will do the rest 
 (provided, of course, you buy all your stationery from them!) 
 
 The auditor should bear in mind that books are intended 
 to record business transactions and the results thereof ; there- 
 fore it is essential that the system of accounting should be 
 adapted to the needs of the business, and not the business 
 made to fit some cut and dried accounting system. 
 
 The literature upon the subject of cost accounting is improv- 
 ing in quantity and quality so rapidly that it is not considered 
 advisable to draw attention to any particular books, but rather 
 to advise the reader to make his investigations as wide as 
 possible. 
 
 FORM OF CASH BOOK. 
 
 A good form of cash book not only saves time and trouble 
 every day of the year, but also — to an even greater extent — 
 when the ledgers come to be balanced. 
 
 It is impossible to go fully into this matter here, but it is 
 suggested that, in all businesses of any magnitude, the auditor 
 should consider the advisability of recommending the introduc- 
 tion of various columns into the cash book that would facilitate 
 the balancing of the various ledgers employed. In an extreme 
 case, the use of a ledger might be almost obviated by the use 
 of a numerous columned cash book ; and in many cases a little 
 ingenuity will suffice to materially reduce the labor of posting 
 during the year and to a corresponding extent facilitate the 
 balancing of the ledgers at the end of the fiscal year. 
 
METHODS OF ACCOUNT. 6l 
 
 In large concerns a great saving of time may be effected 
 by assigning a separate cash book to each ledger clerk. These 
 separate cash books will, of course, all work into the general 
 cash book. (See further, under " Self-balancing Ledgers," 
 posiea.) 
 
 DISCOUNT AND INTEREST. 
 
 A considerable amount of time may be saved by a proper 
 system in recording cash discounts. Every trading or manu- 
 facturing concern should have discount columns in its cash 
 book; by which means the necessary number of postings may 
 be considerably reduced. The common practice of posting 
 the total of the debit discount column to the debit of the 
 ledger, and vice versa, is, however, condemned by some author- 
 ities as unscientific. They claim that an entry should be made 
 at the foot of the debit column for the total amount of dis- 
 counts received, and posted thence to the credit of the dis- 
 count account; while on the credit side of the cash book an 
 entry is made in the discount column of the total amount of 
 discounts allowed, which is posted to the debit of the discount 
 account. By this means the total of the debit and credit dis- 
 count columns will be made to agree, while the advantage of 
 posting totals to the ledger account instead of differences, is 
 not lost. Moreover the rule that the debit cash entries arc 
 posted to the credit of the ledger, and vice versa, is uniformly 
 maintained, which will always be an advantage theoretically, 
 and — where one is dealing with second-rate bookkeepers — 
 practically as well. 
 
 In every case the total of discounts received should be cred- 
 ited to a properly named profit and loss account, and the total 
 of discounts allowed debited. A further consideration arises, 
 however — ^namely, that, while discounts are theoretically sup- 
 posed to represent an allowance granted for a payment made 
 before it is due, it is an almost universal custom to deduct 
 discount from all outstanding accounts at balancing time, and 
 to amend the profit and loss account accordingly. The posi- 
 
62 AUDITING. 
 
 tion is not very logical; but where, upon the whole, discounts 
 show a loss, there is much to commend it. 
 
 Discounts allowed for prompt or anticipated cash payments 
 must not be confounded with trade discounts. Many book- 
 keepers confuse the two, and it is therefore necessary, in many 
 cases, for the auditor to analyze the Interest and Discount 
 Account in the ledger. 
 
 There should, however, be little difficulty in distinguishing 
 between cash and trade discounts ; wherever the rate is higher 
 than that which an ordinary concern would usually pay for 
 the convenience of prompt payments it can safely be treated 
 as a trade discount, and the amount so received should be ap- 
 plied in reduction of the cost of the goods purchased. 
 
 Cash Discounts (so-called) received on account of capital 
 expenditure are clearly a reduction of such capital expenditure. 
 
 INTEREST, received and allowed, requires to be separated 
 in the profit and loss account, just the same as discount; and, 
 where it is desired to reveal the whole effect of the working of 
 a concern, it is advisable to separate discount from interest. 
 
 The question of outstanding discount and interest is dealt 
 with more fully in Chapter VI . 
 
 BANK CHARGES.— Before taking leave of the cash book, 
 it is well to note that the auditor might with advantage roughly 
 check the bank charges debited to his client, and see that the 
 rate actually charged is in accordance with arrangements made. 
 
 PETTY CASH. 
 
 The author is acquainted with two good systems of petty 
 cash, and with numerous bad ones. It is not proposed to 
 deal exhaustively with the latter, but a good system is suffi- 
 ciently uncommon to merit a record in these columns. 
 
 The system of debiting petty cash payments en bloc to ex- 
 penses is bad ; and it is therefore assumed that, under each of 
 
METHODS OF ACCOUNT. 63 
 
 the following methods, the various payments are periodically- 
 analyzed. The petty cash book should be ruled and balanced 
 at least once a month, and frequently it will be found advan- 
 tageous to balance at even shorter intervals. The analysis 
 may be made either by means of analysis columns in the book 
 itself or by a summary written in the book after being pre- 
 pared on loose dissecting sheets, as may be found most con- 
 venient. 
 
 Under one system the petty cashier is started with an 
 amount, say $100.00, which is supposed to be more than suffi- 
 cient for the payments for the month (or whatever other 
 period be adopted). At the end of the month he hands the 
 cashier a summary of his payments, and receives a cheque 
 for that amount. On the stub of the cheque the summary 
 (or a reference to it) is written, and the cheque is written up 
 in detail in the cash book at once, and thence posted direct 
 to the debit of the various accounts. Under this system no 
 ledger account is required for petty cash, but an account 
 should in every case be opened for the initial balance, as, if it 
 be left as a floating balance on Office Expenses, or any other 
 nominal account, it is apt to get lost sight of. The chief 
 cashier should thoroughly examine the petty cash book each 
 time he draws a cheque ; and when the cheque has been cashed, 
 the initial balance should be shown him intact. The auditor 
 also will, of course, require to see this balance, or to have it 
 properly accounted for. 
 
 In some instances where vouchers are required for all petty 
 cash payments, a loose summary sheet is used to which the 
 vouchers are attached and on which they are entered in detail. 
 This system does away entirely with the petty cash book. 
 
 The other system is more suitable where the expenditure 
 is too large for it to be deemed desirable to trust the petty 
 cashier with an amount sufficient to cover a month's expenses. 
 
 In this case, there will be a small initial balance, and when 
 it becomes nearly exhausted a cheque will be given for the 
 
64 AUDITING. 
 
 exact amount spent up to date. This system is thus similar to 
 the former, but with shorter rests; but to avoid numerous 
 entries in the cash book the cheques drawn (including that 
 for the initial balance) are posted to the debit of a Petty Cash 
 Account in the ledger. The result of the monthly summary is 
 credited to Petty Cash Account and debited to the various 
 nominal accounts, either by being posted direct from the sum- 
 mary or by means of a journal entry. The balance of the 
 Petty Cash Account at the end of each month will thus always 
 represent the amount of the initial balance. 
 
 It will be noticed that debiting nominal accounts has always 
 been spoken of. In the comparatively rare cases where it is 
 desirable to make purchase ledger and other payments (which 
 involve the debit of a personal account) by cash, every consid- 
 eration of convenience will tend to the use of a separate cash 
 book for this purpose, which will, of course, be kept upon 
 similar lines to those indicated. Sometimes (as in the case of 
 lawyers) it is better to keep only one petty cash book, but in 
 that case separate columns should be employed for expenses 
 and for payments on account of clients. 
 
 Both the above are varieties of the " Imprest System," so 
 called from the demand (or imprest) presented to the chief 
 by the petty cashier from time to time for a sum to reimburse 
 him for his payments. 
 
 A good system of petty cash is of the greatest value, both to 
 the auditor and to his clients, and it is therefore always advis- 
 able that the auditor should use his influence in this direction. 
 
 RENTS (RECEIVED AND PAID). 
 
 Where a considerable portion of the income is derived from 
 the receipt of Rents it is probable that some reasonable system 
 of accounts will be found in connection with them ; but where 
 the matter is, so to speak, a side-issue, the probabilities are 
 that there will be found to be no system whatever. Cottages 
 
METHODS OF ACCOUNT. 6$ 
 
 let to workmen are, perhaps, the most ordinary instance of a 
 revenue being incidentally derived from rents received; and, 
 as a rule, the accounts in connection with them will be found 
 extremely primitive. The usual method is to deduct the 
 amount of rent from each man's pay, and credit the total de- 
 ductions to a Rent Received Account. This method might 
 answer if the proper deductions were invariably made; but 
 under such a system — if a man were allowed to get into arrears, 
 or if no wages were due to him — the matter is very liable to be 
 lost sight of; and, in any case, no proper record will be kept 
 of any allowances made to tenants for taxes, repairs, &c. In 
 every case, therefore, a proper rent-roll should be kept. In 
 general, this will be found an actual saving of time in the end ; 
 and, in any case, it will probably save its cost in the increasing 
 resultant revenue. 
 
 Suitable rulings for rent-rolls (for rents payable weekly, 
 monthly, &c.) will be found in the author's "Auctioneers' Ac- 
 counts." 
 
 The proportion of rent accrued, but not due, should be in- 
 cluded in the balance sheet as an asset; as also should all 
 arrears, unless, indeed, there is reason to believe that they 
 will not be recovered. All accrued and outstanding liabilities 
 for ground rent, rates, taxes, &c., must also be included, and 
 the auditor must not be put off with any suggestion that 
 " they about balance one another." What he has to deal with 
 are the facts. 
 
 In the case of cottage property, occupied by workmen, it is 
 desirable to show the whole matter in a nutshell in the profit 
 and loss account; therefore show rents, less expenses, on the 
 credit side, and carry out only the net revenue derived. 
 
 Where only a portion of certain premises is occupied, and 
 the remainder sub-let, a similar course should be pursued. 
 That is to say, the total rent paid should be shown on the debit 
 side, the rent receivable deducted, and the net rent paid carried 
 out. It is considered in some quarters that a statement of the 
 
66 AUDITING. 
 
 net amount is sufficient ; but the effect of the sub-let premises 
 becoming vacant should be considered, for if this be ne- 
 glected, the amount stated in the accounts would be liable to 
 sudden and unexplained fluctuations. If accounts are intended 
 to show the whole facts of the case, it will be seen at once how 
 defective are statements containing the net amount only. 
 
 RENTS PAYABLE. — Where the business is carried on in 
 premises owned by the proprietors and there are other tenants 
 there is no reason why the rent account should not be charged 
 with a fair amount for the use of the premises. This prac- 
 tically amounts to the proprietors giving themselves a lease 
 of the property, which naturally leads to a consideration of the 
 question of leaseholds. 
 
 WHERE A VALUABLE LEASE is held, for which a pre- 
 mium has been paid, the annual amount written off for de- 
 preciation may appropriately be charged to rent account, it 
 being in fact merely a portion of the rent paid in advance; 
 but it would be well for the accounts to state that this has been 
 done. 
 
 "SELF-BALANCING" LEDGERS. 
 
 All accountants — and, for that matter, most bookkeepers — 
 will be familiar with the method usually adopted for verifying 
 the accuracy of each ledger in a system of accounts. It 
 would probably be the exception to find a set of books in which 
 some device for the separate balancing of each ledger was not 
 in use ; although the system of applying this check is not always 
 properly organized. 
 
 When the latter is the case the usual method is to take the 
 total of the list of ledger balances at the previous time of bal- 
 ancing, allow for the total amounts that should have been 
 posted to the debit and credit of the ledger respectively, and the 
 resultant figure should agree with the total of the present list 
 of balances. This method is often of the greatest possible 
 assistance when dealing with books that have been more or less 
 
METHODS OF ACCOUNT. 6/ 
 
 incompletely kept ; but it can hardly be called scientific, and is, 
 at best, but a convenient makeshift. 
 
 The general ledger should contain a controlling account for 
 each of the subsidiary ledgers, and in some instances, e. g., 
 ledgers at branch houses or at works offices, it may be found 
 desirable to have a complement of the controlling account in 
 the subsidiary ledger, but in the case of ledgers for accounts 
 receivable, &c., which are kept in the same office as the general 
 or private ledger, it is not, as a rule, necessary to have the con- 
 trolling account appear in both ledgers. The detailed consid- 
 eration of this matter is, however, a question of bookkeeping 
 rather than auditing; it will accordingly be found to be fully 
 dealt with in the author's " Bookkeeping for Accountant Stu- 
 dents." The controlling account is a most valuable device, as 
 by this means each ledger can, at any time, be balanced with the 
 minimum of trouble, and independently of the other ledgers. 
 Hence it follows that a rough balance sheet and profit and loss 
 account can always be prepared in a very short space of time, 
 without involving the labor of balancing every ledger. Again, 
 the clerk keeping the general ledger (naturally the clerk most 
 to be trusted, if not actually one of the principals, or perhaps, 
 even the auditors themselves) has a very good check on every 
 other ledger clerk. It must, however, never he lost sight of 
 that the only reliable verification of the various balances of the 
 controlling accounts in the general ledger lies in the thorough 
 verification of the various suhsidia/ry ledger balances. If this 
 fact be lost sight of, there is a serious risk of fraud; but, if 
 the system be intelligently applied, it is a distinct preventive 
 of any kind of irregularity. 
 
 The auditor who once adopts this system will find it not 
 only lessens his own work and that of the bookkeeper, but also 
 adds to the completeness of whatever system may have previ- 
 ously been in use ; and, further, materially increases the pleas- 
 ure attendant upon the investigation. Where the auditor 
 himself keeps the private ledger (a not uncommon practice 
 where private persons and firms are concerned) the advantage 
 
68 AUDITING. 
 
 of making each ledger " self-balancing " must be sufficiently 
 obvious to need no further demonstration. 
 
 Where proper stock accounts are kept, or there is a reliable 
 means of estimating the amount of stock on hand (cf. Stock 
 Accounts), the existence of self-balancing ledgers makes it 
 possible for a reliable balance sheet and profit and loss account 
 to be prepared, at any time, in a few hours ; and the advantage 
 of this — where no cost accounts can be kept — is hardly to be 
 over-estimated. 
 
 TABULAR LEDGERS.— Another form of self-balancing 
 ledger — to which indeed the term " self-balancing " may, per- 
 haps, be more appropriately applied than to the kind described 
 in the preceding paragraph — is the tabular ledger. This 
 ledger is suitable to those concerns in which accounts are 
 rendered only at certain definite intervals, and where the num- 
 ber of customers is extremely numerous, while the number of 
 transactions with each customer is but small. These limita- 
 tions naturally reduce the general utility of tabular ledgers, 
 but they are common with gas companies, water companies, 
 electric light companies, and also for the purpose of recording 
 the collection of taxes made by various governmental bodies. 
 In each of these cases the account rendered to the -customer 
 virtually consists of a single item, but the same form of ledger 
 is sometimes found convenient in cases where a large number 
 of items have to be recorded; in these latter cases, however, 
 a subsidiary ledger has to be kept for the purpose of collect- 
 ing the items which constitute the account to be collected. 
 Under ordinary circumstances the extra labor involved would 
 go far to prevent the employment of tabulated ledgers in such 
 cases as this, but it sometimes occurs — e. g., in the case of a 
 mine — that the daily deliveries are only invoiced as regards 
 weight and quality, without being priced out, and that the sub- 
 sidiary ledger is also kept in quantities only; the pricing out 
 being only done when the monthly statement of account is sent 
 in, and this being so, a tabulated form of ledger might con- 
 veniently be adopted in such a case, although probably the 
 
METHODS OF ACCOUNT. 69 
 
 number of accounts would not be sufficient to render such a 
 course imperative. 
 
 In undertakings with numerous branches or mines it has 
 been found very convenient to use tabular operating ledgers 
 for the various nominal accounts, such as labor, &c. 
 
 Instead of having a separate ledger account for the operat- 
 ing accounts (and property accounts, too, for that matter), of 
 each mine, columns are provided for all under the one heading ; 
 a total column being used for the general trial balance or 
 balance sheet. This system reduces the number of postings, 
 pagings and labor generally, and makes comparisons and state- 
 ments easy. 
 
 Yet another form of tabular ledger is that in general use 
 at hotels. The especial object of this form is to make the 
 ledger do duty not only as a personal ledger, showing the 
 state of account between the hotel and the various visitors, but 
 also as a nominal ledger, showing the analyzed receipts from 
 day to day. This form of ledger is especially applicable to 
 hotels, on account of the large number of nominal accoimts 
 employed to analyze the income derived from various sources ; 
 it is also most convenient on account of the fact that it pre- 
 sents the readiest means of keeping each account written up 
 to date, with a minimum of labor. 
 
 It is a question, however, as to whether it would not be a 
 saving of time and insure more accurate results to abandon 
 the analyses in the ledger and cash book and depend upon 
 the footings of the original records from which the ledger is 
 posted. The ordinary hotel cashier is extremely careless about 
 the distribution of receipts, and as he usually works " on the 
 jump," there is much to excuse him. It is quite feasible to 
 have the various records from which the postings are made — 
 e. g., restaurant, laundry, service to room, livery, baggage and 
 other charges — either footed in the books themselves or sum- 
 marized on sheets ruled for the purpose. The cashier by this 
 method need not, of course, analyze his receipts, while at the 
 «ame time accurate results are obtained. 
 
70 AUDITING. 
 
 LOOSE LEAF AND CARD BOOKKEEPING, CBl,c. 
 
 Of late years the loose leaf and card systems of bookkeep- 
 ing have been steadily advancing in favor, and there seems 
 to be every indication that as their advantages become more 
 widely known they will be still further utilized. A full descrip- 
 tion of the various applications of these systems will be found 
 in the author's "Advanced Accounting," and would be out 
 of place here. It is necessary, however, for the sake of com- 
 pleteness, to now consider the matter from the point of view 
 of the auditor. There can be no doubt but that, unless a thor- 
 oughly efficient system of account-keeping prevails, the intro- 
 duction in any form whatever of the loose leaf system is likely 
 to make confusion worse confounded; but, given a properly 
 organized accounting department, it seems that practically the 
 only drawback that can be suggested is the increased responsi- 
 bility that is thrown upon the auditor of maintaining a vigilant 
 outlook for fraud. 
 
 A great deal has been made by some critics of the possi- 
 bility of cards, or sheets, being destroyed, and replaced by 
 others containing falsified entries. With a proper system, 
 however, such irregularities would be more speedily detected 
 than would their equivalent under the old-fashioned system 
 of recording all entries in bound books. Bound books are in- 
 variably paged or folioed consecutively, but it is safe to assert 
 that no auditor ever conceived it to be part of his duty to 
 make sure that the pages or folios of each ledger were com- 
 plete. If a folio be neatly extracted from a ledger, it is not 
 unlikely that its absence might remain undetected for months, 
 so long as it had not been removed until after all postings 
 to that folio had been checked. 
 
 With both card and loose leaf ledgers it is as a rule better 
 to check the postings by calling back from the ledger into 
 the books of first-entry, as time can generally thus be saved; 
 while this sequence enables the auditor to more readily satisfy 
 himself that the ledger, as presented to him for audit, is 
 complete. 
 
METHODS OF ACCOUNT. 7I 
 
 It is needless to say that the loose leaf system is not adapted 
 to every business regardless of any peculiar conditions which 
 may exist. It is true that some stationery houses claim that 
 they can install a system suitable for any business whereby 
 loose leaves and cards can be substituted for every bound 
 book in use, but in numerous instances where this has been 
 done the result has not borne out the expectation, and it 
 simply adds further proof of their inability to displace the 
 professional auditor. 
 
 STORES AND STOCK ACCOUNTS. 
 
 In many businesses it is quite practicable to keep a reliable 
 record of all goods or stores in stock, and — wherever this is 
 possible — it is clearly desirable that the auditor should place 
 before his clients the indisputable advantages of such a course. 
 
 Full details as to the best method to be adopted in all cases 
 would naturally involve a consideration of the particular stocks 
 employed in various trades and manufactures, and would be 
 out of place in this volume, but the following general recom- 
 mendations (quoted from "The Accountants' Manual," Vol. 
 II) will doubtless prove sufficient for the purpose: — 
 
 (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 woujd 
 be entered, with such particulars as were necessary or suitable, 
 the difference representing what ought to be in hand, or there- 
 abouts — 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, what- 
 
72 AUDITING. 
 
 ever theorists may say. But many useful rules may be laid 
 down preventive of fraud and waste, amongst others the fol- 
 lowing, taken from actual experience: — 
 
 (a) Where stores are distributed for use upon a specific 
 job, the job should be stated, with the weight, quantity, &c. 
 
 (b) If material of the same kind is distributed to various 
 men for the same purpose, a comparison should be made be- 
 tween 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, &c. 
 
 (c) The store room 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 experi- 
 ence to appreciate the importance of account keeping. 
 
 (d) The principal, or manager, should make a point of ex- 
 amining at times the stock ledgers and exercising general 
 supervision of the department. Frequent and imnotified visits 
 should be made, and the storekeeper, if possible (it is not al- 
 ways possible), changed (occasionally). 
 
 (e) 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 
 only be supplied on his giving up the old articles. This is a 
 very good check, when the nature of the stores will allow of 
 its application. 
 
 It will be perceived that the above considerations refer pri- 
 marily to the stores purchased by factories for their own use ; 
 an ordinary amount of intelligence will, however, suffice to 
 render the recommendations there made applicable to a trad- 
 ing concern — that is to say, a concern where the goods pur- 
 chased are issued (sold) to outside persons. A simple system 
 will be found described in the author's "Advanced Ac- 
 counting." 
 
METHODS OF ACCOUNT. 73 
 
 In designing stock accounts for trading concerns (and some- 
 times, also, with factories) it is preferable to arrange for the 
 keeping of the accounts in values as well as in weight or 
 quantity; and, where this can be done, it is clearly desirable 
 — ^as it is then possible — ^to make the stock accounts part of 
 the regular system of double-entry bookeeping employed. It 
 is, however, best to retain the record of weights or quantities 
 wherever practicable, as otherwise a discrepancy in quantity 
 might easily be concealed by an error in the values attached 
 to the various stores. 
 
 TRADERS' ACCOUNTS. 
 
 With some businesses (especially traders dealing in small 
 articles broken from bulk) a regular system of stock accounts 
 is not practicable. In such cases a different method of check 
 must be employed. In every trade there is a well-known per- 
 centage of gross profit that ought always to be earned, and 
 can rarely be exceeded. If, therefore, the stock account is 
 started with the actual stock on hand at the commencement of 
 a period, debited from time to time (usually monthly) with 
 the total purchases, and also with the aforementioned esti- 
 mated gross profits on the sales, and credited with the sales; 
 the balance shown will represent the stock on hand — estimated 
 on the assumption that the nominal gross profit has been ex- 
 actly earned. The same result would also be accomplished by 
 crediting the stock account with the sales after deducting the 
 gross profit therefrom, rather than debiting the gross profit 
 and crediting the sales. At the periodical stock-taking this 
 estimate can, of course, be easily verified, or corrected. Where 
 an undertaking trades in various kinds of goods, it is always 
 desirable to dissect the sales and purchases, so that the position 
 of the various departments may be readily perceived. 
 
 This system is in very general use, and serves two miost 
 useful ends, (i) It calls attention to any discrepancy between 
 the actual and nominal gross profits, by means of a similar 
 discrepancy between the ascertained and estimated stock in 
 
74 AUDITING. 
 
 hand. (2) It affords most useful information as to the prob- 
 able amount of stock in each department from month to month, 
 and so serves as a guide to, and a check upon, the various de- 
 partmental managers, as well as affording material for an in- 
 terim balance sheet, if one be required. 
 
 * It is, of course, impossible to give any definite information 
 concerning the gross profits usually made in various retail 
 trades. Naturally, everything depends upon the situation of 
 the store, and the class of business done. Variations are so 
 great in different parts of the United States that it is not 
 deemed wise to attempt the publication of even approximate 
 figures. It is suggested, however, that any auditor would 
 find a table compiled from his own experience of great value. 
 
 *^ It is, perhaps, well to note that, in accordance with the in- 
 variable custom of traders, percentages of gross profits are 
 based upon the selling price of the goods, and not on the cost 
 price. 
 
 It may be added that a comparison of the ratio between the 
 stock-in-trade and the sales during corresponding periods is 
 often useful as a rough test of the accuracy of the stock-taking. 
 
 Another system is in use in some large department stores 
 where a more accurate check on the various departments is 
 desired. All goods are charged to departments at the selling 
 price, which, of course, has been determined in advance; all 
 changes in values, &c., are recorded, and at stock-taking time 
 the inventory is priced, not only at cost for the private ofiice 
 but also at selling price for the purpose of verification, and 
 the account is supposed to balance exactly. It is surprising 
 to find how small the discrepancies may be in houses trans- 
 acting a large volume of business. 
 
 This system can be extended with advantage to other lines 
 of trade, as, for instance, retail branch stores selling cigars, 
 groceries, men's furnishing goods, &c. 
 
 In conclusion, it may be stated that the auditor who has 
 been requested to design stock accounts for any special busi- 
 
METHODS OF ACCOUNT. 75 
 
 ness will do well to avail himself of whatever practical ex- 
 perience may be possessed by his clients, or their managers. 
 Nevertheless, he should take the earliest opportunity of veri- 
 fying the experience thus utiHzed by his own; and, where he 
 should be so fortunate as to possess some practical knowledge 
 of the particular business in question — a knowledge he is very 
 likely to have had the opportunity of acquiring — he will doubt- 
 less find it of the greatest assistance. 
 
 CAPITAL STOCK ACCOUNTS OF COMPANIES. 
 
 With regard to these accounts, much that might have been 
 said has been anticipated under the heading of " SELF- 
 BALANCING LEDGERS " (q. v.). Each class of shares or 
 stock should have an account opened for it in the general 
 ledger, and such account will, in fact, become the controlling 
 account for that particular stock ledger. By this means all 
 transfers are kept out of the general ledger, and — after the 
 issue has once been completed — no further entries are neces- 
 sary. Should the issue be a large one, however, it is often 
 preferable to open separate general ledger accounts for " ap- 
 plications," " allotments," and " calls," respectively. 
 
 This system may be greatly assisted by the addition of an 
 extra column to the debit side of the general cash book, the 
 items entered in such column being posted to the stock ledger, 
 and the totals periodically posted to the general ledger in the 
 usual way. If this method be adopted, the duplication of en- 
 tries is reduced to a minimum, and the auditor's work becomes 
 not only proportionately lighter, but also much more certain. 
 With large companies, whose stockholders are very numerous, 
 it is usual to devote a special cash book to capital receipts, and 
 carry totals only to the general cash book. This system lends 
 itself readily to the method advocated. 
 
 For full information upon this subject the reader is referred 
 to the author's " Bookkeeping for Company Secretaries," or 
 " Advanced Accounting." 
 
76 AUDITING. 
 
 SUSPENSE ACCOUNTS. 
 
 Most of the points comprised under this heading will be 
 found to be fully dealt with at a later stage, under the heads 
 of " Outstanding Assets and Liabilities " and " Contingent 
 Liabilities " ; but the following, which refer rather to questions 
 of account than to general matters of principle, may be more 
 appropriately considered here. 
 
 Any outstanding amounts due, or supposed to be due, either 
 to or by an undertaking, should never be allowed to stand as 
 balances upon a nominal account. The great convenience of 
 bringing the balance down on the nominal account, as opposed 
 to opening a Suspense or Reserve Account which will naturally 
 have to be closed the following morning, makes this method 
 of bookkeeping — if, indeed, it can be called a method — a great 
 favorite with a certain class of bookkeepers; but the objections 
 that can be raised against such a procedure are quite suffi- 
 cient to outweigh any advantages which it may be supposed 
 to possess. From a bookkeeper's point of view, doubtless, the 
 balance on the nominal account may be deemed to answer all 
 purposes sufficiently well, but the auditor must take a higher 
 view of matters. In the first place, the balance is very apt to 
 be lost sight of, and consequently no adjustment made, at the 
 close of the next period — particularly where a standing bal- 
 ance of petty cash in hand is left open upon, say, the office 
 expenses account. Secondly, the method is open to abuse on 
 the part of a fraudulent bookkeeper, and — in the absence of 
 the suggestive headings lof suspense accounts — ^the matter 
 might possibly escape the vigilance of the auditor. And, 
 again, it is a distinct advantage to arrange the trial balance 
 so that it may contain, in itself, all the information necessary 
 for closing the books, and preparing the balance sheet and 
 trading and profit and loss accounts, and this can only be con- 
 veniently effected by making the necessary adjusting entries, 
 by means of suspense accounts, before the trial balance is 
 extracted. 
 
METHODS OF ACCOUNT. ^J 
 
 THE TREATMENT OF BAD AND DOUBTFUL 
 
 DEBTS. 
 
 An intelligent system of dealing with the difficult question 
 of bad and doubtful debts is of such assistance to all commer- 
 cial houses that the auditor should lose no opportunity of sug- 
 gesting that the matter be put upon a scientific basis. 
 
 A very good method is the following:— 
 
 As soon as a debt becomes at all doubtful, or sufficiently 
 overdue to merit special attention, it is transferred to a doubt- 
 ful debts ledger, which is ruled as follows : On the left-hand 
 page are spaces for two or three ordinary ledger accounts, 
 while the right-hand page is left blank for such memoranda 
 as " When applied for,'* " When sued," " When failed," and 
 full particulars as to progress of subsequent realization of the 
 estate. When an account becomes hopelessly bad (either by 
 reason of the statute of limitations intervening, or an execu- 
 tion remaining unsatisfied, or a final dividend having been dis- 
 tributed, or a composition accepted), and not until then, the 
 account is written off to bad debts account; but on no account 
 should an amount be written off until it is known to be irre- 
 trievably bad, as an amount, once written off, is almost certain 
 never to be recovered. It will be noted that not the least of 
 the advantages afforded by this system is the peculiar promi- 
 nence it gives to all overdue accounts, thus offering special 
 facilities for their receiving the particular attention they so 
 urgently require. In a large concern, moreover, it is an obvi- 
 ous advantage that overdue accounts should pass into the con- 
 trol of a different ledger clerk. 
 
 Where it is the custom to pass all overdue debts on to an 
 attorney or agency for collection, their simultaneous transfer 
 to the doubtful debts ledger provides a convenient record of 
 all matters in their hands. 
 
 The necessary provision for loss upon bad and doubtful 
 debts may be made by means of the reserve for bad debts 
 account, which may be credited with the estimated amount of 
 
78 AUDITING. 
 
 such loss, while the bad debts (nominal) account is debited 
 in the usual way. The memoranda recorded on the blank 
 pages of the doubtful debts ledger will readily afford all avail- 
 able information upon which a proper valuation of the amount 
 necessary to be written off may be prepared, and the systematic 
 focussing of such information upn the method here described 
 will generally admit of a much more reliable estimate being 
 prepared than would otherwise have ben practicable. 
 
 A practice which has been found desirable in some lines of 
 business is to charge to profit and loss each year (and credit 
 to reserve for bad debts) an amount for estimated loss on bad 
 debts equal to a certain percentage of the sales. The argu- 
 ment in this case is that the loss was not really made in the 
 year when it was discovered, but in the year when the sale 
 was effected. An analogous practice is to set up a reserve 
 equivalent to a certain percentage on the uncollected accounts. 
 
 It is obvious that the loss eventually to be realized on ac- 
 counts uncollected at .the date of the balance sheet cannot be 
 accurately determined or estimated merely by allowing for a 
 certain amount of loss on overdue accounts and assuming 
 that all accounts not yet due are good; all bad accounts were 
 at one period of their existence in the latter class. The aim in 
 stating the results of a year's business should be to deduct 
 from the apparent profits on the sales any losses, the prob- 
 ability of which may be foreseen by reference to past experi- 
 ence; hence it follows that a reserve should be made for the 
 entire amount of probable loss on uncollected accounts, one 
 of the principal factors being the percentage either to sales or 
 outstandings experienced in the past. 
 
 Since the loss which may eventually be sustained on doubt- 
 ful debts is to a considerable extent a matter of opinion — 
 though not wholly so — the auditor cannot dictate the amount 
 of the reserve which should be set up. If not fully satisfied, 
 however, as to the adequacy thereof, he should call specific 
 attention to the fact in his report. 
 
METHODS OF ACCOUNT. 79 
 
 THE USE OF THE JOURNAL. 
 
 There was a time when practically every entry in a set of 
 books went through the journal, either having its inception 
 in that book or being included in the totals of other books 
 which were periodically journalized. Modern practice, how- 
 ever, has demonstrated that separate books for various classes 
 of entries, such as purchases, sales, &c., are desirable for a 
 number of reasons, and that there is no good reason why the 
 entries in these books should be rehashed in the journal, either 
 in detail or total, but rather that postings should be made di- 
 rectly from the books of original entry to the ledgers. Con- 
 sequently the journal, as quite generally used among progres- 
 sive business houses, is now restricted to such entries as can- 
 not be made in the books specially designed to receive certain 
 classes of entries. 
 
 The journal is useful for recording inventory totals, closing 
 entries, &c., entries being made therein in preference to mak- 
 ing transfers between accounts in the ledgers. The latter 
 method is taught in many bookkeeping schools, but it is not 
 to be commended. 
 
 WAGES AND SALARIES. 
 
 The best method of paying wages has already been detailed 
 in Chapter I., and therefore nothing further need be said upon 
 that subject here. 
 
 SALARIES should, in large concerns, be dealt with in a 
 manner as near thereto as practicable. The distinction made 
 by writers between wages and salaries is by no means invari- 
 ably clear, and therefore some definition seems desirable. By 
 Wages is meant the cost of labor, and also the cost of the 
 immediate supervision of such labor (foremen, &c.), which 
 would probably be paid for at the same time and in the same 
 manner — in a word, cost of artisans' or laborers' work. By 
 Salaries is meant the weekly or other payments to managers, 
 salesmen, clerks, and other more educated workers. Thus, 
 
80 AUDITING. 
 
 wages will be always an expense of production; but salaries 
 may be an expense of production, distribution, or administra- 
 tion, although generally one of the two latter. The above 
 definitions are by no means universally accepted, but for pres- 
 ent purposes the classification according to method of payment 
 and of audit appears to be the most convenient. 
 
 The best method of recording the payment of salaries is 
 by means of a Salary Book, ruled horizontally for the names 
 of employees and vertically with columns for the successive 
 pay periods. The total of each column represents the aggre- 
 gate amount paid out on a given date, and is the amount for 
 which credit is taken in the cash book. Where salaries are 
 not paid by individual checks, a check should be drawn for 
 the total in preference to paying from petty cash. This form 
 of salary book obviates the necessity for a separate salary 
 ledger as all the data concerning date of employment, rate, 
 increases in salary, &c., can be shown together with the 
 amounts actually paid from week to week or month to month. 
 
 Where the salary book is not written up by some one who 
 has authority to approve the rates, provision should be made 
 for securing approval from the proper person. This will 
 usually make it unnecessary to take receipts. 
 
 AGENTS' ACCOUNTS. 
 
 With books which are not kept by very skilled bookkeepers, 
 the auditor frequently has a considerable amount of addi- 
 tional, and wholly unnecessary, trouble in connection with the 
 accounts between his clients and their agents, or between his 
 clients (the agents) and their principals. It is therefore very 
 desirable that agency accounts should be kept upon some 
 definite and practicable system. The conditions of agency are 
 so various that it is impossible to deal in detail here with every 
 conceivable set of circumstances arising in connection with 
 this subject, but it may be pointed out, in general terms,»that 
 where the remuneration of the agent is dependent upon the 
 
METHODS OF ACCOUNT. 8 1 
 
 amount of sales or purchases effected by him, every considera- 
 tion of convenience is in favor of a special sales or purchase 
 book being employed for his transactions ; or, at all events, a 
 special column being devoted to these transactions in the gen- 
 eral sales or purchase book, as the case may^be. When, on 
 the other hand, the remuneration of the agent is by way of 
 profits, or a percentage on the profits earned, whether gross 
 or net, the accounts should be so schemed that an " Agency 
 Account " is opened in the general or private ledger, which 
 virtually becomes the trading, or profit and loss account in 
 respect of the transactions with which the agent is concerned. 
 From many points of view there is much in common between 
 agency accounts and consignment accounts, and therefore the 
 considerations obtaining under the latter heading will frequent- 
 ly be found of use in connection with the accounts between 
 agents and principals, and may be usefully consulted before 
 formulating any definite scheme upon which these latter ac- 
 counts should be kept. 
 
 CONSIGNMENT ACCOUNTS. 
 
 It has already been pointed out under the previous heading 
 that the most convenient method of dealing with many agency 
 accounts is to so arrange the books that what is virtually a 
 special trading, or a special profit and loss, account should 
 be kept in respect of these particular items. These remarks 
 apply a fortiori to consignment accounts. The statement will 
 be found in many text books on bookkeeping (chiefly, how- 
 ever, of the unpractical order) that when a consignee receives 
 goods from a consignor it is unnecessary that any entry should 
 be made in his books in respect thereof. This, it will be 
 obvious, is a complete departure from the fundamental rule of 
 bookkeeping, which requires that it should be "a record of 
 transactions," and this proposition seems so self-evident that 
 no time will be wasted in more fully discussing it. Apart, how- 
 ever, from this academical objection, it may be pointed out 
 that every consideration of convenience requires that in the 
 
82 AUDITING. 
 
 books of the consignee there should be two accounts for the 
 purpose of recording his transactions with the consignor; the 
 one virtually a trading account, showing the actual result of the 
 trading in the goods consigned, and the other a personal ac- 
 count, showing the position between the consignee and the 
 consignor. 
 
 In some cases where several consignments are received from 
 the same consignor, it may be found desirable to open a sepa- 
 rate trading account for each, but one personal account will 
 usually suffice. 
 
 The same remarks apply to the books of the consignor him- 
 self, except that — as he is dependent entirely upon the con- 
 signee for the record of transactions after the goods have once 
 left his office — it becomes possible in some cases to adequately 
 record these transactions in one account. In the vast majority 
 of cases, however, it will be found that two accounts are not 
 only more convenient, but in the long run involve less trouble 
 and time in the keeping. 
 
 A fuller and more detailed exposition of the best method 
 of dealing with these accounts will be found in the author's 
 " Bookkeeping for Accountant Students," to which the reader 
 is referred. 
 
 THE ACCOUNTS OF BRANCH ESTABLISHMENTS 
 
 This is a point upon which the auditor will frequently ex- 
 perience considerable difficulty, by reason of the defective sys- 
 tem of record employed, and it is therefore of especial import- 
 ance in connection with the subject of auditing that a really 
 practical system of bookkeeping should be dealt with in this> 
 connection. 
 
 It may be stated at the outset that the accounts of branch 
 establishments may be ranged under two wholly different cate- 
 gories. In the first case the accounts of the branch are kept 
 at the branch itself, and are practically independent of those 
 kept at the head office ; in the second case a minimum possible 
 
OF THE 
 
 UNIVERSITY 
 
 OF 
 
 METHODS OF ACCOUNT. 83 
 
 amount of accountancy is employed at the branch, returns 
 being made to the head office, and the transactions of the 
 branch incorporated in the head office books. The latter class 
 of accounts, of course, present no serious difficulty, and, indeed, 
 for all practical purposes the bookkeeping is the same as though 
 the branch establishment did not exist, except that for statisti- 
 cal purposes it may be thought desirable that some of the 
 nominal accounts should be divided up so as to show the trans- 
 actions of the branch separately for purposes of comparison. 
 
 It is however, with regard to the former class that most 
 difficulties are likely to arise. In this connection it may be 
 pointed out that any difficulty or complication which can be 
 conceived may be at once got over if the system of accounts 
 at the branch office be regarded in precisely the same light as 
 though the ledgers recording these transactions were in point 
 of fact kept at the head office in self -balancing ledgers, in 
 respect of which controlling accounts were to be found in the 
 head office ledgers themselves. These controlling accounts in 
 the head office ledgers, which, of course, will be written up 
 from returns made by the branches, will provide the means of 
 controlling the record of transactions in the branch ledgers, 
 and at the same time combine the whole system of accounts 
 into one entity. On the other hand, there should be comple- 
 mentary accounts in the branch office books, so that these them- 
 selves may be made self -balancing. 
 
 When balancing time comes it is necessary that a trial bal- 
 ance should be taken of the branch books, and sent to the 
 head office, and this will be found to explain and verify the 
 controlling account in the head office books dealing with the 
 branch transactions. The trial balance at the head office can 
 then be amplified so as to give effect to these records. 
 
 In many cases it will be found preferable not to employ any 
 banking account at the branch at all, but to receive and pay 
 all accounts through the head office alone; and, where the 
 nature of the business renders this possible, every consideration 
 of expediency will be in favor of its being carried out. 
 
84 AUDITING. 
 
 Another point which is well worth bearing in mind, where 
 it can be practically applied, is that with certain classes of 
 business — that is to say, those which deal with the sale of 
 goods in bulk without the bulk being broken, it is of inestimable 
 advantage for the purchases to be all made at the head office, 
 and the goods supplied to the branch offices being supplied 
 to them by the head office at selling price. The stock ac- 
 count at the branch office then becomes much simplified, and 
 the balance of such stock accounts should represent the stock 
 actually available on hand, and without any adjustments being 
 necessary in respect of estimated or actual gross profit. It 
 is not necessary that this system should at all confuse the 
 question of the profits actually earned by the branch, because 
 there is not the least difficulty in the goods supplied to the 
 branch being credited to a special account in the head office 
 books, instead of being credited to the general sales account. 
 
 The mere fact that a business has numerous branches, in- 
 stead of merely one, in no way alters the fundamental princi- 
 ples on which the accounts of these branches should be kept; 
 but it need hardly be added that it strengthens the argument in 
 favor of these branch accounts being organized and rigidly 
 kept upon a thoroughly sound basis of internal check, and one 
 which renders itself readily available to the scrutiny and super- 
 vision of the auditor. 
 
 The introduction of mechanical bookkeeping devices has 
 materially affected the accounting methods of branch offices. 
 It is now possible to duplicate practically all branch records in 
 convenient form for transmittal to the head office, there to 
 be filed in binders provided for the purpose, and thus furnish- 
 ing the means whereby instant reference can be had to branch 
 transactions. The audit thereof can usually be conducted 
 at the head office with most satisfactory results. 
 
 Through the use of typewriters adapted for the purpose, 
 and by one operation, customers' ledgers are posted, customers' 
 monthly statements are written and duplicate ledger sheets 
 
METHODS OF ACCOUNT. 85 
 
 are prepared for the head office, in addition to which the 
 machine automatically registers and adds the amounts posted, 
 which admits of a daily arithmetical proof of all postings. 
 
 CAPITAL AND REVENUE. 
 
 The distinction between capital expenditure and revenue 
 expenditure is one of primary importance, as bearing upon 
 the fundamental question of what profits have actually been 
 made by an undertaking during any given period. But it is 
 thought that much unnecessary complication has been intro- 
 duced in discussing this subject, and that, when these wholly 
 irrelevant matters are brushed aside, the fundamental question 
 will be found to be simplicity itself. 
 
 Briefly stated, the question can in any event be answered 
 by finding the answer to the following question : " Has the 
 particular expenditure incurred in any individual case been 
 incurred for the sake of improving the earning capacity of the 
 undertaking?" If the answer to this question is in the 
 affirmative then, and to that extent, the expenditure in ques- 
 tion is capital expenditure. But if it has only had the eflFect 
 of putting the earning capacity of the undertaking upon the 
 same footing as that which had previously otbained (and 
 which has since declined by the ordinary process of wear and 
 tear, or the effluxion of time, in respect of which no provision 
 has been made), it must be charged against revenue. The pre- 
 cise meaning of this latter qualification is that the mere renezval 
 of wasting assets, not otherwise provided for, cannot be called 
 capital expenditure, but that any extension, or the acquiring 
 of fresh assets, is in the nature of capital expenditure. 
 
 PARTNERSHIP AGREEMENTS. 
 
 There is an increasing tendency upon the part of commercial 
 men entering into partnership to consult professional account- 
 ants as to the provisions which should be made in the partner- 
 ship agreement with regard to the accounts. This tendency 
 
86 AUDITING. 
 
 is distinctly one to be encouraged, as having in the long run 
 the effect of not only consulting the immediate interests of 
 the partners with regard to the keeping of proper accounts, and 
 the equitable apportionment of profits, but also as tending dis- 
 tinctly to lessen the probability of disputes in the future arising 
 out of questions of account. 
 
 The subject is, therefore, one which may be very profitably 
 undertaken by professional accountants, and that without in 
 the least usurping the functions of lawyers. This being so, 
 it has been thought desirable to append a few notes as to the 
 points most ordinarily arising in partnership agreements, to- 
 gether with suggestions as to how they should be dealt with. 
 
 These are as follows : — 
 
 (i) The respective shares of partners in profits and losses 
 should be clearly stated; and where it is provided that these 
 shall be varied during the continuance of the partnership, it is 
 especially important that anything which might tend to effect 
 the amount of agreed profits as between the partners should 
 be very clearly defined. 
 
 (2) It should be borne in mind that, in the absence of ex- 
 press provision to that effect, partners are not entitled to 
 interest upon capital. If, therefore, they are to receive inter- 
 est, the fact should be clearly stated. 
 
 (3) The rate of interest on loans by partners to the firm 
 should be expressly stated. 
 
 (4) Not only should the amount of capital to be introduced 
 by each partner at the outset be expressly defined, but pro- 
 vision should be made as to the manner in which undrawn 
 profits are to be dealt with. That is to say, whether they are 
 to be treated as capital or as loans, the distinction being espe- 
 cially important where it is provided that capital does not bear 
 interest but that loans do. 
 
METHODS OF ACCOUNT. 87 
 
 (5) The amount to be drawn by each partner from time to 
 time on account of profits should be clearly stated, together 
 with the penalty in the event of such limit being exceeded. 
 
 (6) If it desired that interest should be debited to partners 
 in respect of drawings, the fact should be clearly stated. 
 
 (7) The circumstances under which a partnership may be 
 dissolved should be clearly provided. Too much attention 
 cannot be given to this point. 
 
 (8) The exact position of each partner, in the event of a 
 dissolution, is also a matter of the very greatest importance. 
 
 (9) In the event of a partner retiring or dying, the agree- 
 ment should distinctly provide the amount payable to him (or 
 to his representative, as the case may be), and the method by 
 which it is to be ascertained, also the time in which it must be 
 paid, and the interest (if any) it is to bear in the meantime. 
 It is important that the business should not be crippled by 
 making this period unduly short. 
 
 (10) In connection with the preceding it is frequently con- 
 venient that some special arrangement should be made to 
 obviate the necessity of the books being balanced and stock 
 taken at an irregular period. 
 
 (11) The exact scope of the firm's business should be clearly 
 defined, with a view to avoiding disputes as to whether certain 
 profits earned by the individual partners come under the part- 
 nership agreement or not. 
 
 (12) The extent (if any) to which partners are entitled to 
 engage in other operations, outside the partnership business, 
 should be defined. 
 
 (13) It should not only be provided that "proper accounts 
 are to be kept," but that these should be kept upon some ade- 
 quate system of double entry. They should be balanced at 
 stated intervals, and audited by a professional accountant, and 
 provision made that after the audited accounts have been 
 
88 AUDITING. 
 
 signed by the partners they are binding upon each individual 
 partner, except where some manifest error has been discovered 
 within a reasonable time — say, three months. 
 
 (14) In addition to the usual arbitration clause, it is very 
 expedient that there should be one to the effect that all dis- 
 putes upon questions of account should be referred to the arbi- 
 tration of a Certified Public Accountant (preferably, if the 
 question of expense is to be considered, the regular auditor of 
 the firm), and it should be further provided that, in the event 
 of disputes upon questions of mixed law and accounts, such 
 disputes should be referred to the arbitration of an accountant 
 and a lawyer, the arbitrators having power to appoint a referee 
 before commencing their reference. 
 
 INSTRUCTIONS AS TO PREPARATION FOR 
 AUDIT. 
 
 As a fitting conclusion to the present chapter, a brief list of 
 instructions — such as might be prepared by the auditor for 
 the guidance of the bookkeeper, showing the work that should 
 be done before the audit commences — is appended. Such a list 
 is the following : — 
 
 (i) All postings should be completed, all additions inked 
 in, all balances extracted, and the trial balance agreed. 
 
 (2) Vouchers for all payments should be arranged in order, 
 and made available for the auditor's inspection. 
 
 (3) A complete list of all books, with the names of the clerks 
 in charge of each, should be prepared. 
 
 (4) If possible, the cash in hand at the date of closing the 
 books should be paid into the bank; but, where this has not 
 been done, the cashier must have his books written up to date, 
 and the vouchers ready. 
 
 (5) A complete inventory of the stock — priced, extended, 
 footed, and duly certified — should be ready. 
 
METHODS OF ACCOUNT. 89 
 
 (6) All bonds, notes, deeds, and other securities should be 
 ready for production when called for by the auditor, and a 
 list thereof should be prepared. 
 
 (7) A list of all overdue accounts showing the provision 
 (if any) which it is deemed necessary to make against possible 
 loss should be prepared. 
 
 (8) A memorandum should be kept of any other matter to 
 which it is thought desirable to call the auditor's attention. 
 
 (9) A draft balance sheet and profit and loss account should 
 be prepared. 
 
 As has already been pointed out, some of the duties com- 
 prised in the foregoing may devolve upon the auditor in the 
 case of a private firm or trader ; but in the case of a corporation 
 audit it is particularly desirable that these matters should be 
 completed before the auditor commences his investigation, as 
 it cannot be too strongly impressed upon all concerned that the 
 accounts submitted to the stockholders are not the auditor's ac- 
 counts, but the accounts of the directors. 
 
CHAPTER III. 
 
 SPECIAL CONSIDERATIONS 
 IN DIFFERENT CLASSES OF AUDITS. 
 
 In the previous chapters the rules laid down have been of as 
 general a character as possible; but it must not therefore, be 
 supposed that the audit of every concern is to be carried out 
 on precisely the same lines. The opportunities for fraud will 
 vary widely in concerns of a different character, while the 
 chances of unintentional errors of principle and in detail will 
 likewise vary extensively in different classes of concerns. 
 
 As has been already intimated, the auditor who wishes to 
 be of the greatest possible service to his cHent should avail 
 himself of every opportunity to become practically acquainted 
 with the working of the business, as it will only be when he 
 has some real acquaintance with the matter he is discussing 
 that his opinion upon the accounts of any given business will 
 possess any great weight; for if he has no knowledge of the 
 business carried on it is impossible for him to intelligently 
 criticise the system of accounts that records the transactions 
 effected, and if he has no knowledge of the nature of such 
 transactions it is hardly to be expected that he would be in a 
 position to form any reliable opinion as to the risk that exists 
 of the transactions not being correctly recorded in the accounts. 
 These remarks will, perhaps, appear trite to many, but so much 
 has been said about accountants " confining themselves to their 
 own province " that it has become necessary to point out the 
 utter inefficiency of any audit which confines its investigations 
 to an inquiry as to the technical correctness of the bookkeeping. 
 
 90 
 
WHOLESALE MERCHANTS. 9I 
 
 The object of the following chapters is not to supply the 
 reader with such special knowledge concerning each class of 
 undertaking as it may be desirable for him to possess before 
 presuming to certify as to the correctness of its accounts — 
 such a knowledge cannot be altogether imparted by any book, 
 and is beyond the scope (as it is beyond the compass) of the 
 present volume — but in the following paragraphs the reader 
 will find his attention directed to those points most worthy 
 of his consideration in each of the leading classes of accounts 
 he is likely to be called upon to verify. The special opportuni- 
 ties of fraud, and the points upon which an innocent misstate- 
 ment of facts is most likely to occur will, so far as possible, 
 claim attention ; while it may be added that "The Accountants' 
 Library" provides a series of handbooks dealing with the ac- 
 counts of most of the leading industries, and is likely to prove 
 useful to the reader — whether practitioner or student. 
 
 With these preliminary remarks, the categorical considera- 
 tion of the subject will be proceeded with. 
 
 I. COMMERCIAL ACCOUNTS. 
 
 (a) WHOLESALE MERCHANTS.— The chief openings 
 for fraud in these accounts are : Theft of stock ; misstatement 
 of cash sales; fraudulent payment of bogus purchases; mis- 
 appropriation of moneys received in payment of accounts — 
 such accounts being either left open or written off as " bad " ; 
 petty theft by the raising of fictitious items of discount allowed 
 on receipts, or interest incurred on payments ; and similar mat- 
 ters. Of what may be styled " innocent " errors, the most 
 common are errors of principle in the valuation of stock-in- 
 trade; insufficient depreciation on leases and furniture; omis- 
 sion to allow for outstanding discounts and interest ; errors of 
 principle in the valuation of foreign currencies; omission of 
 liability on outstanding expenses, and on bills discounted; in- 
 sufficient provision for bad debts, &c. There are not many 
 trade details with which the auditor will require to be 
 acquainted in these accounts, but he will do well to ascertain 
 
92 AUDITING. 
 
 the terms of payment and discount accorded to, and by, his 
 clients, and to make use of this knowledge continuously. Where 
 the terms vary — and they generally do vary — they should 
 be written in red ink at the head of each account in the ledger. 
 The auditor should make himself acquainted with the percent- 
 age of profit expected by his clients, and should compare it, 
 both with the actual results and the rate generally realized by 
 others in the same trade. Stock accounts can, almost invari- 
 ably, be kept by merchants and warehousemen ; but this is, in 
 practice, only occasionally done. 
 
 The question of patents or trade-marks sometimes arises 
 in these accounts, but the consideration thereof is more appro- 
 priately dealt with in a later chapter. 
 
 (b) MANUFACTURING TRADERS.— Under this head- 
 ing are intended to be included those manufacturers who ordi- 
 narily keep a stock of ready-made articles, and who do not 
 manufacture exclusively (or principally) " to order." The 
 preceding paragraph (a) will also apply to the consideration 
 of their accounts; but a few additional precautions are re- 
 quired in connection with their manufacturing departments. 
 
 The item of wages, in particular, is one requiring the utmost 
 care ; and the question of depreciation of plant and machinery 
 will also require a full share of attention. A proper system 
 of cost accounting becomes all but essential. It is probable 
 that the auditor will find some such system in operation ; but it 
 is at least equally probable that the actual system employed 
 will be found both unscientific and unreliable. 
 
 (c) RETAILERS. — Retailers who give credit in many re- 
 spects follow upon the same lines as the wholesale houses in the 
 same trade ; but the increased number of transactions renders a 
 detailed audit more difficult. It is generally quite impossible to 
 call back all the postings of the sales ledgers, but the balancing 
 thereof can be checked without difficulty, and must always be 
 done. The list of balances should be compared with the ledger, 
 and the footings verified. Where the business is very volu- 
 
RETAILERS. 93 
 
 minous, the audit of the sales ledgers is frequently deputed to 
 some of the counting-house staff ; but, in any case, the auditor 
 should not lose his grip of this department, and should occa- 
 sionally check the balances himself. To check, say, one or 
 two ledgers at random each year will have kll the moral effecty 
 of checking the whole set. 
 
 Many retail houses supply goods to their own employees, &c., 
 at reduced rates, and allow credit until the following pay-day. 
 A separate " Employees' Ledger " should always be kept in 
 these cases, and the auditor is usually expected to see that the 
 payment of these accounts is not unduly delayed. At every 
 stock-taking he should be careful to ascertain that no amount 
 stands to the debit of an employee who has left. 
 
 The purchase ledger is generally of comparatively manage- 
 able proportions; consequently it is rarely impossible, though 
 not as a rule necessary to check it in toto. In a continuous 
 audit it is frequently arranged that the auditor shall pass all 
 the purchase ledger statemejits for payment, and the system 
 has much to recommend it. In addition to seeing that each 
 item on the statements is also in the ledger, the auditor should 
 make the ledger clerk initial — and so guarantee the correctness 
 of — every statement that is submitted by him. The auditor 
 should also compare the discount deducted with the terms of 
 payment stated at the head of each account in the ledger. It 
 need hardly be added that this passing of the purchase ledger 
 statements for payment is not a necessary part of any audit, 
 and — where performed — it should command a special fee. 
 
 The vouching of cash received — whether for cash sales or 
 sales ledger accounts — ^may, under a good system of internal 
 check, safely be left to the care of the staff; but it is the 
 auditor's duty to see that the receipts are duly banked and to 
 verify the bank balance. A large retailer's audit will, almost 
 invariably, be continuous; and it is desirable that the bank 
 balance, and also that of the petty cash, be examined at least 
 once a month. 
 
94 AUDITING. 
 
 The examination of petty cash has already occupied atten- 
 tion {vide Chapter I.), and it therefore only remains to add 
 that — in addition to vouching for the bona iides of all pay- 
 ments — it is essential that some responsible person be made 
 accountable for the correctness of the dissection of the items. 
 
 The departmental accounts must not be lost sight of, as 
 they form one of the most important branches of the auditor's 
 duties. An account showing the sales, purchases, and esti- 
 mated stock should be submitted to the principals each month, 
 and the preparation of this account frequently devolves upon 
 the auditor. At the stock-taking the reconciliation of the esti- 
 mated figures with the actual stock on hand may also profit- 
 ably occupy the auditor's attention. 
 
 The postings of the private ledger should always be called 
 back, and it is highly desirable that such private ledger should 
 contain, within itself, all the materials for a trial balance. 
 
 Bills receivable will but rarely be found in connection with 
 a retailer's business; but bills payable are almost certain to 
 exist, and will require attention. 
 
 The vouching of payments for salaries must not escape at- 
 tention, but it calls for no especial comment here. 
 
 In cash businesses the problem is somewhat simplified by 
 the considerable reduction effected in the number of sales 
 ledger accounts. Indeed, these accounts are, of course, natur- 
 ally abolished in name; but in some cases they remain in es- 
 sence as deposit accounts kept by regular customers who wish 
 to avoid the trouble of remitting with every order. It is an 
 important part of the auditor's duty to see that deposit ac- 
 counts are never overdrawn without proper authority, and 
 that the interest credited (if any) is at the rate agreed upon. 
 
 The system adopted for checking the accuracy of the cash 
 receipts, will, as before, require the auditor's careful considera- 
 tion; but, in the absence of any special arrangement to the 
 contrary, it is not necessary for him to carry his investiga- 
 tion into the accuracy of such receipts beyond seeing that the 
 
CONTRACTORS. 95 
 
 system in use is properly carried out, and that the stated re- 
 turns are duly banked. 
 
 It is very usual for credit notes to be issued against goods 
 returned by customers; and, as these credit notes may be 
 used in payment of subsequent purchases by the customers, 
 or the money therefor obtained upon application to one of the 
 cashiers, the question has to be dealt with by the auditor. It 
 is generally arranged that, at the end of the day, the petty 
 cashier shall redeem all credit notes in the hands of the receiv- 
 ing cashiers, the amounts being charged up through petty 
 cash. The issue of credit notes must, therefore, be carefully 
 guarded against abuse; and it is essential that the system 
 under which the various departments are debited with their 
 respective returns be properly arranged. The credit notes 
 should always be compared with the stubs, and presented to 
 the auditor for cancellation. Failure to properly cancel credit 
 notes has in several instances been responsible for fraud, which 
 has been effected by a dishonest employee securing possession 
 of and recashing them. 
 
 (d) CONTRACTORS.— Under this heading the accounts 
 of those manufacturers who keep little or no ready-made stock 
 will be dealt with. This class includes builders, engineers, 
 shipbuilders, &c. 
 
 In these accounts the cost of — and profit or loss arising 
 from — each contract will require to be separately stated; the 
 contractor, in fact, opening a special trading account for 
 every contract. Cost accounts thus form an especial feature 
 of the contractor's books, and an inquiry into the principles 
 upon which they are based is thus a most profitable occupation 
 for the auditor. 
 
 The systems upon which stores are issued, and wag^s 
 recorded and paid, are also of the greatest importance; and 
 time spent upon such an inquiry is likely to be of considerably 
 greater advantage to the client than any detailed examination 
 of the books. 
 
96 AUDITING. 
 
 It is also important to call for the monthly statements from 
 the sub-contractors, who will frequently be found to have large 
 claims for " extras " which do not appear to their credit on 
 the contractor's books. Probably the contractor has billed the 
 owner for these identical items and passed the amount to the 
 credit of the contract. Frequently it will be found that an 
 agreement has been made with the sub-contractor to pay him 
 for the extras only in the event of the contractor being suc- 
 cessful in collecting, but the books in the meantime show a 
 credit to the contract which must not be carried to profit and 
 loss, and which, therefore, mUvSt be offset by a reserve suffi- 
 ciently large to cover all such items and also for such further 
 claims as the sub-contractor may have, which may not yet 
 have been passed upon or which have not been allowed for 
 various reasons. 
 
 The extent of the auditor's examination into detail will be 
 a matter depending largely upon the nature and magnitude of 
 the undertaking. A detailed audit would not usually be neces- 
 sary, as the main points could generally be accomplished by 
 an examination of the general ledger ; in any case the leading 
 principles will be the really important matter. 
 
 The same rules which have already guided the auditor as 
 to the extent of his inquiry into details will serve him here; 
 the larger the undertaking, the more its opportunities of in- 
 ternal check, and consequently the less necessity for the pro- 
 fessional auditor to check every detail. Many large under- 
 takings keep their own staff auditor, who is responsible for 
 the technical accuracy of the trial balance. 
 
 The valuation of contracts in hand and the calculation of 
 depreciation are both matters of the greatest importance, but 
 they will be more conveniently dealt with at a later stage. 
 (See under those headings in Chapter VI.) 
 
 (e) BREWERIES.— The audit of a brewery is a matter 
 concerning which some experience upon the part of the auditor 
 
BREWERIES. 97 
 
 is especially desirable, and it is by no means easy to indicate, 
 in a few words, the salient features of the task before him. 
 
 Theft of stock and of collections are, perhaps, the two main 
 risks run by brewers. The former is best guarded against by 
 properly designed stock accounts, and the comparative sta- 
 tistics deducible therefrom, combined with a certain amount 
 of practical laiowledge — which latter the auditor will most 
 likely have to take upon trust from the master brewer. The 
 second risk arises from the fact that accounts are frequently 
 collected by the drivers; the matter therefore requires great 
 care, but it presents no exceptional features. The discounts 
 allowed must not be passed without inspection, however, as 
 they can easily be juggled with. 
 
 In connection with saloons controlled by the brewery, the 
 auditor should see that all the revenue receivable from this — 
 as well as from every other — class of investment is brought 
 into the accounts subject only to due provision for bad and 
 doubtful debts. In most cases loans will be due from the ten- 
 ants of these houses, and in connection with these loans pro- 
 vision against loss is a matter of considerable importance, and 
 one requiring the most careful consideration. It should, more- 
 over, be borne in mind that the limit of possiKfe loss in most 
 cases greatly exceeds the amount actually advanced, inasmuch 
 as the brewery will sometimes have guaranteed a loan ob- 
 tained by the tenant, which forms a first charge upon the 
 property. The aggregate amount of such guarantees should, 
 it is thought, be stated upon the balance sheet as a contingent 
 liability. 
 
 Another point of considerable importance is the question 
 of depreciation. In the case of a brewery plant, the actual 
 wear and tear is probably less than in the case of most under- 
 takings, because the plant will not be working every day, and 
 thus — ^^apart from the fact that it is running a comparatively 
 small number of hours per week — ^the intervals of rest afford 
 facilities for making satisfactory and permanent repairs to a 
 
98 AUDITING. 
 
 far greater extent than is practicable with most other under- 
 takings. The result is that a brewery plant can in practice be 
 kept at a very high state of efficiency by careful and reason- 
 able repairs and renewals. On the other hand, some items 
 are especially liable to depreciation by becoming obsolete, and 
 this important fact should not be lost sight of. 
 
 (/) HOTELS.— The accounts of hotels, whether belong- 
 ing to companies or to private persons, do not call for any 
 extended comment. The auditor who is accustomed to hotel 
 accounts will be able, by a careful examination of the items 
 comprised in the profit and loss account, to form a fairly re- 
 liable opinion as to whether or not any leakage exists. If 
 there appears to be any reason to suspect that things are not 
 as they should be, it might be found desirable to thoroughly 
 examine in detail the charges for a portion, at least, of the 
 period under consideration ; but, under ordinary circumstances, 
 it is not usual to carry the investigation behind the guests' 
 ledger, except for the purpose of verifying the wine room 
 stock books. Proper stock accounts ought always to be kept 
 of wines, liquors, cigars, &c., and these should be carefully 
 inspected, especially if the profit and loss account does not 
 show an adequate return on this department. Where the book- 
 keeper is also the cashier, especial care must be exercised to 
 ascertain that all receipts are properly accounted for; and it 
 is also important to see that the petty cash disbursed upon be- 
 half of guests has been duly charged to their accounts and 
 collected. The entries in the purchase, general or private 
 ledgers should always be thoroughly checked; and especial 
 care should be given to the vouching of all payments, includ- 
 ing wages. 
 
 The question of depreciation — ^here, as elsewhere — is also 
 a most important one, and must be carefully considered. Such 
 items as bedding and linen, plate, cutlery, china and glass, 
 &c., are frequently re- valued for each balance sheet, instead 
 of being depreciated regularly ; but perhaps a better plan is to 
 debit profit and loss account and credit renewals account with 
 
CLUB ACCOUNTS. 99 
 
 a fixed (ample) provision for renewals, the actual expendi- 
 ture being debited to renewals account, and any credit bal- 
 ance treated as a reserve. The advantage of this course is 
 that it equalizes profits, so that a period of five years could 
 be averaged; but it is well for the auditor to satisfy himself 
 that the amount written off against revenue is ample for all 
 ordinary contingencies. 
 
 RESTAURANTS follow, in many respects, the same lines 
 as hotels. The accounts are, in some ways, simpler; but, on 
 the other hand, they are generally less complete. An experi- 
 enced auditor may prove himself of considerable value to the 
 proprietor of a restaurant, but he cannot pretend to protect 
 him against fraud on the part of his employees; neither is it 
 always possible for him to detect any fraud that may have been 
 committed. He can, however, prepare — or superintend the 
 preparation of — accounts that will show exactly how the net 
 profit has been earned, and these accounts will suffice the ex- 
 perienced client, for he knows just about what result ought 
 to have ensued from a given turnover, and so can judge for 
 himself as to the satisfactoriness of the existing management. 
 
 It is important, too, that the auditor examine thoroughly the 
 system of collecting for meals served and make certain that 
 it is the most efficient which is practicable under the circum- 
 stances obtaining in each case. 
 
 (g) CLUB ACCOUNTS.— The accounts of clubs follow 
 very much upon the lines previously indicated with regard to 
 hotels; but there are one or two points with which it seems 
 desirable to deal in a little further detail. In the business of 
 an hotel it is practically impossible for the proprietors to rely 
 upon their customers to in any way assist them in checking 
 their employees, but, in the case of clubs, where the members 
 themselves are the proprietors of the undertaking, the ac- 
 counts can be, to a certain extent, modified with advantage 
 with a view to devising a system by which the members them- 
 selves may assist in preventing fraud upon the part of em- 
 ployees. 
 
100 AUDITING. 
 
 Numerous instances have been disclosed where the members* 
 dues have been misappropriated, and this has usually happened 
 where the payments were in currency. It is a good plan, 
 therefore, to print a request on the bills to members to pay 
 same by cheque to the order of the club. 
 
 It is also advisable to request the members to pay their 
 house accounts in the same way, and as it is becoming the 
 custom of many clubs to require all payments to be made at 
 the office, very little difficulty should be experienced in enforc- 
 ing the rule of payment by cheque. 
 
 In connection with the bar, also, the accounts of clubs pre- 
 sent an advantage over those employed by many hotels, viz., 
 that all orders for drinks have (frequently) to be signed by 
 the member, and are thus available as vouchers for verifying 
 the taking of wines and spirits out of stock. It may be added, 
 however, that this is a system which is used by a considerable 
 number of hotels, although many dispense with it on the ground 
 that it is difficult to get their customers to take the necessary 
 trouble. In clubs, where the orders are returned to the mem- 
 bers monthly after payment of their accounts, carbon sheets 
 are frequently used and duplicate orders obtained. 
 
 Another system is that of ticket books, everything bought 
 by members to be prepaid therefrom. It saves bookkeeping — 
 no personal accounts being necessary — and has much to com- 
 mend it. 
 
 In connection with hotels, restaurants and clubs there are — 
 or ought to be — miscellaneous receipts from various sources, 
 such as the sale of bones, fat, &c., from the kitchen and the 
 like. In some establishments, the receipts from the sales of 
 offal are considered perquisites of the chef, but such a system 
 is bad, as all compensation of employees should pass through 
 the payroll. It is extremely difficult, if not well nigh impos- 
 sible in some cases, to be certain that all such receipts have 
 been properly accounted for. The entire absence of them 
 should, however, arouse suspicion, and it is well to compare the 
 
THEATRES. lOI 
 
 amounts received during one period with receipts during pre- 
 vious periods. 
 
 (h) THEATRE ACCOUNTS, &c.— The most difficult 
 feature in theatrical and similar accounts (from the auditor's 
 point of view) is the large amount of cash — i. e., currency and 
 coin — which is necessarily handled by all persons connected 
 with the financial part of the management. It is to be regretted 
 that managers cannot be induced to make their payments by 
 cheque more generally, although the practice is gradually in- 
 creasing in this country. 
 
 An auditor, must, however, above all things, be practical; 
 and it is, therefore, well to face the situation at once, and do 
 his best with the existing cash system, for he may rest assured 
 that no amount of " representation " upon his part will induce 
 managers to make all their payments by cheque, while it is, of 
 course, quite impossible that their receipts should be, to any 
 great extent, in anything but currency. 
 
 It is not usual for the auditor to be expected to verify the 
 cash receipts ; this is usually performed by the treasurer, who 
 is considered a sufficiently responsible person for the perform- 
 ance of a function that requires integrity certainly, but no 
 great technical knowledge. 
 
 Theatre accounts differ so widely from ordinary commercial 
 accounts that a brief description of their methods is in order 
 before we consider the question of audit. The treasurer 
 makes up a daily statement as follows: About half an hour 
 after the beginning of each performance the treasurer of the 
 theatre counts his unsold coupon tickets and makes 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 he then submits this statement 
 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 
 
I02 AUDITING. 
 
 statement. After the count the theatre treasurer makes out a 
 final statement, which is signed by both treasurers. 
 
 At the end of each week the theatre treasurer makes up a 
 " settlement sheet," which shows the gross receipts, and the 
 share of same due to the theatre. To this are added any ad- 
 ditional earnings, and after deducting the salaries and petty 
 expenses, he pays the remainder, in currency, to the manager. 
 The latter usually pays all advertising, bill posting, light, &c., 
 about Tuesday of each week to cover the previous week. In 
 some theatres the treasurer pays all bills and settles with the 
 manager for the profit or loss shown by the weekly statements 
 only, but this is unusual. 
 
 The treasurer of the theatre 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 sale " ; this is an important 
 item sometimes, and will be considered again further on. 
 
 The object of theatre bookkeeping is to show the profit or 
 loss of each week's business so as to determine which attrac- 
 tions pay best. It is, therefore, usual to apportion such items 
 as the annual license fee, rent, repairs, &c., weekly on a basis 
 of a season of thirty or thirty-five weeks. 
 
 With the foregoing in mind the audit of theatre accounts 
 will be a simple matter, and should be made somewhat as fol- 
 lows: 
 
 Count the coupon tickets in the rack and deduct the number 
 on hand from the total capacity of the house ; secure a state- 
 ment of " hard " tickets furnished treasurer at beginning of 
 season, deduct number on hand at time of balancing, and the 
 remainder must be accounted for in cash. The total result 
 should then agree with the cash and vouchers in the hands of 
 the treasurer. 
 
 See that all niglitly statements during period covered by 
 audit are signed by the treasurers of the companies. Com- 
 
THEATRES. IO3 
 
 pare contracts with managers' settlements to ascertain that re- 
 ceipts have been properly divided, and that the proper shares 
 of " extras " have been collected from companies. 
 
 Call for properly authorized vouchers for all payments. The 
 vouching of payments resolves itself upon the lines ordinarily 
 adopted in trading concerns; and here — as elsewhere — it is 
 not the least important of the auditor's functions to inquire 
 into the manner in which the pay-rolls are prepared. It need 
 hardly be stated that all persons entering the premises before a 
 performance sign an " Attendance Book " kept at the stage 
 door for that purpose, and that fines for absence or lateness are 
 arrived at from this source. It is not usual for the auditor to 
 verify the composition of the pay-rolls, but there would be no 
 harm done if he did so occasionally — and unexpectedly. 
 
 It will be easy to suggest improvements in the methods gen- 
 erally found in force, but it will be almost impossible to secure 
 any changes. One of the greatest difficulties in theatre ac- 
 -counting is to divide the responsibility of the treasurer and 
 his assistant. They both have access to the same cash, and, 
 as it takes an expert at least an hour to count a rack, it will 
 be seen that one cannot balance to the other as hotel clerks 
 do when they change watch. The same difficulty arises in con- 
 nection with the weekly payments to the manager. After mak- 
 ing settlement with him the cash remaining represents the 
 advance ticket sales, which, of course, should be verified at the 
 time. Owing to the difficulty of counting a large number of 
 tickets, managers seldom do it, and more than one defalcation 
 has been carried along by means of using the proceeds of ad- 
 vance sales to cover up shortages. 
 
 In " continuous performance " houses most of the admis- 
 sions are " strip " tickets, which are, of course, easily counted. 
 
 (i) THEATRICAL COMPANIES.— The audit of the ac- 
 counts of a company should be quite a simple matter, but 
 owing to the conditions under which a company treasurer 
 
104 AUDITING. 
 
 usually works, his books and accounts will be in a more or 
 less unsatisfactory state. 
 
 In any event, he should be required to keep a cash book 
 and balance it at least once a week. 
 
 With this as a basis it will be comparatively simple to build 
 up what are generally known as "Production'' accounts, which 
 may be classified as follows : 
 
 Preliminary Expenses. — Covers all expenses incurred 
 during rehearsals, such as stage manager's salary, musical di- 
 rector's salary, typewriting parts, orchestra, rent of hall, &c. 
 
 Scenery. — This is usually built by one firm, but it may be 
 painted by different artists. A certain high-priced artist may 
 be engaged to paint a difficult landscape, but the painting of 
 a simple interior would be given to a cheaper man. The work 
 of building and painting is nearly always done under contract 
 and payments made at specified times. 
 
 Properties. — This item includes almost everything used in 
 the stage representation which could not be classified as scen- 
 ery, costumes, or electrical apparatus. It includes furniture, 
 draperies, artificial flowers, spears, animals (either papier 
 mache or alive). Perishable properties are not charged to 
 production, but to current expenses. 
 
 Costumes. — This item includes hats, wigs, shoes, &c. 
 
 Electrical Apparatus. — This covers calcium lamps, special 
 devices, &c., and is sometimes a very large item. Some com- 
 panies rent the electrical equipment ; the rental is then charged 
 to current expenses. 
 
 The company's profit and loss account is also made up weekly 
 to accord with the theatre accounts. An audit would consist 
 largely in checking the receipts by comparison with the nightly 
 statements signed by the house treasurer; seeing that all fines 
 imposed by the stage manager have been collected; examin- 
 ing the contracts and securing proper vouchers. 
 
PUBLISHERS. lOS 
 
 Theatrical productions are so uncertain in their outcome that 
 no rule for dealing with the question of depreciation can be 
 laid down. Obviously the copyright of a successful play is 
 an asset which does not depreciate rapidly in value, while the 
 total cost of an unsuccessful production must be written off 
 at once. It is stated on good authority that the entire cost 
 of production is charged off against the first year's business 
 by all of the New York managers. Each undertaking should, 
 therefore, be considered with respect to the usual custom, pro- 
 vided it is conservative. 
 
 (;) PUBLISHERS.— The audit of publishers' accounts 
 presents a peculiar combination of complications. In many 
 cases publishers will do their own printing, and in this respect 
 they follow the rules of manufacturing traders. (See under 
 heading 1. (b) above.) Almost invariably, however, they will 
 also be retailers, and hence the considerations detailed under 
 heading I. (c) will also apply. Many houses add the further 
 occupation of trading, either wholesale or retail, or both, in the 
 publications of other firms, which, to a great extent, brings 
 them under the heading I. (a) above ; while almost every house 
 will occasionally undertake the publication of authors' works 
 upon such terms, as to royalty, &c., as make it absolutely 
 necessary that both stock accounts and cost accounts should 
 be carried to perfection. In this respect publishers' accounts 
 involve many of the considerations discussed under heading I. 
 (d) when dealing with Contractors' Accounts. 
 
 A complete audit of publishers' accounts is on account of 
 the multiplicity of detail involved a practical impossibility ; the 
 extent to which a partial audit may advantageously be carried 
 must, on the other hand, of necessity, vary with almost every 
 individual case. The considerations involved in the previous 
 paragraphs are the only ones that can be offered; but it may 
 be added that here — as in the case of all other partial audits — 
 the precise routine may be varied from time to time with the 
 greatest advantage. 
 
I06 AUDITING. 
 
 Permanent assets, such as buildings, plant, &c., must, of 
 course, be subjected to proper depreciation, and stock-in-trade 
 will require careful valuing. It ought to be possible for the 
 auditor to obtain absolute proof as to the quantity of stock- 
 in-trade, but he can hardly be expected to check the inventory 
 in extenso. The prices set upon unsold publications should 
 never exceed the cost of production. 
 
 Care should be taken to ascertain that the stock list is not 
 unduly inflated by almost entire editions of absolutely unsal- 
 able publications that are not worth anything like the cost of 
 production. 
 
 With regard to the valuation of copyrights for balance sheet 
 purposes, it is usual for a separate account to be opened for 
 each publication, which is, in the first place, debited with the 
 actual cost of production, including, of course, the printing, 
 binding, illustrations, &c. (and, where the copyright is pur- 
 chased the purchase-price thereof, together with that of any 
 stock which may have been taken over therewith.) Many 
 firms at balancing time review the debits to the various copy- 
 right accounts, depreciating some and appreciating others; 
 that is to say, the system is adopted of valuing the copyrights 
 by inventory at each period of balancing, wholly irrespective 
 of the actual cost. It is, of course, very desirable that where 
 necessary the cost should be written down from time to time ; 
 but the arguments with regard to the writing up the value of a 
 copyright are precisely those which might be — and, indeed, 
 should be — invariably used against writing up the value of the 
 asset goodwill and crediting the difference to profit and loss 
 account. It may be perfectly true that a large revenue is 
 expected from this asset in the future ; but that, in itself, can 
 afford no possible argument for anticipating that revenue, and 
 taking credit for it in the current period. On the other hand, 
 it will probably be generally admitted that no great harm can 
 be done by writing up such copyrights as have appreciated 
 so long as the actual effect of so doing is not to increase the 
 book-value of copyrights as a whole. In this connection, it 
 
PUBLISHERS. 107 
 
 may be mentioned that with many houses there is a good gen- 
 eral rule in use, to the effect that the value attached to any 
 copyright should not exceed three years' purchase upon the 
 gross profit earned therefrom during the past year. 
 
 Sometimes, even when a publication is itself a failure, some 
 residual value will attach to illustrations, &c., which have been 
 used in its production. It is very important, however, that no 
 fictitious estimate should be put upon the value of such doubt- 
 ful assets as these, and of the two it seems infinitely preferable 
 that they should be stated at nil in the balance sheet. 
 
 The value of artists' original drawings (for illustrations) 
 is often considerable, and has not infrequently been found to 
 exceed the price originally paid for both original and copy- 
 right. It is hardly safe, however, to reckon such originals as 
 assets — if valuable, they will generally be sold, and if retained, 
 the most that can be said is that they have a latent value. 
 
 It is unfortunately the custom in many large publishing 
 houses in the United States to carry their plates at cost, or 
 with a very small allowance for depreciation. No matter how 
 successful the publication may be, it should always be borne 
 in mind that every book turned out will have to bear a pro- 
 portionate share of the costs of all the plates. The failure of 
 more than one publisher has been traced to this omission. 
 
 On behalf of his clients it may be thought desirable for the 
 auditor to thoroughly check all royalty accounts, but this does 
 not form part of a regular audit. 
 
 Newspapers and magazines present several special features. 
 In the absence of a staff-auditor, the auditor will require to 
 satisfy himself that every advertisement is eventually paid for 
 (unless, of course, a bad debt has been made), or else that it 
 has been franked as " free " by some responsible person. The 
 commission accounts of agents and canvassers should also 
 always be examined. 
 
 In the case of a monthly magazine, at least two numbers 
 out of twelve should be selected and checked thoroughly to 
 
I08 AUDITING. 
 
 see that every advertisement is accounted for. A certain por- 
 tion of the contracts should also be checked into the adver- 
 tising register, as it very often happens that this book is kept 
 by a clerk in the advertising department who does not appre- 
 ciate the importance of accuracy. 
 
 The subscriptions will be more difficult to verify. Usually, 
 however, great care is taken to secure a good internal check, 
 and the system should be looked into carefully. It is needless 
 to say that the clerks in charge of the subscription cards and 
 records should not have access to the cash. The balance sheet, 
 must, of course, contain a reserve for unfilled subscriptions, 
 although most publishers do not provide such an account. 
 
 The " inside " of a paper is the work of the regular staff, 
 or of " contributors " ; the former are usually paid a regular 
 salary, the latter are paid for the actual work done. It 
 would be a desirable thing to make sure that a contributor was 
 never paid for a sub-editor's work, but no auditor could ever 
 ascertain such a thing for himself, and he must therefore rest 
 content with the certified contributors' accounts as they are 
 submitted to him. 
 
 It frequently devolves upon the auditor to prepare weekly, 
 or monthly, statements, showing approximately the income 
 and expenditure. Such work naturally commands a special 
 fee. 
 
 The printing of the publication calls for no special comment 
 here; when done by the proprietors they will, of course, be 
 printers, as well as publishers, and the auditor must take his 
 stand accordingly. 
 
 The number of copies printed, issued, returned, exchanged, 
 distributed free, and in stock, should always be certified by the 
 publishing manager. From his returns the individual ledger 
 debits may be vouched. 
 
 The Post Office returns, or vouchers, for second-class post- 
 age are a good check on the total circulation of a periodical. 
 
MINES. 109 
 
 Every periodical is started at a loss, and it is usual to debit 
 this loss to an Establishment Account; when the concern pays 
 — and so acquires a goodwill — the cost of such goodwill is 
 represented by the amount to the debit of Establishment Ac- 
 count, which thus virtually becomes a Goodwill Account. There 
 is no great objection to this system, and it is much in favor 
 on account of the information it afford to the intending pur- 
 chaser of a recently established paper; but, when a periodical 
 is once fairly started, the auditor should require a very good 
 reason to be furnished him before he sanctions the transfer of 
 an unexpected loss to the Establishment Account ; if such loss 
 arises from an increase of matter (in quantity or quality) or a 
 reduction in price, it may be in the nature of capital outlay, as 
 tending to increase the permanent value of the concern, but an 
 unexpected loss is likely to have the contrary effect. 
 
 II. MINING ACCOUNTS 
 
 (a) COAL MINES. — Better advice can hardly be given 
 to the accountant who is about to audit the accounts of a 
 mine for the first time than to suggest that he should make a 
 tour of the whole works (both above and below ground) in 
 company with the colliery manager. If he be of an observant 
 turn of mind he will probably by the end of his inspection, 
 have formed at least some idea of the scope of the undertaking, 
 and he will doubtless find that the gloom of the underworld 
 has thrown considerable light upon the records kept above 
 ground. Even the auditor experienced in colliery accounts 
 will probably find that the thorough inspection of a new mine 
 is really a wise economy of time ; in fact, whatever the nature 
 of the business may be, the auditor who acquaints himself 
 with the manner in which it is carried on does wisely. 
 
 A question of particular importance in these accounts is the 
 treatment of the capital expenditure account. Great care 
 must be taken to see that no expenditure properly chargeable 
 against revenue is included herein — indeed, it is always de- 
 
no AUDITING. 
 
 sirable to get the capital expenditure account altogether closed 
 as quickly as possible. 
 
 Some mining companies, in calculating the cost per ton of 
 the ore extracted, include the expense of dead work, develop- 
 ment, exploration, &c., while many others state as the cost 
 of extraction work the actual expenditure for stoping and 
 hoisting only, treating the development work, especially in shaft 
 sinking, as a capital expenditure. 
 
 The item " Minimums paid in excess of royalties earned," 
 which frequently occurs as an asset in the accounts of young 
 collieries, requires some little explanation. The royalty pay- 
 able is based upon the quantity extracted — usually upon the 
 number of tons, but sometimes upon the number of cubic 
 yards, or the acreage of the seams worked — a fixed "minimum'* 
 royalty being payable in any event, whether the mines are 
 worked or not. During the sinking of the shafts and first 
 working of the mine, therefore, the royalty paid naturally ex- 
 ceeds the normal percentage upon the output. Under ordi- 
 nary circumstances tjiis would represent a charge against Rev- 
 enue in the usual way; but, as the lessees are empowered to 
 recoup themselves out of subsequent production, it is quite 
 justifiable that the excess so paid at first should be carried for- 
 ward as a set-off against the output of later years. It is very 
 necessary, however, that the auditor should examine the consti- 
 tution of the amount so carried forward. It not infrequently 
 happens that the mine as a whole is comprised of several leases, 
 some of which are not being worked, and never will be ; the 
 minimum royalty upon such portions ought, of course, to be 
 charged against Revenue each year, and where, in the early 
 days of the colliery's existence, an accumulation of such mini- 
 mums has been allowed to be carried forward, it must be writ- 
 ten off as soon as possible. Again, there is often a limit to 
 the time during which advance royalties may be recouped, and 
 this limit, of course, must not be exceeded. It need hardly 
 be added that the only justification for treating the whole — 
 
MINES. Ill 
 
 or any portion — of the balance of this account as an asset is the 
 reasonable probability that it will be redeemed out of future 
 production within the time limit allowed by the lease. 
 
 The question of depreciation upon mines is naturally one 
 of no slight importance; but it is not certain that — however 
 desirable it may be that an adequate provision should be made 
 for depreciation arising either from the exhaustion of minerals, 
 or from the lapse of the lease, or from both — it is legally neces- 
 sary for a mining company to set aside any portion of its earn- 
 ings to replace wasting capital. The auditor can thus do no 
 more than advise the extreme desirability of so prudent a 
 course. 
 
 Many mortgages upon coal and ore lands require a sinking 
 fund to be established to cover exhaustion, usually at a fixed 
 rate per ton. Here, of course, the accounts must be con- 
 structed accordingly, and a careful reading of all mortgages 
 will be required. 
 
 Unfortunately, sinking fund provisions in mortgages are 
 not always entirely clear. They are almost invariably written 
 by lawyers, who rarely consider the matter in connection with 
 the accounts of the undertaking. 
 
 For instance, where a clause in a mortgage on coal lands 
 requires the setting aside of five cents per ton on all coal 
 " shipped," a diflference of opinion can easily arise over the 
 question as to whether the coal consumed in the company's 
 own operations both at the mines and in transit should be pro- 
 vided for. If the provision was based on probable exhaustion, 
 certainly every ton produced must be taken into account, but 
 if the original intention was to cover sales, no payment to the 
 sinking fund would be required therefor. 
 
 Subsequent dififerences of this nature would not arise if 
 more attention were given to the wording of these provisions. 
 
 In this connection it will be of interest to note the following 
 extract from " The Profits of a Corporation," by A. Lowes 
 
112 AUDITING. 
 
 Dickinson, F. C. A., C. P. A. (paper read at the St. Louis Con- 
 gress of Accountants, 1904) : 
 
 " 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 prop- 
 erty after the minerals have all been extracted. The same principle 
 would also apply to timber lands, where no provision is made for re- 
 foresting. 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 whatever amount has been extracted ; and while the new discoveries 
 may be accepted as reducing the necessary rate of provision for ex- 
 tinction from (say) one dollar to one cent per ton, the original prin- 
 ciple that provision must be made holds good on the smaller figure, 
 whatever it is. It may be, of course, that the provisions made in ear- 
 lier 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 discoveries, 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." 
 
 Usually mining companies own the cottages occupied by 
 their employees, and this matter will require the auditor's at- 
 tention. Rents receivable, however, have already been con- 
 sidered. 
 
 (b) GOLD MINES, &c.— The services of an auditor are 
 frequently required in connection with gold, silver, copper, 
 and other mining enterprises carried on in the far West. 
 Usually the services consist in ascertaining for dissatisfied 
 creditors or stockholders just where the cash capital has been 
 sunk, in which case it is rather of the nature of an investigation 
 than an audit. It sometimes happens, however, that ore is 
 actually found in paying quantities, and the question then 
 
MINES. 113 
 
 arises as to how far the mine manager's accounts can be ac- 
 cepted. He usually remits periodically a statement of his 
 receipts and payments, which is incorporated in the accounts 
 kept at head office. Such accounts are not usually very volu- 
 minous, and are generally examined by the auditor in extenso. 
 It is, of course, desirable that all expenditure at the works be 
 properly vouched, and for the auditor to examine these 
 vouchers. 
 
 For balance sheet purposes the mine manager should be 
 required to apportion all expenditure between capital and 
 revenue, and to certify such apportionment; also to submit a 
 certified statement of local floating assets and liabilities, or a 
 certificate that no such assets or liabilities exist locally, and 
 at the same time he should report upon the state of efficiency 
 of the plant and machinery, together with any buildings and 
 other more or less permanent assets there may be upon the 
 works. This latter report is most essential for a proper con- 
 sideration of the question of depreciation. 
 
 It is always well — and where the produce of the mine is 
 precious, it is very essential — for the auditor to use every 
 available means of ascertaining that credit has been taken in 
 the books for the value of the whole of the output. 
 
 Depreciation of plant should, of course, be provided for; 
 but that question is best dealt with in a later chapter. 
 
 The wages paid by mining companies require the same care- 
 ful attention that must at all times be accorded to this most 
 important item; but inasmuch as the great bulk of wages paid 
 is at the rate of so much per ton, the aggregate amount pay- 
 able can be tested with greater facility than in many other 
 cases. 
 
 The peculiar conditions obtaining to mining accounts gen- 
 erally render it desirable that the audit should descend into 
 somewhat considerable detail; concerning the actual extent 
 of such detail, however, no general rules can be given, as 
 
114 AUDITING. 
 
 each case must be judged upon its own merits. Great care 
 should be taken to sec that no expenses are capitalized that 
 are not bona fide of a " capital " nature. 
 
 In conclusion, it may be added that the auditor should ex- 
 pressly state in his report what the precise extent of his exam- 
 ination has been. 
 
 III. FINANCIAL ACCOUNTS. 
 
 (fl) BANKS. — In dealing with the question of bank audits, 
 it is well to remember that one of the most controversial sub- 
 jects relative to professional practice is being discussed. So 
 far as possible, a position that few will care to assail will be 
 occupied; but it were well to admit at once that the authors 
 consider the duties of a bank auditor to be very much more 
 onerous than some eminent accountants care to admit, what- 
 ever his bare legal responsibilities may be. It is not necessary 
 to criticise the motives that have dictated the position taken 
 by some of the leading members of the profession; but it is 
 difficult to see the force of an argument that virtually amounts 
 to the assertion that the mere multiplicity of a series of state- 
 ments is a valid reason for not inquiring into the accuracy 
 of those statements. Further, it is to be remembered that the 
 bare legal responsibility is not the highest measure of the 
 duties of a professional man. It is certainly very desirable 
 that the law should not be unduly harsh — or the position of an 
 auditor would be intolerable — ^but it is imagined that few 
 would consider that they had discharged all moral obligations 
 when they had complied with their legal duties. These re- 
 marks, however, apply equally to all classes of audits. 
 
 The inference must not be drawn, however, that the authors 
 consider that a bank audit is fundamentally difficult, or that 
 it requires special knowledge of an extraordinary sort; on 
 the contrary, it can be successfully maintained that a general 
 practitioner of wide practice is better qualified to audit the 
 accounts of a bank than one who devotes his entire attention 
 
BANKS 115 
 
 to this class of work. In the latter case the mere familiarity 
 with the usual books and methods tends to narrow one's vision, 
 and a bank examiner is apt to fall into a rut. After all, the 
 theory of a bank audit is very much like that of any other 
 audit, and the same careful study of a bank's statement which 
 an auditor must pay to the balance sheet of a manufacturing 
 concern will indicate to him the scope of the audit, and after 
 one or two experiences he need expect no trouble. 
 
 In all cases the auditor should secure the most recently pub- 
 lished statement of the bank whose accounts he expects to 
 examine, and a general scrutiny of the several asset and lia- 
 bility items will reveal far more of what he has before him than 
 in almost any other work he undertakes. 
 
 Under our National Banking Act, compulsory examinations 
 are made by examiners in government employ, and while in the 
 past they have rendered valuable service, and many of them 
 are auditors in the highest sense of the word, it must be re- 
 membered that their chief duty is to see that a bank is solvent 
 and complying with law, and this accounts for the large num- 
 ber of minor defalcations which they never discover. Owing 
 to the insufficient time which is allotted to each bank, it is a 
 physical impossibility for them to cover the ground thoroughly, 
 and it is no longer a rarity to hear of bank defalcations which 
 have been going on under the eyes of the national bank ex- 
 aminers for twelve to fifteen years. 
 
 For these reasons bank directors are gradually coming 
 around to the feeling that it is their duty to have more thor- 
 ough audits, and naturally the work falls to the Certified Pub- 
 lic Accountant, and it is very satisfactory to note that several 
 State bank examiners have made recommendations to this 
 effect. 
 
 The certification of a bank balance sheet involves the thor- 
 ough examination and exhaustive testing of every account in 
 the general ledger, the counting of the balance of cash in hand,, 
 the examination of all notes (especial care being taken to note 
 
Il6 AUDITING. 
 
 that all overdue notes are properly explained) and the inspec- 
 tion of all securities — whether owned by the bank or held as 
 collateral for borrowers. With regard to the counting of the 
 cash balance, the only safe way of dealing with cheques in 
 hand is for the auditor to himself forward them to the clear- 
 ing house and other agents, or where this is impracticable, to 
 secure direct confirmation of the clearing house returns. The 
 disregard of this precaution has left the door open for most 
 serious frauds upon the part of bank managers and others. 
 
 The counting of the cash in a large bank is very hard physi- 
 cal work, to say nothing of mental strain. As the securities 
 and collaterals should be taken up the same day, it is useless 
 for an auditor to undertake this work unless he has a staff 
 of reliable men, some of whom should have had previous ex- 
 perience in counting cash and handling securities. Not less 
 than five or six men will be needed the first day in a fairly large 
 bank, but after (say) the second day the force can be 
 decreased. 
 
 It hardly seems necessary to urge the importance of making 
 the audit without notice to any one, and this means the officers 
 and directors as well as the tellers and other clerks. 
 
 The work of counting the cash and examining the securities 
 can be commenced early in the afternoon by taking up the re- 
 serves first, and working down to the settlements. The staff 
 should be so distributed and instructed that any transfers from 
 one teller to the other, or sending out for cash to conceal a 
 defalcation, would be immediately detected. 
 
 The examination of demand loans and collaterals therewith 
 is one of the most important branches of the work. Exten- 
 sive defalcations have been covered up by the failure to en- 
 dorse partial payments on the notes ; the only way to ascertain 
 the correctness of these loans and collaterals is to send out a 
 memorandum to each borrower, setting forth the amount of 
 loans and collaterals held as at the day of commencing the 
 
BANKS. 117 
 
 audit. The confirmation should, of course, be returned direct 
 to the auditor. 
 
 The recent death of a prominent broker in Philadelphia dis- 
 closed the fact that for some years he had been borrowing 
 large sums, aggregating nearly one million dollars, from banks 
 upon stock certificates which had been " raised '' from a small 
 to a much larger number of shares. The forgeries were clev- 
 erly executed, and in every case deceived bank officers through 
 whose hands they passed, so that a professional auditor could 
 hardly be criticised for failure to detect the alterations; the 
 instance should, however, be borne in mind, and a knowledge 
 of the facts in this case may be a reminder to an auditor that 
 " eternal vigilance " is always necessary in bank audits. 
 
 In connection with the inspection of securities, it is, per- 
 haps, well to call attention to the extreme importance of all 
 the securities being produced simultaneously, and of their 
 all remaining in the auditor's sole keeping until the inspection 
 is completed. Extensive frauds have been known to remain 
 undetected through failure to observe this simple precaution. 
 If the examination cannot be completed the first day, the 
 securities and bills not inspected should be locked up, and 
 access denied to any one connected with the bank except under 
 the eye of the auditor. 
 
 The accounts with other banks will have to be verified by 
 correspondence, and these confirmations should also be directed 
 to the auditor and not to the bank. 
 
 How far the auditor should extend his examination of the 
 depositors' accounts is a matter concerning which considerable 
 diflference of opinion obtains. The ideal way would be to 
 have all the pass-books called in at once, and have them settled 
 by the auditor's own staff. It is, of course, practically impos- 
 sible to do this, but it is of the utmost importance that as many 
 be examined as possible. The auditor should keep a list of the 
 books inspected, and in the course of a few years the entire 
 list of customers might be covered. 
 
 ^ OF THE 
 
 UNIVERSITY 
 
 OF 
 
Il8 AUDITING. 
 
 The auditor should see that a proper internal system of 
 checking the balances prevails. It is now customary in large 
 banks for all pass-book balances to be compared with the 
 ledgers and initialed by some one other than the bookkeeper 
 before they are handed to the customer, and in some banks 
 customers are requested to fill out and return a memorandum 
 confirming the balance. 
 
 A number of banks, more particularly in the West, have 
 adopted a system of stating depositors' accounts which is su- 
 perior to the pass-book settlement. Their practice is to pre- 
 pare monthly statements of all accounts; these are mailed to 
 the depositors with the paid cheques or vouchers. This plan 
 has the merit of enabling the auditor to verify all the deposit- 
 ors' balances at the same date, as he can compare the state- 
 ments therewith, enclose a request for confirmation of their 
 correctness and mail them himself, thus insuring the best check 
 which it seems possible to devise. 
 
 It will be observed that the view adopted here with regard 
 to a bank audit is that the verification of certain details may, 
 and indeed must, to a large extent be left to the staff audit. 
 The recent frauds upon the Bank of Liverpool, which paid 
 upwards of $850,000 upon cheques forged by one of its ledger 
 clerks, may perhaps raise a question as to whether this reli- 
 ance upon the system of internal check is altogether justified 
 in practice. It is thought, however, that the Liverpool frauds 
 have little, if any, bearing upon the point, in that the system 
 of internal check seems to have been chiefly conspicuous by its 
 absence, or at least by its inefficiency. Three of the funda- 
 mental rules of any effective system are: (a) That no clerk 
 should have access to books recording entries which go to 
 check the entries kept by that clerk, e. g., tellers should not be 
 permitted to keep or assist in keeping any of the ledgers or 
 taking off trial balances thereof, (b) That the clerks should 
 be shifted about at frequent intervals, so that a fraud — even 
 if committed — may be speedily detected by a fresh clerk go- 
 ing over the same ground, (c) That no unusual entries, as. 
 
BANKS. . 119 
 
 for example, transfers, should ever be made without special 
 authority. None of these rudimentary precautions appear to 
 have been adopted in the case mentioned, and it seems safe 
 to say that, had any one of them been in force, the frauds 
 could not have been committed, or would at least have been 
 discove,red at a very early date. At the same time, as has 
 already been stated elsewhere, it is always desirable that an 
 auditor, when considering the exact extent of his investiga- 
 tion, should make careful inquiry into the system of internal 
 check employed, and satisfy himself that the system theoret- 
 ically in force is actually carried out in practice. 
 
 In dealing with bank accounts, and all other accounts of a 
 similar nature, the auditor must never forget that his responsi- 
 bilities are not confined to safeguarding the interests of the 
 proprietors. His certificate is virtually — whatever it may be 
 legally — a guarantee to the public that the accounts submitted 
 are to be relied upon as being, in every respect, correct. It 
 is not, of course, suggested that he guarantees the safety of 
 the customers' deposits; but he would reasonably be blamed 
 were it to transpire that a bank which he had certified as sol- 
 vent was afterwards discovered to have been hopelessly in- 
 solvent at the time of such certification. 
 
 At first sight it may appear impossible for the auditor to act 
 up to the position here indicated, but he must remember that, 
 in reality, the test of an auditor's competency is in his ability 
 to judge of the correctness of items by an exhaustive testing — • 
 not necessarily of the items themselves, but of their totals. 
 
 A few remarks concerning the revenue account will not be 
 out of place. The items of interest constituting the gross 
 profit must be carefully tested, especially as to the rate charged 
 upon current transactions, and the interest and dividends upon 
 securities owned must, of course, all be accounted for. 
 
 It will frequently be found that the banking house and fix- 
 tures are carried at a sum considerably less than their value, 
 and this constitutes one of the secret reserves that many con- 
 
120 AUDITING. 
 
 servative bankers favor. The most recent instance is that of 
 a prominent trust company in Philadelphia, which has erected 
 a magnificent banking house (costing about $1,500,000) 
 charging the cost thereof against current earnings during the 
 three years in which it was being built, so that the property 
 account represents the cost of the land only. It should be stated, 
 however, that in this case the stockholders were notified of the 
 intention to so treat the account. While frankly admitting 
 that the abuse of secret reserves is to be deprecated, it must 
 be remembered that a balance sheet is not — and does not pur- 
 port to be — ^a statement of finally determined facts, but rather 
 an estimate of a position of affairs which by its very nature 
 cannot be accurately determined. As proof of this it may 
 be mentioned that only a few banks in the United States carry 
 any reserve for unearned discounts, yet in a large bank this 
 is a very considerable item. 
 
 The time will probably come when all banks will be required 
 to keep their accounts upon a more scientific basis, and the 
 bank officer, who now freely criticises a customer's statement 
 which takes credit for future earnings, will reach the point 
 where his own statement will reflect conditions more in accord 
 with the facts than is now the case. 
 
 The audit of Savings Banks will be, in the main, along prac- 
 tically the same lines as that of national or State banks, 
 though naturally it will be found that the assets consist more 
 of long-term investments, such as bonds, than of loans. Com- 
 mercial paper or unsecured loans should not be found at all. 
 
 It will probably be found more practicable to verify the 
 depositors' balances by sending out statements thereof, with 
 provision for confirmation and return direct to the auditor at 
 a special post-office box than by calling in pass-books. 
 
 In the foregoing remarks the desirable extent of the audi- 
 tor's duties has been stated rather than the bare limits of his 
 legal responsibilities; the latter question will, however, be 
 
INSURANCE COMPANIES. 121 
 
 found more fully discussed under the heading of " The Lia- 
 bilities of Auditors." 
 
 (b) TRUST COMPANIES.— During the past twenty-five 
 years trust companies have increased greatly, both in numbei- 
 and importance, in the United States. In addition to acting 
 in a fiduciary capacity and exercising trust functions, they are 
 authorized in many states to transact a banking business. Their 
 charters are usually more liberal than those of either national 
 or state banks; even as to banking functions themselves they 
 enjoy certain advantages over banks, being permitted, for ex- 
 ample, to make loans on real estate, which national banks are 
 not, though on the other hand they are not permitted to issue 
 circulating notes and they are forbidden in some states to 
 discount commercial paper. In at least one state, Illinois, 
 banks are permitted on due compliance with provisions of the 
 law, to conduct a trust department. 
 
 It follows that the audit of a trust company partakes in a 
 large measure of the nature of a bank audit which has al- 
 ready been referred to under (a). To be thorough, however, 
 the audit must not be limited to the banking department but 
 embrace the trust, safe deposit and such other departments as 
 may be conducted by the company under examination. The 
 examination of the securities in the trust department, for in- 
 stance, is just as important as the audit of the banking 
 department. 
 
 The audit of the income and expenses of the various de- 
 partments must likewise not be overlooked, though the exact 
 procedure will be more or less dependent on the circumstances 
 connected with each individual case and to a considerable ex- 
 tent on the system of internal check. The volume of routine 
 detail in a large trust company is very great, but if a proper 
 system is in use the examination of much of it may safely be 
 omitted. 
 
 (c) INSURANCE COMPANIES.— The general corpora- 
 tion laws of the various states do not, usually, cover insur- 
 
122 AUDITING. 
 
 ance companies, and they must incorporate under special laws. 
 These laws give the companies special privileges, but they 
 also impose numerous restrictions. In most of the states 
 there is an Insurance Department which is empowered to ex- 
 amine the affairs of all companies, local and foreign, doing 
 business within the state. These departments vary consider- 
 ably as to methods, and while the examinations made by some 
 of them are thorough in their nature, yet their purpose is 
 not in line with that of an audit conducted in the interests 
 of stockholders. Like the examinations of national banks, 
 these audits are not to be relied upon to prevent fraud or care- 
 lessness by the employees, because the chief object of the 
 state examination is merely to determine the solvency of the 
 company, and its observance of the state laws. 
 
 A number of the European companies have their American 
 accounts audited and reported upon monthly, and this may 
 form a valuable part of an auditor's practice. These monthly 
 examinations are of the nature of a continuous audit, and 
 should, of course, be supplemented by a more exhaustive audit 
 at the end of the year. 
 
 The accounts of a FIRE INSURANCE COMPANY are 
 usually not at all complicated, and it will be in order to outline 
 briefly the more important parts of an auditor's work in con- 
 nection therewith. 
 
 The income must be thoroughly checked. The agents' orig- 
 inal reports form the basis of the premium income, and enough 
 of them should be checked into the books to test their 
 accuracy. 
 
 The remittances from agents should be properly recorded 
 at once, and no opportunity afforded to the cashier to " hold 
 over " remittances. 
 
 The total outstandings due from agents at the end of the 
 period should be thoroughly verified. The detailed balances 
 should be analyzed, and any accounts in arrears should be 
 
INSURANCE COMPANIES. 123 
 
 taken up with the manager. It should be an invariable rule to 
 have some one other than the cashier write the agents about 
 their overdue accounts. 
 
 A considerable part of the income arises from investments; 
 this can be checked thoroughly, and must not be overlooked. 
 
 Likewise the examination of the securities themselves forms 
 an important part of the audit, and will be conducted on the 
 same lines as with banks. 
 
 The vouching of the cash payments very often occupies a 
 larger proportion of the time than should be given to it; of 
 course, the work is important, but it may be noted that an 
 analysis of defalcations in insurance offices discloses the fact 
 that very few are in connection with fraudulent vouchers. It 
 is perhaps enough to say that the loss, expense and all other 
 vouchers should be properly approved and recorded, and if 
 this is seen to, the payments will have been sufficiently covered. 
 In connection with the payments there should be in force a 
 good system of recording re-insurances, so that in case of a 
 loss the re-insured portion will surely be collected. 
 
 The verification of allowances to agents for rebates, return 
 premiums and commissions falls under the heading of vouch- 
 ers. Some special knowledge is desirable in this connection, 
 but with reasonable care these points can be satisfactorily 
 covered. 
 
 The balance sheet items require very little explanation, and 
 present no unusual features, with one or two exceptions. In 
 most States the insurance departments will not permit furni- 
 ture and fixtures to appear as assets in the company's reports, 
 and for this reason very few companies carry this account. 
 This is an instance of a secret reserve, although not very 
 flagrant. 
 
 The principal item among the liabilities is that of unearned 
 premiums, or, as it is usually termed, the Re-insurance Re- 
 
124 AUDITING. 
 
 serve. This must be calculated on the basis prescribed by 
 statute or by the regulations of the insurance department. 
 The basis most generally used is that of reserving 50 per cent, 
 of the gross premiums (less re-insurance) on all unexpired 
 fire risks running one year or less from date of policy, includ- 
 ing interest premiums on perpetual fire risks, and pro rata 
 percentages of the gross premiums on unexpired risks run- 
 ning more than one year from the date of the policy ; the liabil- 
 ity on perpetual policies is taken in at the amount of the 
 deposit reclaimable by the insured. 
 
 Ample provision should also be made for losses adjusted and 
 unpaid, and for all other losses which may be disputed or 
 unadjusted, as well as for accrued taxes, unpaid expenses, &c. 
 
 A very good article on auditing insurance accounts, by 
 George Wilkinson, C.P.A., appeared in The Business World for 
 August and October, 1904, and will well repay reading. 
 
 The audit of a LIFE INSURANCE COMPANY will pre- 
 sent very few unusual points. The distinguishing feature of 
 these accounts is the actuarial valuation of the Company's lia- 
 bility to the policy holders. The auditor is not responsible 
 for the accuracy of this valuation, but it is his duty to see 
 that the accounts are duly prepared in accordance with the 
 actuary's figures. 
 
 On account of the nature of the business the investments 
 will be a very considerable item, and will be likely to include 
 more real estate and other fixed property than is usually 
 owned by any other undertaking. In most of the States the 
 companies cannot purchase real estate except for their own 
 occupancy, but as this has been construed to cover enormous 
 office buildings, from which large rentals are received, and 
 as foreclosure proceedings bring in numerous other parcels, 
 it usually happens that a very fair portion of the assets will 
 be represented by real estate. The income from rentals, &c., 
 will have to be looked after carefully and the balance sheet 
 
INSURANCE COMPANIES. 125 
 
 valuations should be supported by the appraisals of competent 
 men. 
 
 The loans made by the company to its policy holders upon 
 the assignment of their poHcies as collateral should be care- 
 fully checked, and the presence in each case of the policy 
 properly assigned ascertained. These loans are supposed to 
 constitute one of the best assets which life insurance companies 
 possess. 
 
 As a rule, investments must be made in accordance with 
 State laws, but an auditor can hardly do more than obtain a 
 certificate from the company's counsel that the laws have been 
 properly complied with. The valuation of the investments is 
 also a most important matter; this is considered in Chapter 
 VII hereof. 
 
 Insurance companies as a rule do not carry any liabilities 
 on their books for accrued expenses, with the exception in 
 some cases of an allowance for medical fees, because it is their 
 custom to charge these expenses only as paid. Recently, how- 
 ever, the State examiners have recommended that proper re- 
 serves be carried for accrued salaries, rents, office expenses, 
 taxes, bonuses, commissions, legal fees, &c. The plan is, of 
 course, in the line of proper accounting. 
 
 The routine of the audit will differ but little from that of 
 fire companies but the auditor will be wise to pay particular 
 attention to the surrenders. Claims should also be more care- 
 fully looked at than is necessary in fire offices. 
 
 The audit of the investments will be a much more volumi- 
 nous matter than before, and will require considerable care, 
 both to see that the principal is intact and that the prescribed 
 income has been received. As, however, the method of keep- 
 ing investment ledgers varies very considerably with different 
 offices, this matter cannot well be gone into in further detail. 
 
 ACCIDENT, TITLE GUARANTEE, GENERAL AND 
 SPECIAL LIABILITY AND OTHER COMPANIES do 
 
126 AUDITING. 
 
 not raise any new considerations. The great majority of such 
 accounts follow entirely upon the lines of fire companies, the 
 principal variation being that the basis of calculating the un- 
 earned premiums or re-insurance reserve differs in some cases, 
 e. g., in the case of marine and inland navigation companies it 
 is usual to set up as such reserve the entire amount of the 
 gross premiums on unexpired risks. The business of health 
 insurance, however, more nearly approaches that of life insur- 
 ance, and actuarial assistance will be required for the deter- 
 mination of the value of the unexpired risks. 
 
 {d) INVESTMENT COMPANIES.— The accounts of 
 these companies are probably as simple as accounts can well 
 be. The ostensible purpose of such companies is to enable in- 
 vestors to spread their capital over a large field, and so, by 
 the principle of average, obtain a better security for their 
 principal without a corresponding sacrifice of interest. 
 
 The history of many of our mortgage and debenture com- 
 panies has not been satisfactory from the investors' point of 
 view, and an auditor's position here is a responsible one. 
 
 The auditor will require to see the original memoranda 
 for all sales and purchases, and also to ascertain that all in- 
 terest and dividends have been properly accounted for. Pur- 
 chases cum div. and sales ex div. will probably be the most 
 likely cases in which an irregularity may occur. Only income 
 earned during the time that an investment is held should be 
 credited to revenue, while per contra revenue is entitled to 
 take credit for all the income earned during that period. 
 
 The valuation of investments is perhaps the most important 
 function of the audit of investment companies. Under exist- 
 ing conditions, the auditor cannot, of course, prevent the direc- 
 tors issuing accounts stating investments at cost price (regard- 
 less of value) but he at least can — and certainly should — call 
 attention in his report to anything that he considers to be an 
 undue inflation of assets. 
 
INVESTMENT COMPANIES. \2'J 
 
 It is not always imperative that investments should be 
 written down to market price. In the first place, the principle 
 of averages may consistently be followed here, and it will 
 suffice if the total market price be not less than the total cost 
 price. If, however, there be a deficiency in this respect, it 
 should be met, not by a revision of individual values, but by a 
 setting aside of a lump sum to an Investment Fluctuation Ac- 
 count as a reserve against loss. This reserve may either be 
 deducted from the amount of investments in the balance sheet, 
 or separately stated as a liability. A reserve so created 
 should, except in very special cases, not be reduced in subse- 
 quent years, except for the purpose of providing for the actual 
 loss realized upon the sale of depreciated investments. 
 
 When the total market value exceeds the total cost price 
 it is not at all desirable that the capital value of the investments 
 be increased. To credit such an increase to revenue is dearly 
 as incorrect as it would be to credit it with an assumed increase 
 in the value of goodwill. There is no particular harm in writ- 
 ing up the assets and crediting the difference to a reserve not 
 available for equalizing dividends, but it is much better kept in 
 hand — at all events until the permanence of the increase be well 
 assured — as a secret reserve, against which the company may 
 draw in bad times. 
 
 With regard to the profits or losses arising from sales made 
 during the period under audit, in the first place the dividend 
 should be apportioned (from day to day) so that the actual 
 capital profit or loss may be arrived at. Such profits and 
 losses made during any one 3'ear should be treated in the 
 aggregate ; if the result be a profit, it is available for dividend ; 
 if a loss be the result, it should come out of revenue, unless 
 an adequate reserve exists from which the loss may be taken. 
 It is, however, highly desirable that profits made by changes 
 of investments be taken to reserve, and not credited to revenue. 
 Although if the directors of the company choose to pursue the 
 opposite course they would doubtless be wholly within their 
 
128 AUDITING. 
 
 legal rights and the auditor could not do much more than to 
 see that the profits on changes of investments are not reported 
 as current income. 
 
 In bad times the conscientious auditor of investment com- 
 panies has an unthankful task before him, but he must not 
 shrink from the responsibilities of his situation. 
 
 It is important to distinguish between investment companies 
 and speculative finance companies. The chief profits of the 
 former are income derived from investments, and profits de- 
 rived from a change of investments only arise incidentally. 
 In connection with the latter the profits derived from a change 
 of investments form the main source of income ; consequently 
 all such investments must be regarded as so much stock-in- 
 trade — as current assets — and valued accordingly, whereas the 
 investments of a bona fide investment company may fairly 
 be treated as fixed assets. The importance of this distinction 
 lies in the fact that whereas the investments of a speculative 
 finance company ought never to be valued at a price in excess 
 of the current market price, it is frequently difficult (if not im- 
 possible) to arrive at any reliable basis of valuation; for stock 
 exchange quotations are by no means necessarily a reliable 
 basis, if there be no free market. Again, it may be pointed 
 out that, following the ordinary principles of the valuation 
 of unsold stock, no appreciation in the value of investments 
 ought to be credited to revenue until those investments 
 have been actually sold. It is not, however, necessary to 
 write down each separate investment that has depreciated, 
 while writing up those that have appreciated ; the proper course 
 would appear to be to maintain the investments in the balance 
 sheet at cost price, making provision for a reserve sufficient to 
 cover any deficiency in the aggregate intrinsic value, as con- 
 trasted with the aggregate book value. Realized profits may, 
 of course, be properly credited to revenue ; but care should be 
 taken to see that they have been actually realized in cash, and, 
 so far as possible, the auditor should be upon his guard against 
 
STOCKBROKERS. 1 29 
 
 the inflation of profits by means of " accommodation " trans- 
 actions between different members of a group of companies. 
 Probably the Whitaker Wright frauds will be sufficiently fresh 
 in the minds of readers to make unnecessary any detailed 
 explanation of what is alluded to under this heading. 
 
 This whole point was very carefully covered and clearly 
 stated in Mr. Dickinson's paper, " Profits of a Corporation," 
 already referred to. The section is reproduced in full, page 
 224 hereof. 
 
 To sum up, it appears that although, so far as the authorities 
 have hitherto gone, it would appear that under some cir- 
 cumstances dividends may be legally declared out of current 
 revenue without first making good depreciation of invest- 
 ments, it is, on the other hand, certain that the declaration 
 of such dividends is a direct violation of every principle of 
 sound finance, and should at all times be discouraged by the 
 auditor who should make sure that the true position of affairs 
 is sufficiently revealed to the stockholders either upon the face 
 of the accounts or by a special clause included in his report. 
 
 (e) STOCKBROKERS.— A considerable amount of mys- 
 tery appears to envelop stock exchange accounts, and the 
 remark has frequently been made that the audit of brokers' 
 accounts is altogether too technical a matter to be safely con- 
 ducted by the general practitioner. The advantage of special 
 practical knowledge on the part of the auditor has already been 
 freely admitted by the authors, but it is contended that the de- 
 sirable knowledge may be readily obtained, even by the general 
 practitioner ; and, with stock exchange accounts in particular, it 
 is suggested that the necessity of '' specialism " has been greatly 
 exaggerated. 
 
 It is, however, essential that an auditor should have had 
 some acquaintance with brokers' books before attempting an 
 audit, and this can frequently be gained by the special work 
 which they require at especially busy periods. 
 
130 AUDITING. 
 
 Brokers' books differ widely from the usual books of ac- 
 count. Many use a cash journal which serves as a daily 
 record of all cash and securities received and delivered. In 
 this book the left-hand page contains the receipt of cash and 
 the delivery of securities, while the right-hand page represents 
 cash payments and receipts of securities, or vice versa. 
 
 The subsidiary books also vary materially from commercial 
 books, and some little experience is valuable, and perhaps 
 essential, before attempting to audit them. 
 
 In the large New York houses initials are used for all 
 active stocks, which is not only confusing, but requires consid- 
 erable memorizing before any attempt can be made to verify 
 the books. 
 
 As in a bank, a large force must be put on without notice, 
 and, as the stocks will have to be " balanced " before many 
 changes occur, this will mean quick and accurate work. 
 
 For the benefit of those not familiar with stock exchange 
 transactions, it may be said that all big brokerage houses carry 
 large lines of stocks and bonds for customers '' on margin." 
 These are in turn hypothecated with their banks as collaterals 
 for loans. It is necessary, therefore, to go through the cus- 
 tomers' ledgers and prepare a list of all stocks and bonds to be 
 accounted for, taking into account the " shorts " as well as 
 " longs." Lists must then be prepared of the stocks and bonds 
 deposited with the banks, and the securities verified by corre- 
 spondence, those on hand in the " box " must be examined, and 
 the stocks at transfer offices checked. If everything is in 
 order the lists will balance. 
 
 In an active market all this must be done within a very 
 few hours or the verification will be worthless, as the changes 
 will be too numerous to follow. 
 
 Customers' accounts at the first end of the month after the 
 audit commences should be mailed by the auditor, and the 
 confirmations, which are usually addressed to the client, should 
 be secured before being opened by the clerks. 
 
STOCKBRBOKERS. I3I 
 
 llie custom of having the confirmations mailed direct to the 
 auditor has made satisfactory headway during the last few 
 years. 
 
 Testing the charges for interest and commissions may dis- 
 close a fruitful source of errors, as it is not unusual to discover 
 inaccuracies v/hich will repay the cost of the audit. These can 
 readily happen on busy days, as it is not possible to prove the 
 calculations except by going back over them, and this is not 
 always done. 
 
 For the audit of these accounts to be of any value, how- 
 ever, it is necessary that it should be of the most detailed 
 description; the danger of error or fraud — either of which 
 might assume alarming proportions — is extremely great, and 
 the utmost care and circumspection are, therefore, imperative. 
 
 Perhaps the chief danger in this class of audits lies in the 
 fact that in the great majority of offices there exists no regular 
 system affording a reliable internal check, and no efficient 
 supervision. To remedy this obvious weakness the visits of 
 the auditor should be frequent, say, at least twice during each 
 year ; indeed — although a " completed " audit is doubtless use- 
 ful, as affording a reliable periodical statement of accounts — 
 the only really efficient audit of stock brokers' accounts would 
 appear to be one that is both detailed and continuous. 
 
CHAPTER IV. 
 
 SPECIAL CONSIDERATIONS 
 IN DIFFERENT CLASSES OF AUDITS. 
 
 (Continued.) 
 
 IV. PUBLIC SERVICE CORPORATIONS. 
 
 The recent agitation in the United States with regard to 
 municipal ownership of public utilities has aroused consider- 
 able interest in the methods of keeping the accounts of such 
 utilties and preparing them for publication. So far municipal 
 operation has not proved so successful as municipal ownership 
 coupled with private operation through leases, and it is prob- 
 able that the latter plan will prove more desirable for some 
 time to come. Furthermore, the great majority of public utili- 
 ties in this country are still being operated under franchises, 
 many of them perpetual or practically so, granted to private 
 corporations. 
 
 The day may come, however, when all public service cor- 
 porations, at least in the more populous States, will be under 
 the supervision of a State Board, or Commission, empowered 
 to fix rates and compel reports prepared along uniform lines. 
 The State of New York enacted laws in 1907 creating two 
 Public Service Commissions (one for the counties of New 
 York, Kings, Queens and Richmond, and the other for the re- 
 maining counties of the State) which in addition to other broad 
 powers were vested with the power to prescribe uniform sys- 
 
 132 
 
PUBLIC SERVICE CORPORATIONS. I33 
 
 terns of accounts for the electric railways, gas companies and 
 electric light, heat and power companies operating in the State. 
 This power has been exercised, classifications of accounts for 
 the three classes of corporations mentioned having been pro- 
 mulgated by the Commissions. 
 
 The most notable case of public regulation is that of the 
 Interstate Commerce Commission, appointed under authority 
 of Congress to supervise the operation of steam railways doing 
 an interstate business. The results — so far as encouraging, 
 and in some cases compelling, the keeping of and submitting 
 accounts prepared along uniform lines — have been wonderfully 
 successful, and part of the prosperity of our railways is no 
 doubt attributable to the increased attention which has neces- 
 sarily been given to the accounting departments of the railway 
 corporations which have been subject to this control. 
 
 By amendments made to the Interstate Commerce Act in 
 1906, the powers of the Commission were very much broad- 
 ened, its jurisdiction being extended to cover electric railways, 
 express companies, sleeping-car companies, carriers by water 
 (as described in the act) and pipe lines (excepting water and 
 gas) transacting an interstate business. In addition to other 
 far-reaching powers, including the fixing of maximum rates, 
 the Commission is now empowered, not only to call for uni- 
 form reports, but also to prescribe a uniform system of ac- 
 counts for each of the transportation agencies named, deviation 
 from which becomes a penal offense. It is of particular inter- 
 est to accountants that the classification of accounts for steam 
 railroads promulgated by the Commission requires that entries 
 for depreciation of equipment be made and it is to be expected 
 that in due season such depreciation charges will require to be 
 made for other parts of the physical property in which depre- 
 ciation undoubtedly occurs. This official recognition by an 
 important governmental body of a principle for which account- 
 ants have long contended is a " sign of the times " and should 
 assist in convincing our courts when the question of deprecia- 
 
134 AUDITING. 
 
 tion comes up for judicial determination that it cannot be con- 
 sidered otherwise than as a charge to be reckoned with and 
 provided for before stating net profits or paying dividends. 
 
 In the case of local public service corporations, State Legis- 
 latures can readily and in some cases have, passed the necessary 
 acts delegating to commissions or municipalities the power to 
 fix rates. 
 
 This puts a responsibility on an auditor which is far more 
 serious than when he is deaHng solely with stockholders and 
 other owners, for now he finds himself not only in the position 
 of safeguarding the interests of the owners, but he also occu- 
 pies a quasi-public position. The accounts to which he certifies 
 should not be so conservative that the profits are unduly dimin- 
 ished and the public deceived ; nor, on the other hand, should 
 they be so lacking in proper reserves and depreciation allow- 
 ances that the profits will appear too large, and the attention of 
 the consumers will consequently be called to this fact, with the 
 result that agitation for rate reductions will naturally ensue. 
 
 This matter received the attention of the Congress of Ac- 
 countants held at St. Louis in September, 1904, and the atten- 
 tion of the student of public utility accounting is therefore 
 called to the published proceedings of the Congress. 
 
 It is not amiss in this connection to report the findings of a 
 special committee appointed to pass upon this subject. 
 
 "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 Prac- 
 tice in Determining the Profits of Public Service Corporations Where 
 Municipalities Have the Power to Regulate Rates,' having taken the 
 paper into consideration, 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 undertak- 
 ing from the point of view of the general community and the profits 
 available for dividends from the point of view of a corporation own- 
 ing such undertaking. The former would be the net earnings from 
 
PUBLIC SERVICE CORPORATIONS. 135 
 
 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 only be arrived at after providing also for any 
 possible loss on capital assets arising from causes not directly inci- 
 dent to such operation and for interest on borrowed money. 
 
 " II. The Net Earnings of a Public Utility with which the general 
 community is concerned are determined by the excess of Gross Earn- 
 ings over Expenses, defining the latter terms as follows: 
 
 Gross Earnings consist of the charges for all services rendered dur- 
 ing 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 maintenance (ordinary 
 repairs), expenses of management and provisions for bad debts, 
 damage claims and rebates, as well as extraordinary expenses in- 
 curred 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, including di- 
 rect requirements for renewals, etc., arising both from known and 
 probable causes, such as electrolysis, &c. 
 
 (b) On plant — indirect — due to obsolescence and the like, but 
 not that dlue 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 fran- 
 chise 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 operat- 
 ing 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, &c., on the 
 purchase at the end of the franchise of the whole undertaking by 
 the public authorities, i. e., the State or Municipality. 
 
 "III. In dealing with the private accounts of a corporation operat- 
 ing the utility. Earnings will also embrace miscellaneous receipts, if 
 
136 AUDITING. 
 
 any, not connected with the actual operations of the undertaking, and 
 the following additional expenses should be allowed for, before ar- 
 riving 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 pro- 
 vided for under Section 2, sub-section 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 pub- 
 lic, regard must be had (a) to the profit ascertainable under Section 
 II., and {b) to the 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 con- 
 sidered a reasonable rate for a corporation to earn, taking into con- 
 sideration 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 pro- 
 vide for the risks and expenses stated in Section III. 
 
 A. Lowes Dickinson, 
 
 Elijah W. Sells, 
 
 Harvey S. Chase, 
 
 Ernest Reckitt, 
 
 John B. Niven, 
 
 Robert H. Montgomery, Chairman." 
 
 It will be noticed from the foregoing that the most important 
 matter, from the auditor's point of view, is the division of all 
 expenditure into two classes — capital and revenue. It is not, 
 however, always possible for the auditor to judge as to the 
 correctness with which, say, the cost of an improvement, or 
 renewal, has been apportioned as between capital and revenue ; 
 nor, indeed, is it necessary that he should attempt to constitute 
 himself an engineering expert. He will, however, require to 
 see that the company's engineer has certified the apportionment 
 to be correct, and that the expenditure on capital account has 
 been properly authorized. In addition, it is desirable that he 
 should satisfy himself that the principle followed by the 
 engineer in arriving at his apportionment is a sound one. There 
 is, properly speaking, no " safe side " in these matters — an 
 undue charge to capital is unfair to the proprietors, while an 
 
PUBLIC SERVICE CORPORATIONS. l^J 
 
 undue charge to revenue is (through increasing the apparent 
 cost of the service rendered) an injustice to the consumers. 
 The following examples of apportionment will, however, be 
 found useful, as indicating, in general terms, the correct 
 method of arriving at the amount chargeable against capital, 
 and against revenue, in any special case that may arise : — 
 
 New Works (including extensions) : Capital. 
 
 New Works in Place of Old Works: Charge original 
 cost of old works pulled down, less value of old materials, 
 against revenue; charge the remainder against capital. (This 
 amounts to debiting capital with total cost, debiting revenue 
 and crediting capital with original cost of old works, and 
 crediting revenue with value of old materials sold.) 
 
 The above description accurately explains the theoretical 
 apportionment of expenditure on renewals as between capital 
 and revenue; but, for practical purposes, it is important to 
 bear in mind that the cost of any kind of construction work 
 does not remain constant over an extended period. Assuming 
 it did remain constant, no modification of the principle already 
 described would be necessary; but, inasmuch as variations in 
 cost are to be expected, it is claimed by many practitioners that 
 only the bona Ude " betterment " can be properly capitalized. 
 Thus, if assets which originally cost $100,000 were, on renewal, 
 to cost $125,000, the whole of the cost of such renewal would 
 be a revenue charge. If, however, the assets which originally 
 cost $100,000 were replaced by assets of a higher revenue- 
 earning capacity at a cost of $150,000, the correct method of 
 apportioning this $150,000 would be, in the first place, to ascer- 
 tain what the exact re-instatement of the original assets would 
 have cost, to charge that sum to revenue, and to only capitalize 
 the excess. 
 
 There is reason to believe that in the past this rule has not 
 always been applied with sufficient strictness to all companies. 
 In new countries the cost of construction work has, owing 
 
138 AUDITING. 
 
 to facilities for transport and improvements in methods, been 
 materially reduced of late, and thus the question arises as to 
 whether the same principles may be fairly applied. If they 
 were to be strictly applied, it is clear that pure renewal work, 
 involving no " betterment " whatever, would indirectly result 
 in a credit to revenue, in that the original amount of capital 
 expended would be maintained in spite of the fact that capital 
 assets actually existing to represent it had cost less. Thus, 
 an asset which originally cost $100,000, and which was renewed 
 (without detriment) at a cost of $80,000, would still be in- 
 cluded in the capital account at the former figure. The proper 
 method would, imder this theory, be to write down the book 
 value of the capital account as and when renewal work is 
 undertaken at a reduced price. 
 
 The policy which is more generally followed in the United 
 States, however, does not agree with the foregoing views. 
 It is argued that the best practice requires, or at least per- 
 mits, the plant account on the books to represent the last cost ; 
 that is to say, if assets which originally cost $100,000, on re- 
 newal cost $125,000, the excess is properly chargeable against 
 capital, the best proof of the soundness of this position being 
 the attitude of insurance companies with respect to paying 
 claims for fire losses; it should be remembered that the mat- 
 ter of insurance is a vital one to every business ; therefore, the 
 books should be arranged so that they will influence a fair 
 settlement in case of fire, provided, of course, that sound ac- 
 counting principles are not violated. The theory of insurance 
 is that the insurance company will bear the cost of replacing 
 the article destroyed (having regard to its condition at the 
 time it was destroyed) ; therefore, if the books show the last 
 cost of the plant, it will be easy to arrive at an equitable ad- 
 justment by using the book values less a faif rate of depreci- 
 ation. If it were found in the instance cited above that 
 $25,000 had been debited to revenue and the asset stood on the 
 books at $100,000, the owner would probably have difficulty 
 in proving his claim for $125,000. 
 
GAS COMPANIES. 139 
 
 The question must also be considered from the standpoint 
 of the return which a public service corporation would be en- 
 titled to earn on the capital invested. It would certainly seem 
 that the depreciation on plant which forms an item in the cost 
 of the service rendered (see Section 2, sub-section 2 (a) of 
 Committee's report, page 135 hereof) should be based on the 
 cost of the plant actually used therefor, which would neces- 
 sarily include the last cost of any parts of the plant which 
 might have been replaced since the inception of the operation. 
 
 In other words, it is claimed that cost is the only correct 
 basis, for it must be assumed that an undertaking builds or 
 replaces its plant at the lowest cost possible, and, if through 
 any contingency, commodities increase in value and certain 
 renewals cost more than the original assets, it is quite enough 
 to charge the latter against revenue and allow the asset ac- 
 count to represent actual cost of the existing plant. 
 
 Conversions. — In case old materials, instead of being sold, 
 are used for other purposes on the works — treat the particular 
 department of capital expenditure as the purchaser of the old 
 materials in question, debiting it with the value of the mate- 
 rials and the full cost of conversion (if any). 
 
 There are some special features connected with public util- 
 ity enterprises which will be considered under their appropri- 
 ate headings. 
 
 (a) GAS COMPANIES. — The income of a gas company 
 consists of gas sales, residuals sold, and generally profit on 
 fittings and rents, in addition to interest on investments. The 
 collections of gas sales are best checked in totals (care being 
 taken to fully test both allowances and arrears), the total re- 
 ceivables being arrived at from the meter readings books, which 
 will show the total amount of gas consumed and what meters 
 are in use. The residuals sold cannot well be checked as to 
 quantity (save by comparing the results of various working 
 statements), but, of course, the auditor may, and should, check 
 the collection of the amounts debited. The same remark ap- 
 
140 AUDITING. 
 
 plies to fittings, which will almost invariably be found to form 
 a part of a gas company's business. It may be added that it 
 is best merely to state the profit arising from fittings on the 
 credit side of the revenue account (rather than to credit rev- 
 enue with income, and to debit it with expenses). The leading 
 items of expenditure arise from coal and other fuel, stores, 
 and wages; the latter has already been considered in Chapter 
 I., and the former in Chapter IL, and need no further con- 
 sideration beyond saying that both must be fully vouched, and 
 carefully tested. The question of depreciation should be care- 
 fully considered in connection with gas companies, because 
 a considerable part of the plant must be wholly renewed at 
 comparatively short intervals. A provision must, therefore, be 
 made for these renewals. 
 
 The investments held against reserve, insurance, and (if 
 any) depreciation funds, must be verified by an inspection of 
 the securities held. 
 
 This leads up to the consideration of the depreciation fund 
 (in reality a sinking fund), which must be accumulated by 
 companies owning works on leasehold lands. The case will 
 not often arise, but, when it does occur, a sufficient sum must 
 be set aside, and invested to accumulate to the cost of the 
 works by the time the lease expires. The auditor should 
 satisfy himself as to the sufficiency of the annual instalments. 
 
 The auditor of a gas company should be thoroughly familiar 
 with the system of uniform accounts submitted to the Amer- 
 ican Gas Light Association at its annual meeting in 1902, and 
 with the later amendments thereto. The report covers the 
 ** Classification of Operating Expense Accounts; Classification 
 of Betterments or Property Accounts; Forms of Monthly 
 Journal Entries and Rules for Closing." While certain fea- 
 tures of this system can be improved upon, especially the 
 nomenclature, it forms a valuable basis for an ideal system. 
 
 The Public Service Commissions of the State of New York 
 have issued elaborate classifications of accounts for gas com- 
 
ELECTRIC LIGHTING COMPANIES. I4I 
 
 panics, which companies operating in that State are required 
 to use. 
 
 (b) WATER COMPANIES.— The audit of water com- 
 panies is sHghtly simpler than that of gas undertakings, by 
 reason of the fact that the rates charged are, for the most part, 
 fixed, instead of fluctuating with the quantity used. Such 
 portion as is suppHed by meter, for trade purposes, will en- 
 tirely follow the method recorded under gas companies. With 
 regard to the greater portion, which is based on a sliding 
 scale, it is not usual to exhaustively check the calculations in- 
 volved, but they should be tested to such extent as may appear 
 desirable. Vacancies may sometimes be vouched by a declara- 
 tion of the owner that the property in question has been vacant 
 for the whole of the quarter. Allowances (which should be 
 very exceptional) must be properly explained, while arrears 
 and bad debts must both receive careful attention. 
 
 Most companies are empowered to make their charges in 
 advance, and consequently their books will, at the date of the 
 accounts, reveal a profit that has not yet been earned; due 
 allowance must, of course, be made for this in the general 
 balance sheet. 
 
 GAS and WATER COMPANIES (combined) will— in 
 almost every instance — ^be found to keep the accounts of the 
 two undertakings separate. In the few old companies where 
 no such practice exists, separate accounts should, at least, be 
 made out for capital expenditure and revenue (the man- 
 agement expenses being apportioned according to, say, the 
 ratio of the average gross income from each department), so 
 that the profit upon each may be known and the proper work- 
 ing statistics prepared. 
 
 (c) ELECTRIC LIGHTING COMPANIES.— The gen- 
 eral method of audit will practically follow the lines indicated 
 under the head of Gas Companies ; especial care should, how- 
 ever, be directed to the correct apportionment of expenditure 
 between capital and revenue. 
 
142 AUDITING. 
 
 Care should be taken to see that all proceeds of sales of 
 lamps, &c., are accounted for and proper stock accounts kept. 
 
 Electric light accounts differ from those of most other 
 undertakings in that the perishable nature of the fixed assets 
 renders it imperative that special attention should be devoted 
 to the subject of depreciation. It is not merely sufficient that 
 the working plant should be fully maintained in a state of 
 working efficiency out of revenue, as the high speed at which 
 the machinery is run, combined with the fact that only the 
 smallest possible intervals of rest can be afforded to rectify 
 defects, very materially shortens the duration of the life of 
 these assets. Moreover, in connection with this particular in- 
 dustry the advances of modern science are so rapid that, in 
 spite of this comparatively short time of life, many parts of 
 an electrical plant become obsolete before they are worn out. 
 For these reasons a high rate of depreciation must be provided, 
 and it is now being realized that in most cases depreciation 
 has occurred at a more rapid rate than has been provided for 
 in the accounts. 
 
 It is thought that a minimum safe provision against depre- 
 ciation of the actual expenditure as a whole would be one 
 equal to five per cent, on the total capital expenditure. In 
 the English editions of this work the minimum stated is four 
 per cent., but general opinion seems to require a somewhat 
 higher rate in the United States. It may be added that five 
 per cent, allowance for depreciation on the entire cash invest- 
 ment is the minimum figure used by a prominent American 
 electrical engineer who has made a careful study of condi- 
 tions in every part of the United States; in the case of one 
 ten-million-dollar plant he claims that the annual depreciation 
 rate should be nine per cent. It is of interest to note that of 
 the British municipal corporations which appear to have been 
 among the first to appreciate the importance of adequate pro- 
 vision for depreciation, Glasgow provides — on machinery, 
 seven and one-half per cent.; accumulators, ten per cent.; 
 
STEAM RAILWAYS. 143 
 
 mains, two and one-half per cent. ; meters, six per cent. ; in- 
 struments, five per cent. 
 
 One caution in conclusion may not, however, be out of 
 place : where no regular purchase ledger exists — and this state 
 of affairs will also be frequently found in connection with 
 both gas and water companies* as well — particular care will 
 be necessary to guard against any omission of outstanding 
 liabilities, when the annual accounts are prepared. 
 
 V. TRAFFIC ACCOUNTS. 
 
 (a) STEAM RAILWAYS.— Railwa^r accounting in the 
 United States has reached such a high state of perfection, that 
 the auditing department usually has at its head a thoroughly 
 competent official. During the past few years, audits of the 
 accounts by professional accountants have been increasing and 
 it is thought that the time is not far distant when railroad 
 stockholders will not be satisfied unless an independent exam- 
 ination is made on their behalf. Until the promulgation of 
 the Interstate Commerce Commission's revised classification 
 of accounts in 1907, of which mention has already been made, 
 it was not customary to make any systematic allowance for 
 depreciation, and there is still a remarkable lack of uniforrnity 
 with regard to writing off so-called betterments. The Com- 
 mission has, however, issued a tentative classification of Ad- 
 ditions and Betterments Expenditures which will doubtless be 
 succeeded later by a formal classification to be used by all 
 roads. If definite standards of extensions, additions and bet- 
 terments are set up and the accounts stated accordingly, this 
 is really all that can be expected, as it will be conceded that, if 
 they act in good faith and violate no accounting principles, the 
 directors must be permitted to dictate the policy of the com- 
 pany, even though it be ultra-conservative. If the stockhold- 
 ers are fully informed and want a different policy pursued 
 they have the power to bring about a change. 
 
 A few remarks on the routine work are in order: The 
 auditing department, in itself, constitutes a continuous and 
 
144 AUDITING. 
 
 thorough check upon every other department under the super- 
 vision of the controller, and, as no moneys whatever pass 
 through that office, it may safely be taken that the work is 
 honestly performed. 
 
 The professional auditor's work may thus be said to com- 
 mence with the certified returns of traffic, and the certified 
 vouchers for expenditures made. He must, however, himself 
 examine and verify the summaries of these items. He must 
 see that they tally with the cash and notes received, and that 
 the latter find their way into the bank in due course. He must 
 examine the vouchers of all expenditure, and, so far as pos- 
 sible, verify its apportionment; in particular must he satisfy 
 himself as to the correctness of the apportionment of such 
 expenditure between capital and revenue. With regard to the 
 issue of new capital, he must see that the amount actually re- 
 ceived agrees with the totals shown in the stock ledgers kept 
 at the secretary's office. He should compare the certified re- 
 turns of " foreign " railways with the entries in the books 
 of his own company. He should check the transactions in 
 notes in detail, follow the matured notes into the banking 
 account, and verify the outstanding notes by the inspection 
 of the actual documents. He must check the traffic outstand- 
 ings with the certified statements, examine the entries on both 
 sides of the banking account, and check the additions, and, 
 so far as possible, the classification of the items. He should 
 examine all bonds that have been redeemed, and see that they 
 have been cancelled. He should also see that all paid coupons 
 have been cancelled and properly filed. He should examine 
 the accounts for repairs made to the rolling stock of private 
 car lines and compare the lists with the ledger. He should 
 examine the accounts of rent received, thoroughly check the 
 general ledger, compare the balances of the various stock ac- 
 counts with the certified list of stores on hand, and compare 
 the totals of the general ledger expense accounts with the 
 totals of the subsidiary books. It will then still remain for 
 him to ascertain that such liabilities as traffic drawbacks are 
 
ELECTRIC RAILWAYS. 145 
 
 provided for, verify the investments by inspection of securities 
 and examination of the interest received, compare the capital 
 issued with that authorized by stockholders* minutes, give a 
 final consideration to the apportionment of capital and revenue 
 expenditure, and see that the necessary certificates have been 
 furnished as to the efficiency of the permanent way, rolling 
 stock, &c. 
 
 Of course all of the above details cannot be covered in the 
 audit of one of the great trunk line systems. In such a case, 
 however, the internal check is likely to be more efficient. As 
 with other undertakings, the auditor must be governed by the 
 special circumstances of the case, and should only omit such 
 details as are checked intelligently by independent employees. 
 
 Any one interested in the accounts of steam railways should 
 by all means read the addresses relating thereto by Prof. 
 Henry C. Adams, in charge of Statistics and Accounts, Inters 
 state Commerce Commission, and Arthur W. Teele, C.P.A., 
 delivered before the meeting of the American Association of 
 Public Accountants, held at Atlantic City, October, 1908, and 
 which appear in its 1908 year book. 
 
 (b) ELECTRIC RAILWAYS.— In 1898 the Street Rail- 
 way Accountants* Association of America (now known as the 
 American Street and Interurban Railway Accountants* Asso- 
 ciation) recommended to its members a standard classification 
 of accounts prepared by a committee of the Association. This 
 classification has been adopted by the majority of street rail- 
 way companies and has also been prescribed by quite a num- 
 ber of railroad commissioners for use in making reports to 
 the State. During the past year the Interstate Commerce Com- 
 mission has issued a more elaborate classification (at least for 
 the larger corporations) and while the number of electric rail- 
 ways which are under its jurisdiction is comparatively small, 
 the classification may come into general use through being 
 adopted by the various State commissions having jurisdiction. 
 The New York Public Service Commissions also issued re- 
 vised and amplified classifications during 1908, the use of 
 
146 AUDITING. 
 
 which is compulsory for railways operating in that State ; these 
 classifications were patterned to a considerable extent after 
 that of the Interstate Commerce Commission. 
 
 The auditor should make himself familiar with the classifi- 
 cation in use before commencing an audit of a street railway. 
 The audit, however, is rather simple, as the business may be 
 said to be on a " cash " basis. 
 
 The audit of the receipts is of the utmost importance. The 
 daily returns will usually be found to be certified to. An 
 examination of the system will develop whether this can be 
 depended upon. If so, the daily receipts should be traced 
 into bank. It may, perhaps, seem superfluous to suggest the 
 propriety of seeing that receipts are accounted for upon every 
 day of the year. It will be found in nearly all cases that the 
 entire daily receipts are deposited, which is, of course, the 
 only proper way, and if it should not be in force the change 
 should be made instantly. Other sources of receipts should 
 be inquired into, and it may prove to be a fruitful inquiry, for 
 in many undertakings, where a most rigid system exists of 
 looking after the usual transactions, infrequent items of rev- 
 enue, such as sales of old materials, &c., receive scant atten- 
 tion, and numerous cases are known of these sales being un- 
 accounted for. 
 
 The question of the proper method of treating ticket sales 
 is also one to be considered in connection with railway ac- 
 counts. From a purely theoretical standpoint there can be no 
 question that ticket sales only become actual revenue or in- 
 come when the service to which the purchasers are entitled is 
 rendered; consequently the credit arising from ticket sales 
 should go to a suspense account (stated in the balance sheet 
 as deferred or unearned income) and transfers made, say 
 monthly, to the appropriate earnings account for the tickets 
 " lifted.'* 
 
 In many cases, however, where the ratio of ticket sales to 
 cash fares is small the outstanding tickets are a negligible 
 
ELECTRIC RAILWAYS. I47 
 
 quantity. In other cases, however, they may run into large 
 amounts; in a recently published balance sheet of the street 
 railway company of one of the large cities the liability stated 
 for uncollected tickets was over $90,000. Many companies, 
 however, ignore the outstandings entirely and include the en- 
 tire amount of sales in the current earnings, pointing to the 
 example of the steam railroads, with which this custom is 
 nearly universal, as a justification of the practice. In the lat- 
 ter connection it should be noted that the Interstate Commerce 
 Commission makes an exception in the case of interchange- 
 able mileage books, permitting the mileage therein to be 
 credited to earnings only as honored. 
 
 It should be noted that the inaccuracies in the gross earn- 
 ings account, due to the failure to take cognizance of uncol- 
 lected tickets, will be greatest for some time after making 
 changes in kinds of or methods of selling tickets, also when 
 special tickets are being sold for a limited time. 
 
 The only other source of revenue of any importance will 
 be advertising; but, as this is almost invariably sub-let to an 
 advertising agency, it needs no comment. 
 
 The expenditures — which should always be made by cheque, 
 no payment out of traffic receipts being on any account per- 
 mitted — must be carefully vouched ; while the analysis thereof 
 must, so far as possible, be verified. In particular, the appor- 
 tionment between capital and revenue must be thoroughly 
 scrutinized. 
 
 It is only a few years since street railway men and even 
 some professional auditors claimed that it was quite unneces- 
 sary to provide for depreciation in street railway accounts. By 
 some it was claimed that the current renewals to keep the 
 property in good operating condition were a sufficient charge 
 to operating expenses, while others claimed that the enhance- 
 ment in the value of the franchises held offset any depreci- 
 ation in the physical property. 
 
148 AUDITING. 
 
 If the directions laid down in the uniform system are prop- 
 erly carried out, and if renewals were uniform from year to 
 year over, say, twenty years, it might, perhaps, be claimed 
 with some show of reason that, so far as the current operat- 
 ing accounts at least are concerned, there was no necessity for 
 providing directly for depreciation. 
 
 It frequently happens, however, that the first examination 
 the auditor makes follows immediately, or very closely, the 
 reconstruction of the road, or its consolidation with other lines, 
 or with electric light companies. During this period the 
 charges to construction will be heavy — legitimately so — and 
 the direct charges to repairs and general maintenance light. 
 It is contended that the only scientific way to prepare the ac- 
 counts of such a year is to include an allowance for depreci- 
 ation. If this is not done, it almost invariably happens that 
 in later years, when the renewal charges are heavy, the neces- 
 sity arises for capitalizing these large expenditures, and where 
 there should be ample reserve to provide therefor, laid aside 
 out of earnings, there is not a dollar in hand for this purpose, 
 and the fact that the dividends paid were in fact out of capital 
 develops too late. 
 
 It is, however, becoming recognized that electric railways 
 are no exception to the economic rule that use of plant is 
 inseparable from depreciation and exhaustion. It is immate- 
 rial whether the plant is that of a manufacturing establishment 
 or that of a railway ; the exhaustion through use is going on 
 just as surely in the case of the latter as in the case of the 
 former. Again, there is probably no other industry in which 
 obsolescence has operated to render property useless for operat- 
 ing purposes more rapidly than in the electrical field. The 
 classification of accounts recently prescribed for electric rail- 
 ways by the New York Public Service Commissions provides 
 for depreciation charges; the Interstate Commerce Commis- 
 sion's classification likewise takes cognizance of the necessity 
 of provision for depreciation. Such recognition of the fact of 
 the existence of depreciation and the necessity of providing 
 
ELECTRIC RAILWAYS. 149 
 
 therefor is encouraging, and is, in some measure at least, a 
 tribute to professional accountants, who for a long time were 
 almost alone in their stand for the recognition of this 
 principle. 
 
 It is within the province of, and it is in fact the duty of, tlie 
 professional auditor to take a firm stand upon this question, 
 and to refuse to certify the profit and loss statement of a 
 street railway company which does not amply provide for 
 depreciation — either directly or by satisfying himself that the 
 charges for renewals represent a fair equivalent. If he is un- 
 able to secure this result his certificate should draw prominent 
 attention to the fact, and it must follow ultimately that the 
 protest will be heeded. 
 
 The opinion of an engineer on the question of depreciation 
 of electric trolley railways is of value to professional audi- 
 tors. The following extract is from a report made by a promi- 
 nent engineer. The undertaking in question is ai small one, 
 but it is not likely that the figures would be altered in any 
 event. Pole lines and copper, ten per cent.; ties, twenty per 
 cent ; machinery, ten per cent. ; cars, twenty per cent. 
 
 During the past few years interurban electric railways have 
 developed rapidly, and in some states, particularly in the mid- 
 dle West, there is now a perfect network of them. Running 
 through the open country — often on private right of way be- 
 tween cities and town — they frequently have a mileage com- 
 paring favorably with that of the smaller steam roads and 
 construction equalling steam roads standards. In addition to 
 the short haul passenger traffic of the ordinary urban street 
 railway, there is long distance passenger business and freight 
 and express traffic to be handled. 
 
 These conditions necessitate accounting methods — and con- 
 sequently auditing methods — which approach closely those in 
 use on steam roads. Where the road is a large one it will 
 naturally have an auditing staff of its own which will take care ■ 
 
150 AUDITING. 
 
 of the routine auditing of traffic receipts, and the professional 
 auditor's course of procedure will be much like that outlined 
 under (a) Steam Railways. 
 
 (c) SHIPPING COMPANIES.— Unlike the accounts of 
 railways, the accounts connected with marine traffic are sub- 
 ject to no uniform recommendations with regard to form. 
 
 There are comparatively few shipping companies operating 
 in the United States, but the subject is, nevertheless, of 
 interest. 
 
 There is no essential difficulty in connection with shipping 
 accounts, but the fact that it is both desirable and customary 
 to show the net result of every voyage of every ship necessi- 
 tates some very nice apportionment of the items constituting 
 shore expenses and insurance. 
 
 The extent of an auditor's investigations will vary greatly 
 in different cases; in the case of a single ship it is desirable 
 that the audit be as exhaustive as possible; but in the case 
 of one of the larger companies such a course would be quite 
 as impracticable as in the case of a railway. The actual ex- 
 tent in any particular case will thus be very largely a matter 
 of arrangement and of expediency. 
 
 The following considerations may, however, be safely sub- 
 mitted, as they will in every case require to be dealt with in 
 more or less detail: 
 
 Ascertain that freights and passage money are duly ac- 
 counted for ; that the apportionment of shore expenses is equi- 
 table; that the cost accounts are not improperly manipulated 
 (especial care being required where one cost account is kept 
 for a whole fleet) ; that only structural improvements are 
 debited to cost account ; that proper depreciation is allowed — 
 especially in regard to boilers; that outstanding freights and 
 agents' balances are provided for in accordance with the docu- 
 mentary evidence; that unclaimed return passages are in or- 
 der; that proper return of insurance premiums has been ob- 
 
SHIPPING COMPANIES. 15 1 
 
 tained for the time during which any vessel has been " laid 
 up," and, generally, that insurance matters are in order; that 
 the question of foreign exchanges has been dealt with upon a 
 proper basis; and that no profits are taken credit for on ac- 
 count of uncompleted voyages. 
 
 In order to prevent misunderstanding, it seems desirable to 
 point out, for the benefit of the reader who has no experience 
 of shipping accounts, that the " Cost Account " is really 
 neither more nor less than a capital expenditure account, and 
 must on no account be confused with the cost accounts kept by 
 manufacturers. 
 
 Some shipowners, instead of insuring with underwriters 
 against risk of total loss or damage to their vessels, raise an 
 insurance fund wherewith to meet such losses by periodical 
 charges against revenue. The effect, of course, is that, instead 
 of profit and loss being debited with insurance premiums, it 
 is debited with an instalment — probably somewhat in excess 
 of that which would have been thus paid — which is credited 
 to the insurance fund. At the same time, to make the insur- 
 ance fund really effective when required, it is desirable that a 
 corresponding amount of cash should be invested in readily 
 realizable securities, the insurance fund thus becoming for all 
 practical purposes a sinking fund, rather than a mere reserve. 
 When any loss is incurred, the cost of replacing it is. debited 
 to the insurance fund account, a corresponding amount of in- 
 vestments being realized to provide the necessary cash. It 
 need hardly be pointed out that an insurance fund can only be- 
 come an effective provision against loss in the case of com- 
 panies owning a large fleet of vessels, so that within their own 
 exi>erience they get a reasonable average of risk. Even here, 
 however, it will sometimes happen that a loss occurs which 
 will more than swallow up the whole of the accumulated fund, 
 and the question then arises whether it is reasonable to bring 
 forward the debit balance of the insurance fund account as an 
 asset upon the balance sheet. If there is a reasonable prob- 
 ability that this debit balance can be extinguished out of future 
 
1.52 AUDITING. 
 
 instalments within a short time, there might possibly be no 
 objection to this course of procedure; but, in any event, it 
 seems desirable that it should appear as a special item in the 
 balance sheet, so that no stockholder may be deceived as to the 
 actual position of affairs; and in addition the auditor should 
 draw attention to the facts in his report. 
 
 Owners of single ships and single-ship companies almost 
 invariably make no provision for depreciation; the auditor 
 need not waste his time upon any efforts to convince his clients 
 of the imprudence of this course, but he should not forget to 
 append the necessary qualification to his report. 
 
 The auditor of single-ship companies must bear in mind 
 that, as regards fraud, there is no such thing as " safety in 
 numbers " here, for the accounts are usually all in one person's 
 hands — let him, therefore, not omit to examine the voyage 
 account book in detail. In a recent case it transpired that the 
 same manager had control of the funds of several single-ship 
 companies ; and, by an ingenious process of " ringing the 
 changes," was enabled for many years to conceal from the 
 auditors the fact that there were serious deficiencies in his 
 cash balance. 
 
 It is a good plan always to ascertain that no mortgage lias 
 been registered against the ship which is not recorded in the 
 books. 
 
 The professional accountant who endeavors to acquaint him- 
 self with all of the ramifications of the accounts of public 
 service corporations, and who is interested in the subject of 
 municipal v. private ownership, will find it necessary to read, 
 or at least consult, the voluminous reports of the National 
 Civic Federation on " Municipal and Private Operation of 
 Public Utilities," issued in 1907. 
 
 VI. THE ACCOUNTS OF PUBLIC AUTHORITIES. 
 
 The whole subject of municipal accounting has received 
 consideration attention in the United States recently, but it 
 
PUBLIC AUTHORITIES. 153 
 
 cannot be said that there is any immediate prospect of the 
 audit of these accounts in general being turned over to the 
 professional auditor. It is sure to come ultimately, however. 
 Therefore serious consideration should be paid to this subject. 
 
 The National Municipal League has done much to further 
 the cause of uniform municipal systems, and the St. Louis 
 Congress of Accountants also gave the matter attention. The 
 proceedings of both bodies can be readily secured, and should 
 be in the hands of everyone interested. When it is considered 
 that practically each of our fifty States and Territories has dif- 
 ferent laws regulating the affairs of municipalities, the vast 
 work undertaken by the National Municipal League will be 
 appreciated. 
 
 The United States Bureau of the Census has during recent 
 years taken an active interest in this subject, and through its 
 co-operation with the other agencies which are working for 
 improved municipal accounting methods has contributed ma- 
 terially to the progress which is being made. The Census 
 Bureau's classification of revenues and expenses, based on that 
 of the National Municipal League, has been adopted by quite 
 a number of cities, which is in itself an encouraging sign. 
 
 With such an extensive field and complex conditions before 
 him, the practitioner who has in mind making a specialty 
 of municipal accounting will, of course, be compelled to make 
 a rather exhaustive study of the whole subject, and anything 
 short of a general review of what has been recently accom- 
 plished would be of little value; it is, therefore, unnecessary 
 to explain that the limits of this book will not admit of further 
 discussion. 
 
 The practitioner or student who desires to make an exhaus- 
 tive study of municipal accounting would do well to secure the 
 various reports on the system of accounts in use by the City 
 of New York. These accounts have probably received more 
 attention than any other accounting system in existence. In- 
 
154 AUDITING. 
 
 vestigation kas followed investigation, and out of them all a 
 system worthy of the name has at last seen the light. 
 
 The Bureau of Municipal Research of New York should 
 have the principal part of the credit for this result, because 
 its directors worked unceasingly for several years to bring 
 about the much needed reforms. 
 
 A full and detailed description of the new system as ap- 
 proved by the Bureau has been published by the city, and any 
 accountant interested can no doubt secure a copy. 
 
 It is believed that cities not nearly so large as New York 
 may well follow some of the new features recently introduced, 
 for — as was declared by the Chamber of Commerce of New 
 York at one of its meetings — a proper system of accounts will 
 " fix responsibility, expedite business, and eHminate waste." 
 
 The Chamber of Commerce, in its desire to ascertain whether 
 or not the proposed system was based on these theories and 
 was working out as well as was promised, appointed a com- 
 mittee consisting of one of its own members, together with 
 Francis F. White, C.P.A., and Robert H. Montgomery, C.P.A., 
 to examine and report thereon. 
 
 This committee spent several months in its investigation, and 
 its report, containing a number of criticisms and recommenda- 
 tions, was adopted by the Chamber of Commerce in June, 1909. 
 
 With certain exceptions, chiefly technical, the cominittee 
 approved the system in the following terms: 
 
 "We unhesitatingly assert that the general principles upon 
 which the new accounting system rests are sound, and that 
 their application to the accounts of the city cannot but be 
 beneficial to a marked degree. 
 
 " The substitution of a thoroughly co-ordinate accounting 
 system for the unscientific and incomplete one that has pre- 
 vailed will not only pay for itself by enabling the Comptroller 
 as well as the citizens to secure a knowled^-e of the exact 
 
EXECUTORS AND TRUSTEES. 155 
 
 financial condition of the municipality, and thus furnish the 
 essential data to secure economical administration, but will 
 unquestionably raise the credit of the city." 
 
 VII. EXECUTORS' AND_TRUSTEES' ACCOUNTS. 
 
 It will sometimes happen that the professional accountant 
 is called upon to audit the accounts of executors or trustees, 
 on behalf of some dissatisfied beneficiary, or, as is more fre- 
 quently the case, he will be called in by the executors or trus- 
 tees themselves, because they desire the certificate of an inde- 
 pendent auditor that their accounts are correct. 
 
 The purport of the auditor's investigation in such cases 
 will be to ascertain that the terms of the will or trust have 
 been complied with, and that no improper use, or unauthorized 
 investment, of the trust funds has occurred. Questions of 
 apportionment between principal and income will also claim his 
 attention. 
 
 The fullest investigation into details will be necessary, ex- 
 cept, perhaps, that where the trustees have been authorized to 
 carry on the testator's business and where there is no sug- 
 gestion that their conduct has, in this respect, been improper, 
 the business accounts may be excluded from inquiry. 
 
 In addition to the will and probate, and the accounts kept 
 by tho executors and trustees, the accounts filed with the court, 
 together with the minute book (if one be kept) and all docu- 
 ments and vouchers, will require to be carefully examined. 
 
 With regard to the question of apportionment, it is import- 
 ant to remember that all interest accrued to the date of death 
 (inclusive) forms part of the corpus; that the profit or loss 
 arising from any subsequent bona iide change of investment 
 falls, as regards principal, upon principal, and as regards in- 
 come, upon income ; that, even where investments of a wasting 
 nature are specially authorized, the whole of the income does 
 not of necessity pass to the life-tenant (where the will or deed 
 
156 AUDITING. 
 
 of trust provides that the wasting assets must be administered 
 for the equal benefit of life-tenant and remainderman the usual 
 custom is to consider five per cent, (or thereabouts) as income, 
 and to capitalize the remainder) ; that any loss arising out of 
 an unauthorized investment falls upon the trustees personally, 
 who are liable to repay the amount with such interest as the 
 court may direct — the rate being usually six per cent, (simple 
 interest), and the same rate is usually charged where the 
 trustees have applied the funds to their own use. Any of the 
 above provisions may, however, be modified by the special 
 terms of the will or other instrument creating the trust. 
 
 The investments authorized for trust funds (subject to any 
 special terms in the will) have varied from time to time. The 
 auditor will therefore require to satisfy himself that each in- 
 vestment was a proper one at the time it zvas made. The 
 investments authorized by the several States vary as to their 
 character, but usually consist of first mortgages upon real 
 estate. Government and first lien railroad bonds. 
 
 It is also important to verify the commissions claimed or 
 paid to the executors or trustees, both as to amount and espe- 
 cially to make sure that there are no duplications. An execu- 
 tor who has received a commission on the principal of an 
 estate will not be allowed a second commission for subsequently 
 acting as trustee of the same estate, and as a rule no commis- 
 sion is allowed on changes in investments. 
 
 It frequently happens that an estate is so bequeathed as to 
 be divisible between persons of different ages, with the proviso 
 that the share of each is to be held in trust for him until the 
 happening of a certain event — such as his attaining his majority 
 (or, in the case of a female, on her marriage) — the beneficiary 
 in the meantime only receiving the income on his, or her, share. 
 Under such circumstances it generally follows that the benefi- 
 ciaries do not become simultaneously entitled to their respective 
 shares in the principal ; but the moment any one becomes en- 
 titled to a share in possession he becomes entitled to actually 
 
EXECUTORS AND TRUSTEES. 157 
 
 receive his share, and — save by consent — the division (or par- 
 tition) of the estate cannot be postponed. If the estate consists 
 of investments that are readily capable of division, the problem 
 is, of course, a quite simple one, for the beneficiary entitled to 
 the partition may then have transferred to him (or sold for his 
 benefit) his due fraction of each of the numerous investments 
 held by the trustees; but when the estate includes mortgages, 
 lands, or other non-divisible assets, some arbitrary method of 
 arriving at the beneficiary's share becomes essential. If all 
 beneficiaries are of age, the share of each may be mutually 
 agreed ; but if any one of the beneficiaries be under age, there 
 is no means of obtaining his (or her) consent. The only 
 course is then to apply to the court to direct a " partition " of 
 the estate, and the ascertainment of the share immediately pay- 
 able to the beneficiary entitled to a possessory interest, and the 
 order of the court will be a protection to all parties concerned. 
 Upon payment of the amount found to be due to the benefi- 
 ciary, he ceases to have any interest in the trust estate, and the 
 residue of the estate is then held in trust for the remainder 
 of the beneficiaries, who alone are concerned in any subsequent 
 fluctuation in the value of the trust investments. 
 
 It is especially important to remember that beneficiaries, 
 unless of full age, have no power to consent to any variation 
 in the terms of the trust. 
 
 In conclusion, it need hardly be pointed out that one of 
 the most important duties in these audits consists of a very 
 careful verification of the investments. 
 
CHAPTER V. 
 
 SPECIAL CONSIDERATIONS 
 IN DIFFERENT CLASSES OF AUDITS. 
 
 (Continued.) 
 
 VIII. ACCOUNTS OF INSTITUTIONS. 
 
 (a) CHARITIES.— Under this head may be included the 
 accounts of hospitals, certain endowed universities and schools, 
 and similar institutions. 
 
 The distinguishing feature of most charities' accounts is the 
 receipt of subscriptions and donations. These will, of course, 
 require to be vouched in the usual way ; but, perhaps, the most 
 effective check consists in the publication of a list of subscrib- 
 ers and donors along with the accounts. 
 
 In the case of hospitals there will be a considerable revenue 
 from patients' board, &c., which will have to be carefully 
 checked. It is not always the custom to keep these accounts 
 upon a double entry system, and abuses frequently occur. 
 
 There is no reason why the patients' accounts should not be 
 as carefully kept and easily checked as the accounts of guests 
 in a hotel. There is always a patients' register, giving time of 
 arrival, &c., and the other books can be arranged conveniently 
 to allow of a satisfactory audit. 
 
 It is unfortunate that the accounts of institutions receiving 
 State and private aid should be lacking, as most of them are, 
 
 158 
 
ACCOUNTS OF INSTITUTIONS. 1 59 
 
 in uniformity and clearness. It is hoped that the increased 
 attention which is now being given to uniform municipal ac- 
 counts will extend to public institutions, and great benefit may 
 be expected in this direction. 
 
 In some States where State aid is given to hospitals and 
 other charities an official auditor visits the recipients and 
 " audits " the accounts. It is the custom, however, for these 
 officials to simply satisfy themselves that the State's appropri- 
 ation to the particular institution has been properly expended, 
 without regard to other sources of income and expenditure, 
 and the books are, as a rule, arranged for his convenience. 
 It is needless to say that such a system does not lend itself 
 readily to the preparation of proper income and expense ac- 
 counts. On the whole it will be found advisable to continue 
 whatever forms the State examiners may require, but in addi- 
 tion there should be installed a proper system which will show 
 the actual results of operation rather than a simple cash 
 account. 
 
 The vouchers will probably be in very fair shape, as it is 
 customary to have them examined, not only by the State exam- 
 iners, but by committees of the Board of Directors, Managers, 
 or Trustees as the case may be. 
 
 (b) CHURCHES. — In many respects the audit of church 
 accounts is a peculiarly thankless task. Apart from the fact 
 that they are hardly ever submitted to the auditor in anything 
 approaching proper form, it is almost invariably the case that 
 no effective internal supervision is exercised, and frequently 
 large sums will pass through a Treasurer's hands without any 
 proper check being kept upon his dealings. 
 
 The auditor must check everything he can, and try to teach 
 his clients the elements of commercial caution ; but it is prob- 
 able that he will never feel quite happy with a church audit. 
 
 At a recent church convention it was proposed in good faith 
 by a disinterested individual that in all parishes having a cer- 
 
x6o AUDITING. 
 
 tain minimum income, the treasurer's accounts be submitted to 
 a Certified Public Accountant for audit. Unfortunately the 
 motion was voted down, but the seed has been sown, and no 
 doubt the harvest will ripen at no distant date. 
 
 (c) COLLEGES AND SCHOOLS.— These accounts call 
 for but little comment. The usual method of audit may be said 
 to consist of a " cross " between that employed in " Chari- 
 ties " and " Hotels " (q. v.), but it may be added that only a 
 detailed audit is likely to be found entirely satisfactory. 
 
 The income from tuition fees, room rents, &c., forms a 
 large aggregate as a rule, but is usually recorded by single 
 entry methods, and it therefore will bear careful checking. 
 Obviously every student's name found in the annual catalogue 
 must be accounted for, and it is sometimes found to be a good 
 plan to report to the trustees all allowances and rebates, and the 
 names of all " free " students. It may serve as a surprise to 
 the deans, but the trustees will probably appreciate the report. 
 
 While it is not unusual for colleges to have professional 
 audits, there is a wide difference in the methods adopted of 
 stating the accounts, and there is a vast field for improvement. 
 Most of the balance sheets and income and expense accounts 
 are stated in such an involved way that it is hard to gather 
 any definite information as to the actual results of the " opera- 
 tions." In view of the immense sums which are contributed 
 annually it is to be regretted that more attention is not given 
 to the accounts for the purpose, at least, of showing by com- 
 parisons and proofs that there has been a reasonable return 
 from the " capital " employed. 
 
 It is possible that college accounting methods may undergo 
 a radical improvement in the near future. The deficiencies of 
 present methods are clearly set forth in a series of articles by 
 Clarence F. Birdseye, Esq., published in The American College, 
 and commencing with October, 1909. The student will do well 
 to consult the articles " College Bookkeeping and Accounting " 
 and " Analyzing the College Business." 
 
BUILDING AND LOAN ASSOCIATIONS. l6l 
 
 IX. BUILDING AND LOAN ASSOCIATIONS. 
 
 The number of frauds — some of them of disastrous pro- 
 portions — that have occurred in the accounts of building asso- 
 ciations should suffice to make the auditor of these accounts 
 more than usually cautious. 
 
 Although so far as known all these associations require the 
 appointment of auditors annually, it has not been the custom 
 to employ Certified Public Accountants, chiefly on account of 
 the expense involved, but in view of the losses which have 
 fallen upon stockholders in the past, it would seem that by this 
 time an investor would no longer be satisfied with the amateur 
 auditor. In any event, the auditor's fee would not be more 
 than a small fraction of the association's annual income, and 
 if the matter could be put before the investors in a proper light 
 the great majority no doubt would insist on proper audits. 
 
 It will usually be found that the whole management of a 
 building association devolves upon one man, who — besides hav- 
 ing both books and cash under his entire control — turns the 
 whole of the board round his little finger. Add to this the 
 fact that the system of bookkeeping employed is often of the 
 most primitive kind, and some idea of the responsibility of the 
 auditor's position may be gained. The complexion of affairs 
 is hardly improved where there is more than one real worker 
 upon the staff ; any efficient system of internal check is all but 
 unknown (except in a few — a very few — of the best and larg- 
 est associations), while the class of men employed is usually 
 very different, and very inferior, to the class of men employed 
 in banks for work of a very similar nature. 
 
 The great majority of frauds that have been committed 
 have remained undetected by reason of the very superficial'ex- 
 amination bestowed upon the accounts by the auditors; but 
 cases have occurred in which the most detailed audit (con- 
 ducted by unskilled men truly, but none the less detailed on 
 that account) has failed to detect anything wrong. 
 
l62 AUDITING. 
 
 The authors* experience with building association accounts 
 has convinced them of the extreme importance of making the 
 audit thereof in considerable detail; of carefully verifying 
 every amount received in redemption of mortgages or paid 
 out to investing stockholders; of comparing every pass book 
 with the ledgers^ and both with the lists of balances; and of 
 testing the latter at considerable length in respect of the cal- 
 culation of interest. The income received from properties on 
 hand must be verified in every possible way ; and, where such 
 income does not seem to be a fair return upon the book-value 
 of the various properties, the latter should be either revised or 
 supported by independent valuation. 
 
 The papers relating to all mortgages, and the securities relat- 
 ing to whatever other investments there may be, must also 
 be examined by the auditor, who will do well, in addition, to 
 require the attorney to certify that such papers are all in order. 
 
 In the case of a building association of any pretensions, the 
 number of deeds and mortgage papers that call for inspection 
 will be very considerable, and accordingly a method of saving 
 unnecessary labor will be found acceptable. In all well- 
 managed concerns it will be found that the papers relating to 
 each separate mortgage are enclosed in a separate envelope, 
 upon the outside of which is endorsed a resume of its con- 
 tents. If this endorsement has once been verified and the 
 envelope has been sealed, it is thought that under normal cir- 
 cumstances no similarly detailed verification of the contents 
 is necessary at subsequent audits. At each subsequent audit all 
 fresh sets of papers must, of course, be verified in detail, as 
 must also the contents of those envelopes which for one reason 
 or another have been opened during the current period, and 
 upon which, therefore, the auditor's seal is not intact; but it 
 is thought that where the seal remains intact, and where a suffi- 
 ciently distinctive seal has been employed, any further detailed 
 investigation is unnecessary. It should be sufficient for prac- 
 tical purposes to verify the contents of a few envelopes, taken 
 at random, and also of course the contents of all envelopes 
 
BUILDING AND LOAN ASSOCIATIONS. 163 
 
 which in the opinion of" the auditor may by any possibility 
 have been tampered with. 
 
 The annual statement, printed copies of which are usually 
 distributed among the stockholders, should be carefully veri- 
 fied. Some associations include in this statement a schedule 
 of the account numbers and amounts of dues and interest 
 either in arrears or paid in advance. This is an excellent plan 
 and should be in general use. 
 
 The basis on which profits are apportioned among the differ- 
 ent series of stock should also receive attention. Various 
 plans are employed, some of which are clearly misleading. 
 E. g., by one plan the percentage of profit earned during the 
 year is calculated on the paid in dues only, ignoring the profits 
 earned during previous years on unmatured series and em- 
 ployed as part of the association's capital during the current 
 year. 
 
 This method results in showing a much larger earning rate 
 than is actually the case. An investigation of the accounts of 
 associations which claim to be earning seven and eight per cent., 
 or even more, per annum usually discloses the fact that the 
 percentage of profits is calculated on the basis mentioned above 
 and the actual rate per annum is considerably less. Of course, 
 if the association by-laws distinctly provide for such a basis of 
 apportionment, the auditor can do nothing, but if the basis is 
 not clearly defined in the by-laws the auditor should urge the 
 adoption of a plan which is both accurate and equitable. 
 
 It is more than probable that the fees attaching to his office 
 will afford the auditor no adequate remuneration for an exam- 
 ination conducted on such lines as those laid down ; but, be this 
 as it may, the auditor who — under ordinary circumstances — 
 omits any of the precautions named would be worse than fool- 
 ish. 
 
 It must also be remembered that there is usually a statutory 
 limit to the borrowing powers of a society, which must not be 
 exceeded. 
 
164 AUDITING. 
 
 X. PROFESSIONAL ACCOUNTS. 
 
 (a) LAWYERS.— It is not easy to effectively audit the 
 accounts of lawyers without devoting considerably more time 
 to the task than clients would be willing to pay for, and noth- 
 ing short of a continuous audit appears to meet the necessities 
 of the case. 
 
 Almost all lawyers use the stock forms of books sold by law 
 stationers, and these are designed rather to save time than 
 for any other purpose, and as framed it is difficult to audit 
 them. 
 
 The amount included in the balance sheet for outstanding 
 charges should, in general, be verified by comparison with the 
 draft bills of costs. Agents' accounts should, at all times, be 
 carefully considered, and it is not a bad plan to compare every 
 item of costs charged up with the copy of the bill rendered, the 
 object being to make sure that the full amount chargeable has 
 been debited, for the amount asked for may not (by reason of 
 an amount having been received on — or in — account) be al- 
 ways the amount that has to be debited. 
 
 Of recent years the increasing number of fraudulent fail- 
 ures and defalcations on the part of lawyers has drawn atten- 
 tion to the importance of proper accounts being kept by those 
 who wish to avoid any possible reflection upon their manner 
 of dealing with the moneys entrusted to them by their clients. 
 It is impossible to overstate the importance of keeping clients' 
 money entirely distinct from the moneys of the practitioner 
 himself, while it may be added that in many respects it mate- 
 rially simplifies the keeping of the accounts. Each large estate 
 should have its own separate bank account and separate books, 
 entirely independent of the books of the firm, while all other 
 moneys received in trust for clients should be paid into a 
 " Clients' Account," and a separate column provided in the 
 cash book for keeping this account distinct from the " general " 
 bank account. Not the least important advantage of keeping 
 
ARCHITECTS. 1 65 
 
 the accounts of large estates quite separate from the general 
 accounts is that the cost of keeping them, and of having 
 them audited, may then frequently be charged against the 
 estate in addition to other costs. Moreover, these accounts can 
 be submitted to the clients (or their agents) for audit without 
 disclosing any other transaction; and if they be so audited at 
 regular intervals, it is frequently unnecessary for them to be 
 also audited by the lawyers' auditors, and by this means a 
 further saving of expenses may be effected. 
 
 (b) ARCHITECTS.— The accounts of architects are, per- 
 haps, not frequently the subject of professional audit, but this 
 is a state of affairs which is always undesirable, and particu- 
 larly so in cases where two or more architects are practising 
 in partnership. 
 
 The accounts do not, as a rule, involve a particularly volu- 
 minous record, and it is therefore desirable that in all cases 
 the audit should be a detailed one. The fact that architects are 
 frequently not business men makes it important that the audi- 
 tor should take every precaution to guard his client from loss, 
 both through actual fraud and bad bookkeeping ; it is therefore 
 important for him to see that every item in the cash book is 
 properly vouched, and, so far as possible, that all fees and 
 commissions are duly accounted for. It may Be mentioned 
 here that, with regard to fees payable to an architect for super- 
 vising the erection of buildings, these fees are, as a rule, pay- 
 able by way of a commission upon the value of the work done, 
 as certified by the architect for the purpose of assessing the 
 payments to be made on account to the builder. There will al- 
 ways, at balancing time, be a considerable amount of accruing 
 fees, which, although not actually due for payment at the time, 
 constitutes an asset; a schedule of these items should be pre- 
 pared and certified by the principals for inclusion in the ac- 
 counts. Many practitioners, however, work their accounts ex- 
 clusively upon a cash basis, and the plan has much to recom- 
 mend it when professions are concerned. 
 
l66 AUDITING. 
 
 In all important undertakings in England, a " Clerk of the 
 Works " is appointed to be on the spot, for the purpose of 
 checking the material and workmanship employed by the build- 
 er. The clerk of the works is not infrequently appointed by 
 the architect, but he is invariably paid by — and is the servant 
 of — the architect's client ; if, therefore, for reasons of conveni- 
 ence, his salary has been paid by the architect, it is important to 
 see that it is subsequently recovered by him. This practice is 
 not generally followed in the United States, but it has much to 
 commend it, and in some respects, at least, the plan will no 
 doubt be adopted here ultimately. 
 
 (c) MEDICAL MEN. — ^There are so many different sys- 
 tems of bookkeeping employed by medical men that it is diffi- 
 cult to afford any useful hints as to the method of audit in the 
 space here available. It may be pointed out, however, that 
 it is not, as a rule, either necessary or expedient for the auditor 
 to go behind the debits in the patients' ledger, which, as 
 often as not, are fixed at round sums by the practitioner with- 
 out any strict reference to the number of visits. It is desirable, 
 however, that the auditor should see that some efficient system 
 of recording visits is in force, so that his client has all the 
 facts before him when assessing the amount of his charges. 
 The auditor should carefully check the credit side of the 
 patients' ledger, noting in particular any allowances that have 
 been made, and he should see that all cash credited to patients 
 has been properly accounted for. 
 
 Where payments have been made on account of patients, 
 whether for medicines, or for consultation fees, &c., it is very 
 important that the auditor should see that they are properly 
 charged up and collected in due course. Many practitioners 
 employ one or more assistants, or dispensers, who are author- 
 ized to receive money, and where this is the case it is especially 
 important that the system in use should, as far as possible, 
 follow the ordinary commercial precautions against fraud. 
 With those practitioners who supply their patients with medi- 
 cines, it is also necessary that the accounts of druggists, &c., 
 
MEDICAL MEN. 167 
 
 should be carefully checked, and an allowance will have to be 
 made at balancing time for the value of drugs in stock. 
 
 It need hardly be added that where horses and carriages or 
 automobiles are the property of the practitioner, an adequate 
 allowance must be made for depreciation, at the rate of fifteen 
 to thirty per cent, per annum. Where, however, these are 
 rented it is equally important to see that the cost of hire to 
 the date of balancing is included; or, if this has been paid in 
 advance, that a proportionate part is held over as an asset. 
 
 In concluding this portion of the work, the authors cannot 
 but feel that in spite of the very considerable space that has 
 been devoted to the consideration of the special features attach- 
 ing to the audit of different classes of accounts, the subject has 
 been only very imperfectly dealt with. When, however, it is 
 remembered that an exhaustive treatise upon the audit of any 
 one class of accounts might easily approach the dimensions of 
 the whole of the present work, it is hoped tht it will be con- 
 ceded that — ^however desirable it might have been to have 
 considered the various questions involved at further detail — 
 more could not have been reasonably expected within the 
 limits of this volume. 
 
CHAPTER VI. 
 
 FROM TRIAL BALANCE TO BALANCE 
 
 SHEET. 
 
 That which forms the most important part of every audit, 
 namely, the questions of principle involved in the preparation 
 and certification of the balance sheet and trading and profit 
 and loss accounts from the trial balance, will now be consid- 
 ered. It is especially desirable that in every audit the prin- 
 cipal should give these subjects his personal consideration, not 
 merely because of their intrinsic importance, but also from 
 questions of policy which have already been dwelt upon. 
 
 As the points now about to be discussed are the most im- 
 portant, so are they also the most debatable, accountants of 
 the highest repute being by no means agreed as to several of 
 the principles involved. On the other hand, it would seem 
 to the acute observer that much of this apparent difference is, 
 m reality, merely verbal, while perhaps more is due to the 
 inherent difficulty that exists in casting abstract principles into 
 a concrete form. It is, indeed, not unreasonable to suppose 
 that, in any particular case which might be named, there would 
 not exist among our leading practitioners any radical difference 
 of opinion as to what the profit of a company had really been ; 
 the real cause of the confusion appearing to be that, while 
 one maintains the true net profit to be deducible from the 
 profit and loss account, another maintains that the balance 
 sheet is the only reliable basis. It would seem that, if both 
 balance sheet and profit and loss account be correct, it matters 
 but little which is called the cause and which the effect. 
 
 i68 
 
1 
 
 PRINCIPLE IN VALUATION OF ASSETS. 169 
 
 Throughout the course of this chapter the endeavor will be 
 to view the various questions of principle from the broadest 
 possible standpoint. It is true that, by this means, the inherent 
 difficulty of the considerations involved will not be escaped ; but 
 it is hoped that at least the treatment will be found free from 
 catchwords and all other sources of superfluous mystification. 
 
 PRINCIPLE IN VALUATION OF ASSETS. 
 
 It being the primary object of most ordinary undertakings 
 to continue to carry on operations, it is but fair that the assets 
 enumerated in a balance sheet be valued with that end in 
 view. 
 
 Taking first the case of private traders, whether sole or 
 firms, it is not difficult to see that, inasmuch as no man can 
 reasonably hope to live forever, the business of such an one 
 is ephemeral as compared with that of a corporation. It is 
 true that the business may, and frequently does, live longer 
 than its founder ; but to do so involves a change of proprietor- 
 ship, and with it a re-valuation of assets. It will thus be seen 
 that, although there is no necessity to consider the contingency 
 of liquidation (at what are expressively known as " knock- 
 down " prices), not merely the contingency but also the 
 eventual certainty of a re-valuation must be faced. The basis 
 of such a valuation will be that known as " a going concern," 
 and it will, perhaps, be worth while to consider the meaning of 
 this phrase. So far as it possesses any definite meaning — for, 
 of necessity, the term is an elastic one — the qualification im- 
 plies " at such a value as they would stand in the books if 
 proper depreciation had been provided for " — ^the term " depre- 
 ciation " being taken to represent the amount by which the 
 value of an asset has become reduced by effluxion of time or 
 wear. A fluctuation in value caused by external circumstances 
 will, however, also require to be taken into consideration when 
 property changes hands. It is important to remember that it 
 is not really practicable to so maintain the efficiency of assets 
 that no depreciation shall ever occur. 
 
170 AUDITING. 
 
 The accounts of incorporated companies next claim atten- 
 tion. These companies, having a perpetual succession, are, 
 perhaps, entitled to be considered theoretically permanent 
 (although, in practice, they are often much shorter-lived than 
 private enterprises). 
 
 In the case of a corporation, however, it must be borne in 
 mind that, whereas a private firm is under no obligation to 
 retain the whole of its undertakings intact, the laws of our 
 various States do not allow dividends to be paid out of capital, 
 and this, of course, directly affects the question of permanency. 
 It is also of more importance in the case of corporations to 
 distinguish between what are and what are not fixed assets. 
 
 This is a point upon which even accountants might not 
 always be agreed, while the recent statement of an English 
 judge, that blast furnaces owned by a smelting company must 
 be regarded as part of its current assets, emphasizes the im- 
 portance of a system of accounts which may be as independent 
 as possible of any necessity of definitely distinguishing between 
 fixed assets and current assets. Incidentally it may be men- 
 tioned that the terms most commonly used by lawyers, "fixed 
 capital'* and "floating (or circulating) capital," are clearly 
 incorrect. The capital of a company is that which has been 
 contributed for the purpose of enabling it to carry out the 
 "objects" for which it was formed: it may be possible to 
 say what assets have been acquired with that capital, but even 
 then the assets and the capital are clearly separate entities. 
 
 Then, too, the profit and loss account must obviously be 
 framed so as to show the divisible profits, and the question thus 
 remains to be considered how profits and losses that do not 
 affect revenue — or, to put it another way, capitalized apprecia- 
 tions and depreciations — ^are to be treated. As a matter of 
 bookkeeping, it is clear that two courses are open. Either the 
 capitalized items must be disregarded in the balance sheet by 
 mis-stating the value of an asset or a liability, or some account 
 must be raised to record the profit or loss that is not taken 
 
VALUATION OF FIXED ASSETS. I71 
 
 to revenue. If the latter course be adopted, the accounts 
 should be sufficiently clear to explain what has been done: in 
 the former case, if the assets are over-stated it is also necessary 
 that mention should be made of the fact, as the assets appear- 
 ing in the balance sheet are prima facie assumed to be stated 
 at a reasonable valuation. If, however, a profit has been made 
 which is not available for distribution, it is often considered 
 unnecessary to modify the accounts so as to disclose the cir- 
 cumstance. This point, however, will be discussed more fully 
 under the heading of Secret Reserves. As a rule, the amount 
 at which all assets are stated in the balance sheet should be 
 regulated — at all events to some extent — by the value of such 
 assets. 
 
 In practice, assets may generally be divided into two classes : 
 (i) Those with which business is carried on, and (2) those 
 in which business is carried on; the former may be named 
 fixed assets, the latter current assets. 
 
 VALUATION OF FIXED ASSETS. 
 
 The points to be borne in mind here are that wasting may 
 reduce their value, and that fluctuation may increase or re- 
 duce their value. So far as wasting is concerned, inasmuch 
 as it has directly contributed to the profit earned, it is clearly 
 an expense with which profit may be fairly charged. The 
 only question is "How ?" which will be considered in full under 
 the head of DErRECiAxiON. On the other hand, fluctuation is 
 something altogether apart from trading profit and loss, being 
 merely the accidental variation (owing to external causes) in 
 the value of certain property owned, but not traded in : to carry 
 the amount of such variation to profit and loss account would 
 be to disturb and obscure the results of actual trading, and so 
 render comparison difficult, if not impossible. Moreover, as 
 has already been stated, the profit and loss account should be 
 so framed as to show a balance which actually exists and is 
 legally available for dividends. On no account, therefore, should 
 the results of fluctuations affect the profit and loss account. 
 
\*J2 AUDITING. 
 
 Whether or not it is desirable that such fluctuations should be 
 revealed by the accounts at all will be fully considered under 
 the head of Secret Reserves. 
 
 It follows that the usual rule for stating the values of fixed 
 assets in the balance sheet would be : Cost, less such an amount 
 as is chargeable to profit and loss for accrued depreciation or 
 exhaustion due to the operations of the business for which 
 they have been used. 
 
 The actual cost of acquiring fixed assets (e. g., stamps, con- 
 veyances, miscellaneous fees, &c.) is usually capitalized. This 
 is not unreasonable, as such expenses are clearly an integral 
 part of the cost price of such assets. 
 
 VALUATION OF CURRENT ASSETS. 
 
 It being the essential feature of these assets that the whole 
 aim of the undertaking is to convert — or be able to convert — 
 them into cash at the earliest possible opportunity, the ele- 
 ment of immediate realization is an important factor in their 
 value. The only point to remember is that, while a manu- 
 facturing profit is earned only when the manufacture is com- 
 pleted, a trading profit is only made when the sale is effected. 
 Neither profit must be anticipated, but it does not appear to 
 be invariably essential that manufacturing profit should be 
 held over until a sale has been effected. It may be added that, 
 where a manufacture consists of several distinct processes, and 
 separate accounts are kept of the manufacturing profit earned 
 under each process, there seems to be no great objection to 
 each process being considered as a separate manufacture, so 
 long, of course, as the goods are readily saleable at the usual 
 trading price. 
 
 It must not be lost sight of, however, that these are book 
 profits only, and in this connection it is well to bear in mind 
 the decision in the American Malting case (see Appendix C), 
 where the court said : "To calculate months in advance on the 
 result of the future transactions, and on such calculations to 
 
RESPONSIBILITY FOR VALUES. 173 
 
 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." 
 
 With regard to what is a trading profit, a most ingenious 
 argument was once advanced by counsel who subsequently 
 became Lord Chief Justice of England, who contended that 
 the most scientifically correct method of valuing a stock-in- 
 trade was to take it at selling prices, less the average trade 
 profit; it being suggested that any profit realized in excess of 
 the average was in reality a profit on buying, not on selling; 
 and any profit realized less than the average, a corresponding 
 loss on buying. The argument passed muster at the time, 
 appears to be plausible, and indicates a system that would 
 doubtless prove very convenient in practice; but, unless the 
 profit on different articles was very uniform, it would hardly 
 be a safe one to adopt. 
 
 RESPONSIBILITY FOR VALUES. 
 
 A much-debated point is the extent of responsibility in- 
 curred by the auditor in relation to the values set upon the 
 assets of a company in the published accounts of the directors. 
 The opinion arrived at in the English Court of Appeal in The 
 London and General Bank case upon this most important point 
 appears to be that the auditor incurs no responsibility what- 
 ever so long as, after exercising reasonable care and diligence, 
 he has honestly arrived at the opinion that the accounts are 
 correct. It will be seen, however, that this decision in no way 
 commits itself to the expression of any particular opinion as 
 to the mode of valuation to be adopted. In this latter respect 
 it is interesting to note a recommendation by a Committee of 
 the Englisli Board of Trade that the balance sheet of every 
 company shall show {inter alia) ''whether the assets are taken 
 at cost price, or by valuation, or on what other basis 
 they are stated, and whether any, and if so what, amount or 
 percentage, has been written off, and what other provision, if 
 
174 AUDITING. 
 
 any, has been made for depreciation." This recommendation 
 is a very excellent practice to follow, and has for many years 
 past been adopted by some leading accountants. 
 
 The question of auditorial responsibility is fully considered 
 in Chapter X. 
 
 VERIFYING EXISTENCE OF ASSETS. 
 
 Having settled a basis of valuation, the next thing would 
 appear to be to obtain evidence of the existence of the assets 
 enumerated in the balance sheet. 
 
 The evidence necessary in each class of assets would be as 
 follows : — 
 
 LAND AND BUILDINGS.— The title deeds of the prop- 
 erty should be and sometimes are sufficient evidence, but it is 
 to be regretted that title deeds are not always delivered/ in 
 real estate transfers. Where there is any doubt upon this 
 point the official county records should be consulted. Should 
 the property be mortgaged the title deeds may possibly be in 
 the possession of the mortgagee (although this practice does 
 not, so far as is known, exist in the United States), and in such 
 a case an acknowledgment of this fact should be obtained 
 from him or his attorney, together with a statement of the 
 amount due. Conversely, the verification of an asset repre- 
 sented by a mortgage would be the production of the title 
 deeds and the mortgage papers. In the case of a second mort- 
 gage, the title deeds may, as stated above, be in the custody 
 of the first mortgagee, and here the auditor will require to 
 satisfy himself that such first mortgagee has received proper 
 notice of the existence of a second charge. 
 
 STOCKl-IN-TRADE,— The original stock sheets, signed 
 by the stock-taker, calculator, checker, and manager. Most 
 accountants would, in addition, consider it essential that the 
 extensions and additions be re-checked by one of their own 
 
VERIFYING EXISTENCE OF ASSETS. 1 75 
 
 Staff, and, further, require to be satisfied as to the soundness 
 of the principle of valuation adopted. 
 
 The auditor's liability in connection with the valuation 
 placed in the accounts upon the amount of stock-in-trade has 
 been considered in several English cases, which are more fully 
 dealt with in Chapter X. It may be pointed out at this -stage, 
 however, that the general effect of these decisions seems to 
 be that, where the circumstances of the case are not such as 
 to arouse the suspicions of an ordinarily capable and diligent 
 auditor, he is justified in relying upon the valuation of stock- 
 in-trade which has been submitted to him and certified to him 
 by the manager. It is altogether likely that American de- 
 cisions will follow this general rule. In one English case, 
 the auditors took the precaution to state in their certificate that 
 they accepted no responsibility for the valuation of the stock 
 "which had been certified to them by the managing director," 
 and as a matter of prudence it would no doubt be as well for 
 the auditors to always add this qualification. It may be added, 
 however, that such a qualification as this would certainly not 
 appear to save the auditor, where he had reasonable grounds 
 for doubting the valuation itself ; whenever his suspicions have 
 been aroused, it is absolutely necessary that the auditor should 
 sift the matter to the bottom. 
 
 INVESTMENTS IN STOCKS AND BONDS.— The 
 auditor will require to have produced to him the scrip, certi- 
 ficate, bond, or other document, proving that the ownership 
 of the investment in question is vested in his clients; and he 
 should also require production of the broker's bill, with a view 
 to verifying the cost price thereof. 
 
 In the case of securities deposited under reorganization 
 plans, &c., it becomes necessary to secure a certificate that, 
 upon the date of the accounts, such stock or bonds stood 
 registered in the names of the auditor's clients. Of course, 
 if a negotiable receipt has been given, the receipt itself must 
 be produced, but if it is a mere memorandum receipt, the date 
 
176 AUDITING. 
 
 must be carefully noted, as it may be that in the event of a 
 subsequent sale it does not have to be surrendered. 
 
 Funds deposited as security should be verified by an in- 
 dependent confirmation addressed to the auditor. 
 
 Investments on behalf of a company sometimes stand in the 
 names of individuals, who hold them in trust for the company. 
 A proper declaration of trust, duly executed, should in all 
 cases be produced to the auditor. 
 
 It may be added that if, when examined, the securities are 
 securely sealed up in packages, it is not necessary at subse- 
 quent audits to re-examine them in detail, if the seals remain 
 unbroken. 
 
 BOOK DEBTS.— The extent to which it is practicable to 
 verify the existence of book debts depends largely upon cir- 
 cumsstances. Unless ^they are very numerous, the auditor 
 should satisfy himself that the total appearing in the balance 
 sheet agrees with the ledger balances, and that proper pro- 
 vision has been made for cash discounts and bad debts. With 
 regard to the discounts, it is customary to deduct the full cash 
 discount upon all ledger balances. It is questionable whether 
 this is really necessary, although it is clearly a prudent course 
 to adopt; but where cash discounts are deducted from the 
 trade creditors they must, of course, be also deducted from the 
 trade debtors. With regard to bad debts, the auditor should 
 obtain a certificate of at least one responsible person ac- 
 quainted with the facts, to the effect that in his judgment due 
 provision has been made for any loss that is reasonably likely 
 to occur. It is naturally impossible for the auditor to verify 
 this provision in detail, but he can at least take note of overdue 
 and "dead" accounts, and see whether such provision as ap- 
 pears to him to be adequate has been made in respect of these. 
 As the number of book debts increases it becomes imprac- 
 ticable for the auditor to verify the ledger balances in de- 
 tail; it has already been explained, however, that, where an 
 
OP THE 
 
 UNIVERSITY/ 
 
 OF 
 
 VERIFYING EXISTENCE OF ASSETS. I77 
 
 adequate system of internal check exists, the verification of 
 details can to a large extent be superseded by tests. For all 
 practical purposes it is probably as efficacious to check the 
 balances of, say, one or two ledgers out of twenty as it would 
 be to check the whole. 
 
 PLANT, MACHINERY, FIXTURES, &c.— There is, 
 perhaps, too much tendency to assume the correctness of the 
 "book" figures with regard to these assets, provided reason- 
 able provision has been made for depreciation : it is important, 
 however, to make careful inquiries into all additions, with a 
 view to seeing that they represent bona fide capital expendi- 
 ture that may properly be added to the value of the asset, and, 
 further, to make particular inquiry as to the sale of worn-out 
 or discarded assets. It not infrequently happens that such 
 sales are erroneously credited to sales account, with the re- 
 sult that the latter is overstated, and that due inquiry into the 
 loss in respect of such sales is overlooked. The amount real- 
 ized on the sale of fixed assets should, of course, be credited 
 to the real account standing in the books in respect of this 
 asset; but the realization affords an opportunity of inquiring 
 into the value at which these assets stood in the books, and 
 should they have been sold at a loss, that loss must in all cases 
 be written off, as otherwise an item will be brought into the 
 balance sheet as an asset which represents assets no longer in 
 existence. 
 
 Occasionally, as has already been stated, a re-valuation will 
 be made for the purpose of assessing, or of checking, the pro- 
 vision for depreciation ; but in any case a certificate should be 
 forthcoming, to the effect that the various items included in 
 the last inventory are still the property of the undertaking. 
 
 BANK BALANCE.— Bank pass book verified either by 
 personal visit to bank or by banker's certificate of balance. 
 
 In practice it will rarely happen that the balance recorded 
 in the pass book exactly agrees with the balance in the stub. 
 
178 AUDITING. 
 
 and a Reconciliation Account has therefore to be prepared 
 upon the following lines : — 
 
 Balance as per stub 
 
 
 
 $6,033.08 
 
 Add, Cheques unpaid, viz. : — 
 
 
 
 
 Dec. 16, Jones 
 
 $140. 
 
 ,20 
 
 
 " 21, Smith 
 
 89 
 
 .29 
 
 
 '* 29, Brown 
 
 362 
 
 . 12 
 
 591.61 
 
 Less, Deposits, not credited, viz. : — 
 
 $6,624.69 
 
 Dec. 30, Collection 
 
 $600 
 
 .00 
 
 
 " 31, Sundries 
 
 212 
 
 •50 
 
 812.50 
 
 Balance as per pass book, Dec. 29 
 
 
 
 $5,812.19 
 
 Where practicable it is desirable that the auditor should 
 see that the various adjustments which constitute the differ- 
 ence between the pass book balance and the cash book bal- 
 ance are rectified in due course by subsequent entries in the 
 pass book. 
 
 CASH IN HAND. — Verified by production of actual cash 
 balance, or, if the date of the accounts has gone by, by ex- 
 haustively verifying the bank account up to date of audit and 
 then counting the balance of cash in hand. In cases where 
 there is more than one cash drawer, all must be produced to 
 the auditor and verified by him simultaneously ; and, wherever 
 practicable, it is preferable that all cash in hand should be 
 paid into the bank on the afternoon of the date of the balance 
 sheet, in which case, of course, no occasion arises for the audi- 
 tor to verify the balance of cash in hand, for the all-sufficient 
 reason that there is none. In the case of cash at distant 
 branches, a satisfactory certificate that the balance exists may 
 generally be accepted in lieu of actual counting. In contin- 
 uous audits all cash balances should be frequently verified, say,, 
 at least once a month. 
 
 Whatever may be said in general terms, however, as to the 
 desirability of an auditor verifying balances of cash in hand, it 
 is clear that it would be only prudent to regard the existence 
 
VERIFYING EXISTENCE OF ASSETS. I79 
 
 of a large floating balance as prima facie a matter for sus- 
 picion, and therefore a matter calling for careful inquiry. 
 
 BILLS RECEIVABLE.— Verified by production of the 
 actual notes themselves. Care should be taken to see that no 
 overdue notes are included in a balance sheet under the head- 
 ing of "Bills Receivable"; that due provision is made for dis- 
 count where necessary ; and that all anticipated loss by way of 
 bad debts in respect of bills receivable — both in hand and under 
 discount — is included in the accounts. 
 
 WORK IN PROGRESS.— This should be certified by the 
 factory manager, the chief cost clerk and the manager. In 
 the case of readily saleable goods manufactured in quantities, 
 the usual rule is to value work in progress at cost — the term 
 " cost " being defined as the cost shown by the cost accounts, 
 which, as a rule, includes of course, a certain amount of 
 " loading " for factory and overhead expenses. When the 
 work of any one manufacturing department has been com- 
 pleted, there seems no reason why that department should not 
 be entitled to take full credit for the entire cost of the work 
 performed, and in such case care must be taken to see that 
 the stock of unfinished goods represents items that will be 
 finished and sold at the -normal rate in due course. 
 
 When work in progress consists of single articles — as, for 
 example, in the case of contract work — its valuation becomes 
 both a more difficult and a more serious matter, partly because 
 past experience is no longer available as a guide and partly 
 on account of the magnitude of the figures involved. In the 
 case of contracts extending over a number of years, it is clear 
 that annual accounts can only approximately estimate the true 
 net profit earned in each year. In the case of manufacturing 
 firms it is for the partners to mutually agree on a basis for 
 the valuation of work in progress, but the safest course would 
 appear to be not to take credit for any profit on uncompleted 
 work. In the case of companies, however, which require to 
 produce annual accounts, and to pay annual dividends, this 
 course is hardly practicable. A company is not obliged to 
 
l8o AUDITING. 
 
 wait until profits have been actually realized in cash before 
 crediting anything to revenue. There is, therefore no illegality 
 in taking credit for estimated profit on work in progress ; but, 
 in view of the extreme difficulty of arriving at an accurate 
 estimate, and the extreme uncertainty that often prevails as to 
 what the ultimate result will be, it is clear that only very con- 
 servative estimates can be safely indulged in. Here, again, 
 the principle laid down in the American Malting case should be 
 emphasized, and care taken to keep within the rule that divi- 
 dends must not be paid out of anticipated profits. Cost ac- 
 counts should, of course, in all cases be available to show the 
 actual cost of each contract up to the date of the accounts. If 
 the work has so far proceeded that it is possible for the Man- 
 ager to certify an outside figure, that will not be exceeded, for 
 the cost of completing the work, it would not be unreasonable 
 to apportion the profit between the two periods according to 
 the expenditure incurred in each, providing, of course, ample 
 reserves in all doubtful cases. In connection with work less 
 far advanced it seems more questionable whether anything in 
 excess of manufacturing cost can be safely treated as an asset. 
 In this connection, however, it may be borne in mind that all 
 large contracts are readily capable of division into sections, 
 the cost of each of which has already been estimated in ad- 
 vance. A comparison of the cost accounts in respect of the 
 work performed with the original estimates will thus enable 
 a fairly reliable view to be obtained of the general position 
 of the contract, more especially, of course, in those cases 
 where the speculative part of the work is in the earlier stages. 
 
 In the majority of cases, where contracts extend over a 
 lengthy period, it is usual for payments to be made on account, 
 upon the certificate of the architect, or engineer, as the case 
 may be. The amount of such payments would be from 
 seventy-five per cent, to ninety per cent, of the value of the 
 work actually performed, and it is clear, therefore, that the 
 excess of money received over expenditure incurred may safely 
 be regarded as the minimum profit earned up to date. 
 
SALES FOR FUTURE DELIVERY. l8l 
 
 SALES FOR FUTURE DELIVERY. 
 
 The question has arisen more than once as to whether a 
 company is entitled to take credit for profit expected to be 
 earned in respect of orders booked for future delivery. The 
 point is naturally one of considerable importance in some in- 
 dustries, as, for example, with automobile dealers, who fre- 
 quently book orders for future delivery, and also with regard 
 to coal merchants, cotton merchants, and the like, who enter 
 into contracts to supply their goods for some time in advance. 
 The general rule which has been laid down in this work is, 
 it is thought, unquestionably the safe one to in all cases adhere 
 to, namely, that the profit on the sale of goods should be taken 
 credit for at the time when the sale actually occurs ; and where 
 it is an essential portion of the contract of sale that the goods 
 shall not be delivered until some future date, then the actual 
 sale would certainly appear to be at the date of delivery, and 
 not at the date of booking the order. Like many other mat- 
 ters, however, this is, perhaps, as much a matter of degree as 
 a question of principle, and where orders have been actually 
 booked so that a valid contract exists upon which the customer 
 could be sued for payment, the mere fact that the goods have 
 not been delivered might well be overlooked and the profit 
 taken credit for in the period when the order was booked; 
 this, however, could certainly only be applied where the goods 
 were actually in stock, and not when they were still unmade. 
 Even where it is decided that credit may reasonably be taken 
 for such future sales, it is important to remember that when 
 payment is delayed a reasonable rebate should be made for loss 
 of interest, and under no circumstances could any harm be done 
 by postponing the whole of the profit until the period when 
 the goods were actually delivered. 
 
 The American Malting decision has been handed down since 
 the above was written, and in view of the opinions there ex- 
 pressed it may be assumed that, from a legal point of view, 
 considerable risk is taken whenever anticipated profits are car- 
 ried into the books. 
 
1 82 AUDITING. 
 
 OUTSTANDING ASSETS. 
 
 The point that now claims attention is the question as to 
 how far it is the auditor's duty to consider the propriety of 
 including certain items among the assets that relate to trans- 
 actions which at the date of the balance sheet are uncom- 
 pleted. 
 
 It has been said that no profits should be taken into account 
 that have not been actually received in cash, unless there is 
 every reasonable likelihood that they will eventually be so re- 
 ceived. This, of course, means that a sufficient provision must 
 always be made for bad and doubtful debts, but it means some- 
 thing else besides. With some classes of transactions it is quite 
 possible — even though the transactions themselves are not ac- 
 tually completed — to say with reasonable certainty what profit 
 will eventually result ; and, in these cases, it would appear that 
 the most correct course would be to apportion the profit so 
 that each period took credit for the profit arising from its 
 portion of the transaction. Thus, in the absence of evidence 
 that would lead one to a contrary supposition, the profit arising 
 from sales may safely be credited to the period in which the 
 sales occur, and the profit arising from manufacture similarly 
 belongs to the period in which the articles are manufactured. 
 The income arising from first-class investments (e. g., interest 
 on government or railway bonds, or interest on mortgages, or 
 rents) may likewise be said to accumulate from day to day. 
 With regard to the latter, however, the question of convenience 
 intervenes; and, unless the amount involved is of sufficient 
 magnitude to render absolute accuracy desirable, it would prob- 
 ably be considered sufficient if only those sums actually due 
 were considered as assets — the amount accruing being taken as 
 a set-off against liabilities of a similar nature. Turning now 
 to another class of transactions, the final result of which can 
 only be approximately determined, no accruing profit can, with 
 safety, be taken credit for upon the uncompleted voyages of 
 ships, or uncompleted contracts (except so far as previously 
 indicated), nor for accruing dividends other than on guar- 
 
OUTSTANDING LIABILITIES. 1 83 
 
 anteed stock, nor (under normal circumstances) for uncom- 
 pleted consignments; the eventual result of all these transac- 
 tions being generally of so speculative a nature that it is not 
 safe to do more than carry forward whatever expenses may 
 have been incurred. 
 
 Sometimes, for the purpose of providing a secret reserve, 
 assets are intentionally understated; except when done advis- 
 edly, however, there is but little fear of the auditor finding 
 the assets understated. Occasionally defalcations have, by this 
 means, been made to fall upon revenue (generally by writing 
 off good debts as bad), but the attention thereby attracted 
 to the existence of a leakage prevents such a course from being 
 at all common. 
 
 OUTSTANDING LIABILITIES. 
 
 For a similar reason, there is but little fear of liabilities 
 being overstated; how far it is necessary for the auditor to 
 take special steps to guard against their under-statement is 
 the matter that now claims attention. While the practice of 
 " dating-forward " invoices is so common, there will always 
 be some danger of goods being included in stock without hav- 
 ing been passed to the credit of the purchase ledger. " Stock- 
 taking " statements might help to discover the omission, but 
 they also might not. It will be a great help, therefore, if the 
 services of the stock-keeper are requisitioned, and he be made 
 responsible for the production of invoices for all goods that 
 have passed through his hands. The purchases for the next 
 few weeks after the date of balancing may also be usefully 
 scrutinized. 
 
 All expense accounts (e. g., wages, salaries, &c.) should 
 be carefully examined, to make sure — as far as possible — that 
 no outstanding liabilities have been omitted. 
 
 It is a common practice to set off accruing rent, interest, 
 &c., against insurance, taxes, and other items paid in advance, 
 .and to keep a fixed sum suspended to meet whatever difference 
 
184 AUDITING. 
 
 there may be. The plan certainly possesses the advantage of 
 convenience, combined with practical accuracy; but the suffi- 
 ciency of the fixed sum should be verified at every audit, as the 
 circumstances may easily vary from time to time. 
 
 The auditor's own fee is a matter in which he will naturally 
 be interested. There is no uniform practice, however, some 
 preferring to debit the accounts of the period under audit with 
 the fee, and some the period in which the audit is conducted. 
 The latter course is naturally the most convenient where the 
 amount chargeable depends upon the time occupied, but the 
 former method is probably the more correct. 
 
 The minute book may, and frequently does, disclose the 
 existence of liabiHties — both certain and contingent — that are 
 not recorded in the books of account, and an audit cannot be 
 called complete unless this book is carefully scanned. A case 
 in point occurred in connection w^th the audit of a street rail- 
 way company where the minutes stated that the President was 
 to receive his salary in common stock at par. As a matter of 
 fact, he had been drawing it in cash, but as the stock was worth 
 only a few dollars a share the variation made a material differ- 
 ence to the company. 
 
 CONTINGENT LIABILITIES must not be forgotten. 
 Bills discounted are, perhaps, the most usual source of contin- 
 gent liability; a reserve therefor rarely appears in a balance 
 sheet, however, although frequent losses occur through the 
 failure of makers to pay their notes. The auditor should, 
 therefore, scrutinize the notes under discount, and particular 
 attention should be paid to those which have been renewed 
 one or more times without any reduction being made in the 
 amount. Disputed claims must not be lost sight of ; and 
 claims for dilapidations upon premises, the lease of which has 
 almost expired, should be anticipated, so that the whole loss 
 may not fall upon one year. 
 
 It is sometimes claimed that arrears of cumulative preferred 
 dividends also come under this heading, but this can hardly 
 
HIRE-PURCHASE AGREEMENTS. 185 
 
 be admitted. Such dividends are under no circumstances a 
 liability — definite or contingent — until declared, and any arrears 
 are only of interest as to future distributions of profits between 
 preferred and common stockholders. Hence, a simple foot 
 note on the balance sheet of the amount in arrears would 
 cover the case. 
 
 HIRE-PURCHASE AGREEMENTS. 
 
 This subject is of sufficient importance to merit a separate 
 heading. Detailed treatment of the subject may be found in 
 the author's " Advanced Accounting," which deals fully with 
 those advanced problems that are questions of account, as 
 such, rather than questions of auditing. 
 
 From the auditor's point of view, the main point of im- 
 portance is to see that a correct system of dealing with the 
 transactions is adopted which charges a sufficient proportion 
 of the instalments against the revenue of each year, so as to 
 avoid the proportion which is being capitalized appearing at 
 too high a figure. 
 
 There is some difference of opinion as to the proper method 
 of treating railroad car trust bonds which represent a species 
 of hire-purchase agreement. One opinion is that entries per- 
 taining to car trusts need only be made in the books of the 
 lessee-purchaser as payments provided for in the agreement 
 are made, and consequently no liability need be shown in the 
 balance sheet for the instalments not yet due. As a matter of 
 fact this course is followed by some of the largest railroads in 
 the United States. The President's report of one of them for 
 1908 shows that at December 31 of that year the Company had 
 outstanding for account of itself and its sub-companies car- 
 trust certificates aggregating some $61,000,000.00, which, with 
 the exception of a comparatively small amount (presumably 
 the proportion of the next instalment accrued to December 31) 
 do not appear in the balance sheet at all. 
 
1 86 AUDITING. 
 
 It is submitted that this is a very unsatisfactory method of 
 treating such transactions. Certainly these car-trust certificates 
 are just as real a liability as any of the mortgage bonds, and 
 usually they run for much shorter periods. It may be con- 
 tended that the equipment, which is the subject of these certifi- 
 cates, is not the property of the railroad company and will not 
 be until fully paid for, and hence it would not be proper to 
 include it among the assets of the company. This objection 
 is hardly a logical one, as it would be just as valid against 
 including assets which are specifically pledged, or conveyed in 
 trust, to secure an issue of mortgage bonds, and it is hardly 
 thought that any one would argue for excluding mortgage 
 bonds and the property securing the same from the balance 
 sheet. The best method of treating such obligations from an 
 accounting standpoint is to enter them as a liability when con- 
 tracted, the equipment covered thereby being treated as an 
 asset ; if it is desired, a separate account can be kept for such 
 equipment as well as showing it separately in the balance sheet. 
 
 Cases frequently occur in which furniture, musical instru- 
 ments, books, &c., are sold under hire-purchase agreements, 
 and in these cases the rate of interest charged is almost invari- 
 ably high, usually varying from ten per cent, to thirty per 
 cent, per annum on the unpaid instalments. For present pur- 
 poses it will be sufficient to point out that firms transacting 
 business of this description in the nature of things deal with a 
 very large number of items, each of comparatively small 
 amount. It consequently follows (i) that it is impracticable 
 to keep such intricate accounts as would be necessary to accu- 
 rately apportion every instalment received between interest and 
 capital; (2) that such scrupulous exactness is unnecessary in 
 practice, as the volume of the transactions is sufficient to en- 
 able an average to produce fairly reliable results. The best 
 principle, therefore, is to regard the difference between the 
 cash price and the credit price of the articles sold as interest 
 charged, and having ascertained the average rate of interest 
 to apportion it between the years over which the currency of 
 
DEPRECIATION. 1 8/ 
 
 these agreements runs. By this means practically accurate 
 results can be obtained with a very small expenditure of labor. 
 The apportionment should, however, be in favor of the later 
 years, so as to err upon the side of caution, and it may be added 
 that the provision for bad debts will here require special con- 
 sideration. 
 
 DEPRECIATION. 
 
 This is a question of the utmost importance, and it is there- 
 fore desirable that the matter should be considered in detail. 
 Before doing so, however, it may be well to remind the reader 
 of the distinction between depreciation and fluctuation. De- 
 preciation is a shrinkage in value which, in the ordinary course 
 of events, may be expected to take place, as being a necessary 
 consequence of the possession and use of the asset; it conse- 
 quently is a charge against revenue. Fluctuation, on the other 
 hand, arises from causes entirely outside the scope of the busi- 
 ness, and may affect the value of its assets either adversely or 
 favorably. The operations of fluctuation cannot, however, 
 affect true trading profits either one way or the other, and, as 
 a rule, therefore, it is best to disregard it in the accounts. A 
 favorable fluctuation in the value of fixed assets seems the 
 proper subject for a secret reserve. A favorable fluctuation in 
 current assets is temporarily a secret reserve, which will be in- 
 cluded in the trading profits when those assets are realized. 
 An unfavorable fluctuation in current assets may be disre- 
 garded so long as there is every reason to believe that it is of 
 a temporary character, but if it seems likely that conditions will 
 remain unfavorable until the time comes for realizing those 
 assets, then the loss should be anticipated; or, to speak more 
 accurately, it should be charged against the period in which it 
 actually occurred, rather than against the period in which it 
 was realized. An unfavorable fluctuation in fixed assets need 
 not, under normal circumstances, be charged against revenue 
 before declaring dividends out of current profits. It may 
 therefore, be disregarded in the accounts; but, in order that 
 the true position of affairs may be placed before the stock- 
 
1 88 AUDITING. 
 
 holders, it is desirable that either a note should be appended to 
 the balance sheet, drawing attention to the shrinkage in value, 
 or a paragraph to that effect be inserted in the auditor's report. 
 
 In connection with this distinction between depreciation and 
 fluctuation it should be added that in some quarters the prac- 
 tice has been strongly advocated of occasionally having fixed 
 assets re-valued as a check upon the annual provision for de- 
 preciation, and appraisal companies which make a specialty of 
 valuations, particularly for the purpose of testing the adequacy 
 of insurance carried, have met with considerable success in 
 recent years. There is much to be said in favor of re-valua- 
 tions, in that it is always desirable to take every reasonable 
 opportunity of testing the sufficiency of estimated provisions; 
 but, on the other hand, it must be borne in mind that a re- 
 valuation can hardly fail to take into consideration fluctuation 
 as well as depreciation, and consequently may introduce into 
 the accounts a disturbing element, obscuring the real result of 
 the trading. It ought not, however, to be impossible to check 
 the provision made for depreciation by means of re-valuation 
 without introducing these complications. 
 
 In order to make it quite clear what is intended, it may be 
 pointed out that a machine costing (say) $500, and a further 
 $100 to repair, may answer its purpose for (say) six years, 
 and then have to be sold as second-hand for $75. This leaves 
 a cost of $525 to be written off over the six years' life. Under 
 the circumstances it might be reasonable to charge this at the 
 rate of $87.50 per annum (equals 14^4 per cent.), or the effi- 
 ciency of the machine may be so high when new that the rea- 
 sonable procedure would be to charge 27^ per cent, on the 
 reducing balance, which would reduce the $600 to (approxi- 
 mately) $75 at the end of the sixth year; but, whichever 
 method be adopted, it is more than probable that the balance 
 shown on the machinery account at the end of the first, second, 
 third, fourth and fifth years would not agree with the valuation 
 made by an expert at those times. The reason for this is that 
 the expert would take into consideration the value of the ma- 
 
DEPRECIATION. 
 
 189 
 
 chine in the market, whereas the manufacturer is only con- 
 cerned with its value to him. Moreover, the market value may 
 be influenced by other considerations besides the actual condi- 
 tion and state of newness of the article in question. The 
 existence of new and better types is, of course, a risk that 
 ought to be provided for by depreciation, but fluctuations in 
 the value caused by an increase or reduction in the cost of pro- 
 ducing similar machines in no way affect the cost of the orig- 
 inal machine that has to be written off over a term of years. 
 
 Comparative Table. 
 
 
 Reduced by 
 on Cost 
 
 Reduced by 
 per annum 
 
 Re- valued 
 (say) 
 
 Cost (including Erection) 
 Depreciation i 
 
 $600. 00 
 87.50 
 
 600. 00 
 165 .00 
 
 $600.00 
 200.00 
 
 " 2 . . . . 
 
 512.50 
 87.50 
 
 435-00 
 119 .60 
 
 400.00 
 75.00 
 
 3 • •• 
 
 425 .00 
 87-50 
 
 315-40 
 86.75 
 
 325.00 
 75.00 
 
 4 .. .. 
 
 337-50 
 87-50 
 
 228.65 
 62 .90 
 
 250.00 
 50.00 
 
 5 • •■ 
 
 250. 00 
 8750 
 
 165-75 
 45.60 
 
 200.00 
 50.00 
 
 6 . . . . 
 
 T62.50 
 87-50 
 
 120.15 
 3305 
 
 150.00 
 75.00 
 
 Estiated Break-up Value 
 
 $75-00 
 
 *$87.io 
 
 $75-00 
 
 With these preliminary remarks we may proceed to the 
 special features in connection with the depreciation of various 
 classes of assets to be considered. 
 
 LAND may quickly be dismissed — it suffers no depreciation. 
 Fencing, and other similar works, would, of course, depreciate, 
 but the item would not usually be of sufficient importance to 
 require consideration. If, however, it became a large item, 
 it should be treated separately as plant (q. v.). 
 
 ♦The estimate is (it will be seen) too large. It is, however, no serious matter to 
 charge the whole of the deficit — $12.10 — against the sixth year's profits, increasing 
 that charge to $45.15. 
 
190 AUDITING. 
 
 BUILDINGS depreciate to an extent varying greatly ac- 
 cording to the quality of the workmanship and materials em- 
 ployed in their erection. The amount of the ledger account 
 will frequently include land, which, as we have seen, does not 
 depreciate; the depreciation will, therefore, be confined to the 
 building itself. If the instalment plan be adopted, from one 
 and one-fourth to three (or even five) per cent, of the original 
 amount may be deducted annually; if the annuity method be 
 used a fixed sum debited to revenue, which, after crediting in- 
 terest, will write the asset down to zero in from, say, fifty to 
 one hundred and fifty years ; or, if the sinking fund system be 
 preferred, such a sum may be set aside as will accumulate to 
 the cost of the building in that time. In each case all repairs will 
 have to be borne by revenue, in addition to the depreciation. 
 With regard to the relative merits of the instalment, annuity, 
 and sinking fund methods, the latter two are distinctly prefer- 
 able ; although — on account of its greater simplicity — the instal- 
 ment method is frequently used for short leases. The annuity 
 system differs from the sinking fund in that the instalments 
 are not invested; the (net) amount of each successive instal- 
 ment therefore requires to be increased to compensate for loss 
 of interest on the previous uninvested instalments. 
 
 The student who is not familiar with the best methods of 
 calculating annuities, &c., is referred to a very good treatise on 
 this and other subjects, entitled " The Accountancy of Invest- 
 ment," by Charles E. Sprague, Ph.D., C.P.A. 
 
 GOODWILL does not " depreciate.'' On the other hand, 
 it will generally be conceded that it is liable to fluctuations, 
 both continual and extreme ; as, however, no one would think 
 of calling its omission from a balance sheet a secret reserve, 
 it will probably be most convenient to deal with the question 
 of goodwill under the present heading. As a matter of fact, 
 goodwill is not written down because its value is supposed 
 to have become reduced — such a course is all but unknown. 
 The amount at which goodwill is stated in a balance sheet is 
 
DEPRECIATION. I9I 
 
 never supposed to represent either its maximum or its mini- 
 mum value; no one who thought of purchasing a business 
 would be in the least influenced by the amount at which the 
 goodwill was stated in the accounts; in short, the amount is 
 absolute meaningless, except as an indication of what the 
 goodwill may have cost in the first instance. Inasmuch, there- 
 fore, as nobody can be deceived by its retention, there is no 
 necessity for the amount of goodwill account to be written 
 down. On the other hand, the practice is not unusual, where 
 sufficient profits are being made. The question is not, how- 
 ever, one upon which the auditor is required to express an 
 opinion; and, so long as the item is separately stated in the 
 balance sheet, it is scarcely desirable that he should interfere 
 with the discretion of the management, although there is, of 
 course, no objection to his offering an opinion when he is in- 
 vited to do so. 
 
 HORSES invariably depreciate, and — if heavily worked — 
 very rapidly. The rate of depreciation will probably vary 
 between fifteen and twenty-five per cent, on the starting balance 
 of the account. Until experience has shown the actual rate of 
 depreciation, it will be safer to arrive at the result by a re- 
 valuation (which with horses can be more accurately done 
 than with most things), and where only a small number of 
 horses are employed (say twenty or less) the re-valuation 
 should often be resorted to, if only as a check upon the rate of 
 depreciation employed. 
 
 INVESTMENTS need not be depreciated unless of a wast- 
 ing nature — such as shares in mines or single-ship companies. 
 As to how far it is desirable that fluctuations in their value 
 should be considered, the reader is referred to the paragraph 
 on " Secret Reserves " (postea). 
 
 LEASEHOLD LAND AND PREMISES.— The premium 
 paid for leases may be regarded as the purchase-money paid 
 for a terminable annuity of the difference between the annual 
 value of the property and the annual charges. In short-term 
 
192 AUDITING. 
 
 leases the readiest method will be to charge a proportionate 
 part of the term against each year's revenue ; but the method 
 is too rough to be employed if the term exceeds, say, eight or 
 ten years. In the case of longer leases the annuity, or sinking 
 fund, plans, which were discussed under the heading " Build- 
 ings," should be adopted. Sometimes the termination of a 
 lease finds the late lessee liable to a claim for dilapidations; 
 this claim may amount to one year's rent, or even more, and it 
 is therefore a convenient and prudent course to adopt to deduct 
 about one year from the unexpired term of the lease before 
 making the depreciation calculations. All repairs are, of course, 
 chargeable to revenue ; but they may be averaged by the tem- 
 porary or permanent employment of a repairs (fund) account 
 through which revenue is charged with a fixed amount annual- 
 ly, the difference between the actual expenditure and the annual 
 charge being brought forward as a liability, or (more rarely) 
 as an asset. 
 
 Before leaving this point it is well to bear in mind that, in 
 the case of exceptionally long leases, or exceptionally badly 
 built premises, it may be necessary to increase the annual 
 charges for depreciation beyond the usual rate, so as to pro- 
 vide for the re-building of the structure during the lease. 
 
 MACHINERY depreciates by wear and tear, and by be- 
 coming obsolete. In addition to charging all repairs and 
 (partial) renewals to revenue, from seven and one-half to. 
 twelve and one-half per cent, should be written off annually 
 from reducing balances. Boilers, which depreciate more 
 rapidly, should be reduced from ten to fifteen per cent, per 
 annum. Loose tools are most conveniently dealt with by 
 means of a re-valuation. It is desirable that a sound prac- 
 tical opinion be obtained as to the precise rate to be adopted 
 in any particular case, and a thorough re- valuation from time 
 to time is very desirable. 
 
 The practice of having a subsidiary ledger containing the 
 details of the machinery account in the general ledger should 
 
DEPRECIATION. I93 
 
 always be advocated. It greatly facilitates the labor of se- 
 curing rates of depreciation, and is invaluable in case of fire, 
 and in fact for many other purposes, such as determining the 
 amount to be written off in the event of sales. 
 
 The rates of depreciation on machinery are discussed more 
 frequently than any others, no doubt because they are more 
 difficult to fix. 
 
 In this connection the following extract from an address 
 on ** Depreciation, Renewal and Replacement Accounts," by 
 Herbert G. Stockwell, C. P. A., delivered before the annual 
 meeting of The American Association of PubHc Accountants, 
 held in Denver, October, 1909, is of interest: 
 
 " I think it can be confidently asserted that there are no 
 two manufacturing plants in this country in which the man- 
 agement is sufficiently identical in character, ability and tem- 
 perament that a depreciation charge in the same amount, or on 
 the same percentage basis, could be correctly used in both. 
 This being true, how useless it is to attempt to form aver- 
 ages for the life of machines in all plants, ^ven in the same 
 lines of business ! " 
 
 All interested in the question of depreciation should read 
 Mr. Stockwell's exhaustive and valuable paper; it may be 
 found in the Year Book of The American Association for 1909, 
 published by The Accountancy Publishing Co., New York. 
 
 MINES, undoubtedly, depreciate in direct proportion to 
 the amount of mineral extracted. By a singular inconsistency 
 of the law, however, no depreciation need be provided for by 
 a mining company before declaring a dividend. Where de- 
 preciation is provided, the correct method appears to be to 
 write off annually such proportion of the total cost (less resi- 
 dual value of plant) as the year's output bears to the estimated 
 contents of the mine, or — in the case of a lease — such pro- 
 portion of the total cost as the year's output bears to the esti- 
 mated total output during the lease. 
 
194 AUDITING. 
 
 On the other hand, it inust not be forgotten that there is 
 so much uncertainty about mining ventures that it would be 
 practically impossible, merely by the adoption of any system 
 of accounts, to insure that the whole of the capital of the 
 undertaking was always maintained intact; while the persons 
 who invest in this class of concern would doubtless object to 
 large funds accumulating in the hands of directors, and earn- 
 ing a low rate of interest, which might legally be distributed 
 as dividend, even though in point of fact they constitute a 
 return of capital. Perhaps, therefore, it is best that mines 
 should be regarded as coming under a distinct category as 
 " non-permanent " undertakings, the excess of current ex- 
 penditure being distributed, irrespective of the value of the re- 
 maining assets as contrasted with the paid-up capital. 
 
 PLANT, other than machinery, generally runs compara- 
 tively little risk of becoming obsolete, and a deduction of from 
 five to seven and one-half per cent, will, therefore, usually 
 suffice. Furniture and Fittings should, however, be sub- 
 jected to a somewhat higher rate. In both cases an occasional 
 re-valuation will be desirable. 
 
 Plant (or machinery) acquired upon the hire-purchase sys- 
 tem must, of course, be depreciated. Under normal circum- 
 stances the depreciation will be in accordance with the nature 
 of the asset, whatever it may be. It should be borne in mind, 
 however, that if full depreciation be charged during the cur- 
 rency of the agreement, in addition to the proper interest 
 instalments, the consequence will not infrequently be to charge 
 against the profits of the earlier years a sum in excess of what 
 it would have cost to merely hire the articles in question. The 
 cost of simple hire may fairly be regarded as the maximum 
 amount that need ever be charged against profits for the use of 
 any asset, consequently the full provision for depreciation may 
 require to be modified during the currency of the hire-purchase 
 agreement. 
 
 PATENTS are virtually leases of a monopoly, and although 
 it is possible that some value — in the nature of goodwill — 
 
DEPRECIATION. 1 95 
 
 may remain after the patent has run out, it seems desirable 
 that the cost of a patent should be written off within the course 
 of its life. Where a patent has not been purchased, but re- 
 mains the property of the original patentee, it is very undesir- 
 able that the item should be treated as an asset at all, except to 
 the extent of its actual cost in fees, &c. : such a course would 
 seem to be every bit as artificial as a similar treatment of good- 
 will, which sans dire is a latent asset in every paying concern. 
 
 A similar mode of treatment will apply to Copyrights^ ex- 
 cept that their commercial value has usually expired long be- 
 fore the copyright has run out. (See further under "Publish- 
 ers' Accounts.") 
 
 SHIPS undeniably depreciate, although the rate at which 
 they do so is so variable that no general rules can be given 
 that would prove of any practical utility. The amount of 
 depreciation is usually certified by a competent engineer, and, 
 therefore — so long as his report looks plausible — the auditor 
 is relieved from imdue responsibility. So long as the auditor's 
 certificate makes it perfectly clear that no depreciation is 
 being laid aside, and so long as the Courts see no illegality in 
 such a course, there does not appear to be any valid objection, 
 from an auditor's point of view, that is not outweighed by the 
 resultant advantages. 
 
 THEATRICAL PLANT, &c.— Although there can be no 
 reasonable doubt that theatrical scenery, " props.," and other 
 stock-in-trade are liable to depreciation, it is probable that few 
 accountants would care to accept the responsibility of settling 
 the actual amount. So far as the author has been able to ascer- 
 tain, the only practice in vogue is a periodical re-valuation, 
 and it will very likely recommend itself to the auditor as 
 being, perhaps, the safest course. Copyrights and Per- 
 forming Rights, when not purchased upon " sharing " terms, 
 will also require to be dealt with; but, unless there appear to 
 be very good reasons for believing that a " revival " at no 
 very distant date would prove remunerative, it would probably 
 
196 AUDITING. 
 
 be considered safest to regard the whole cost as a mounting 
 expense. 
 
 REPAIRS will, in all cases, require to be charged against 
 profit and loss; but, with a view to equalizing profits, it is 
 a very good plan to charge a fixed sum to profit and loss, 
 and to credit that sum to a '* Reserve for Repairs Account," 
 against which account the actual repairs will be debited. Ex- 
 cept in very special cases, however, a debit balance on the 
 reserve account should not be passed as an asset. If the 
 amount expended upon repairs is below the average of pre- 
 vious years, it may be desirable to reconsider the value of the 
 property itself. 
 
 LANDLORD'S FIXTURES.— In the case of plant, ma- 
 chinery and fittings erected upon leasehold property, it is im- 
 portant not to lose sight of the fact that, so far as these be- 
 come landlord's fixtures, the minimum rate of depreciation 
 permissable is one that will entirely write off the book-value by 
 the time the lease expires. The question as to what are, and 
 what are not, landlord's fixtures is, however, far too intricate 
 to be usefully dealt with here. 
 
 A few years ago the author contributed a volume on 
 " Depreciation, Reserves and Reserve Funds " to the "Ac- 
 countants' Library" series (Vol. XXVI.). Numerous pamph- 
 lets, articles and lectures on this subject by leading American 
 accountants have in addition appeared from time to time, and 
 reference to them may readily be had. 
 
 PROVISION FOR BAD AND DOUBTFUL DEBTS. 
 
 Unless the outstanding book debts are extremely numerous, 
 it is desirable that the auditor should go over the list in com- 
 pany with his client, or the manager, or some equally respon- 
 sible authority, and settle the amount of loss to be provided 
 for. Where the number of accounts renders this course im- 
 practicable, a certified list of amounts to be treated as bad, 
 and a statement that the provision made is sufficient, signed 
 
PROVISION FOR BAD AND DOUBTFUL DEBTS. I97 
 
 by the aforesaid responsible authority, should be supplied to 
 the auditor. It is a fact that sometimes an experienced ac- 
 countant will give a far more reliable valuation to book ac- 
 counts than the owner or manager of a business can do. No 
 doubt the training and experience of an accountant help him 
 in many ways to gauge the probable realizable value of book 
 debts; but unless his experience be confined to one particular 
 industry (or at most to a few industries), his knowledge of 
 the financial standing of the customers can of necessity be 
 only fragmentary at the best. It is, moreover, thought to be 
 undesirable for an auditor to differ from the deliberate opinion 
 of, say, a manager, unless he is prepared to give solid reasons 
 in support of his views. On the other hand, it is not intended 
 to suggest that, merely because the auditor has been supplied 
 with a certified list of the provision which it is thought neces- 
 sary to make for bad and doubtful debts, all he has to do 
 is to accept it without further comment or inquiry. It, of 
 course, remains for the auditor to satisfy himself that the pro- 
 vision is one which appears to be both bona fide and reasonable. 
 In this connection the following extract from an article which 
 appeared in The Accountant will be found useful : — 
 
 "With trading concerns debtors who always take a cash discount 
 may, in the absence of information to the contrary, always be assumed 
 to be good for any outstanding balance not greatly in excess of their 
 ordinary amount. Debtors who always give notes for their accounts 
 may, under similar circumstances, be regarded as good, provided the 
 notes are always met at maturity without renewal. Where there are 
 renewals, the accounts should be examined more carefully; and, as the 
 number of cases would not be large, this detailed inquiry would not 
 be impracticable. Accounts showing an increasing debit balance require 
 more careful scrutiny than those where the balance is reduced, 
 more particularly if the number of transactions during the period 
 be small. In the case of interest-bearing debts, the punctual payment 
 of the interest may be taken as presumptive evidence that the principal 
 is good, provided it be not in arrear ; but where the interest is in arrear, 
 the presumption is that the debt is at least doubtful, unless sufficient 
 security is held to cover the amount. * Dead ' accounts are more likely 
 to be doubtful or bad than 'live' accounts; and in this connection a 
 debtor who, during the current year, has not paid enough cash to extin- 
 
198 AUDITING. 
 
 guish the balance against him at the commencement of the year, may 
 generally be regarded as a 'dead' account, and treated accordingly. 
 Apart from the open balances standing against the various debtors in 
 the customers' ledgers, it is important not to lose sight of unmatured 
 notes, whether these be in hand or have been discounted; but, as has 
 already been stated, a customer who invariably meets his notes at 
 maturity may usually be regarded as safe to continue to do so." 
 
 It may be added that, in many cases, there should be a 
 fairly constant ratio between the amount of outstanding book 
 debts and the total of the sales on credit during (say) the last 
 three months. 
 
 Although it is very undesirable that an insufficient provision 
 be made for bad debts, it should — on the other hand — be re- 
 membered that, when once a debt is written off, its chance of 
 being eventually collected is greatly discounted; and, further, 
 that there is at least the possibility of its not being accounted 
 for, even if collected: hence the advisability of adopting the 
 system already described. ( Vide page yy.) 
 
 OUTSTANDING DISCOUNTS- 
 
 The usual cash discounts, upon both book debts and trade 
 creditors are sometimes provided for by means of a suspense 
 account. Where, however, the amount is uncertain (by reason 
 of the variable nature of the payments) and the difference be- 
 tween the two sides is but slight, the provision might be 
 omitted without any great harm being done — indeed, it is a 
 very open question whether the profit or loss — as the case may 
 be — ought to be anticipated. Trade discounts are, however, 
 a very different matter, and should be provided for by deduc- 
 tion from the purchases and sales respectively. 
 
 It has been stated that every credit transaction involves the 
 consideration of interest or discount — a statement which is, 
 doubtless, theoretically unassailable, but practically inconven- 
 ient. As a matter of fact, there is no relation between the 
 usual so-called " cash " discount and the rate which is paid for 
 
DIRECTORS FEES. 1 99 
 
 borrowed money. These discounts run from ^ of i'%, for 
 cash within ten days, to 5% for the same period, the terms in 
 both cases being thirty days net. It is not to be presumed 
 that in one case the trader is wilHng to pay 9% per annum for 
 prompt collections and in the other case 90*%- It is merely 
 a premium or bonus paid for prompt payment, and in most 
 cases is in effect a trade discount. 
 
 In the case of banks and other financial houses, interest 
 (which is no longer obscured by trade profits, but is itself the 
 source of all profit) should, of course, be always taken into 
 account, but, as stated heretofore, the almost invariable prac- 
 tice for American banks is to ignore this matter. 
 
 DIRECTORS* FEES. 
 
 In the absence of any special arrangement contained either 
 in the articles of association or in the minutes of general meet- 
 ing, directors are entitled to no remuneration in respect of 
 their services. The auditor will require to see, therefore, 
 before passing any such remuneration, that provision is con- 
 tained therefor in the by-laws, or else that the remuneration 
 has been voted by the stockholders in general meeting. He 
 would also require to see that the amount which the directors 
 have received is in accordance with such provisions. Proper 
 vouchers should be given by directors for fees received by 
 them. It is not likely that under any circumstances objection 
 could be raised to reasonable attendance fees, but it would 
 seem from reference to leading American authorities on our 
 corporation laws that the practice of voting large salaries and 
 other compensation to directors is ultra vires. Of course, if 
 the by-laws distinctly provide for such compensation, no ob- 
 jection can be raised. It is, perhaps, superfluous to state that 
 no one who is not a director can be entitled to receive direct- 
 ors' fees, and it is a very fair question as to whether directors 
 who are also officers of a company, and who draw salaries as 
 such, are entitled to receive directors' fees in addition. 
 
200 AUDITING. 
 
 PRELIMINARY EXPENSES. 
 
 In the balance sheet of almost every young company this 
 item will be found among the assets. It will probably sur- 
 prise few, to learn that with a considerable number of com- 
 panies this item is not written off, and, while it disappears 
 as a separate item, it remains capitalized. It is, however, very 
 desirable to write off the amount of the preliminary expenses 
 within the first three or five years; and the auditor will do 
 well to recommend the adoption of such a course. 
 
 It must not be forgotten that, in every case, the auditor 
 must thoroughly verify the amount of this item by reference 
 to vouchers and contracts. In particular, he should make sure 
 that the company has made no payments that the promoters 
 undertook to pay, or which — for other reasons — may appear 
 improper. It is not an unknown occurrence for directors' 
 qualifications to be paid for out of preliminary expenses. 
 
 RESERVE FUNDS. 
 
 It is very generally conceded, and therefore need not be 
 discussed at length in these pages, that it is not — ^under ordi- 
 nary circumstances — desirable that a reserve fund be specially 
 invested if the moneys can be utilized to better advantage in 
 the business itself or in reducing its liabilities. Where, how- 
 ever, the fund is specially raised for a specific purpose (e. g., 
 the redemption of bonds), its investment would appear to be 
 desirable for the purpose of insuring its being available at the 
 appointed time. Of course, wherever a specific provision is 
 made in a mortgage (as is frequently the case) requiring the 
 fund to be invested, it will be necessary to carefully examine all 
 the provisions relating thereto in order to be sure that the in- 
 vestments are properly made. Where the reserve fund exists 
 for the purpose of strengthening the credit of the company — 
 as in the case of banks — it is doubtless desirable that it should 
 be iirvested in first-class securities; but it is no part of the 
 auditor's functions to interfere with the management in this 
 
INSPECTION OF MINUTE BOOK. 20I 
 
 r.espect. The whole subject is, however, dealt with very fully 
 in the following chapter. 
 
 Unless there is a special provision in the by-laws, there is 
 nothing to prevent directors from transferring the whole or 
 any portion of the amount standing to the credit of reserve 
 fund to the credit of profit and loss account, for the purpose 
 of increasing the amount of profits available for dividends. 
 Where such a course is being pursued, the auditor should, 
 however, take steps to acquaint the stockholders with the facts, 
 unless they are shown with sufficient clearness on the face of 
 the accounts. 
 
 It is obviously desirable that premiums received on issues 
 of stocks should be placed to the credit of a permanent re- 
 serve fund, and not applied to the equalization of dividends; 
 nor should they be included in the surplus, or current profit 
 and loss account, as ordinary earnings or income. With re- 
 spect to premiums received on bond issues (if the premium 
 arises as a matter of fact from the rate of interest which the 
 bonds bear), it would seem proper that the premiums so re- 
 ceived should be set up and distributed ratably over the life 
 of the bonds as a reduction of the current interest account. 
 This, of course, follows the theory laid down with respect to 
 bonds issued at a discount. 
 
 INSPECTION OF MINUTE BOOK. 
 
 The question frequently arises, and is the source of no little 
 contention, as to whether an auditor has the right to inspect 
 the minute book recording the proceedings at board meetings. 
 It is thought, however, that this right cannot be disputed, 
 inasmuch :as it is clearly the duty of the auditor to certify to the 
 accounts after having examined " the books of the company ;'* 
 and certainly the minute book is a " book of the company," 
 inasmuch as it is one of the few books which every compaiiy 
 is required by all corporation laws to keep. Theoretically, at 
 least, it is necessary that the auditor should carefully examine 
 
202 AUDITING. 
 
 the whole contents of the minute book, but in practice it is 
 thought that this rule may frequently be relaxed, and reference 
 only made in respect to items upon which the auditor is in 
 doubt, or with regard to which he requires further elucidation. 
 It need hardly be added, however, that in this respect — as with 
 regard to all other matters where the auditor prefers to take a 
 short cut in his work — he does so at his own risk, and the risk 
 in this particular connection is that he may fail to become 
 acquainted with some contingent liability or contract which 
 would materially alter his views with reference to the accounts 
 which he is called upon to certify. 
 
 If an auditor is refused faciHties for performing his duties, 
 whether such refusal takes the form of declining to allow 
 him access to any of the books, accounts, or vouchers of the 
 company, or to the failure of the directors or officers of the 
 company to give such information or explanations as may be 
 necessary, the auditor should sign a certificate at the foot of 
 the balance sheet stating that all his duties as auditor have not 
 been complied with. 
 
 REDEEMABLE STOCKS AND BONDS. 
 
 Where preference stocks or bonds, redeemable at par or at 
 a premium, have been issued at a lower rate, it is essential that 
 a proper reserve be made to meet the deficit; and, it will be 
 the auditor's duty to see that a sufficient provision is made. 
 
 FORFEITED SHARES. 
 
 Where shares have, for any reason, been forfeited to the 
 company, and have not been re-issued, they should be sepa- 
 rately stated on the balance sheet, as a dividend declared would 
 not be payable in respect thereof. Such shares may at any 
 subsequent date be re-issued at any discount not exceeding the 
 amount per share already received, and when so re-issued the 
 amount already paid (or so much thereof as represents profit) 
 should be treated as a premium upon issue, and credited to a 
 
FLUCTUATIONS IN ASSETS AND SECRET RESERVES. 2O3 
 
 reserve account. The auditor should always make a point oi 
 seeing that the minutes as to forfeiture and as to the calls due 
 are prima facie in order. 
 
 FLUCTUATIONS IN ASSETS AND SECRET 
 RESERVES. 
 
 This most debatable subject is approached with considerable 
 diffidence. Very much can be (and has been) said upon both 
 sides of the question, making it a most difficult thing to say 
 what is really the correct course to adopt in any particular 
 case ; and, if the question be complicated, even when a particu- 
 lar instance is judged upon its merits, how much more difficult 
 is it to lay down any general rules of universal application. 
 
 The object of all secret reserves created in good faith is to 
 equalize dividends, or to equalize apparent profits ; and, in the 
 case of banks and similar institutions, it must be admitted that, 
 were accounts published showing considerable fluctuations in 
 the amount of profits earned, the result might readily be to pro- 
 duce a feeling of disquietude which was altogether unwar- 
 ranted by the actual facts. More particularly in the case of 
 banks largely affected by fluctuations in exchange does it seem 
 desirable that the temporary effect of such fluctuations should 
 be excluded from published accounts. The understating of 
 assets in profitable years (which is the ordinary means of pro- 
 viding a secret reserve) clearly contemplates, however, the 
 possibility of their being written up in less profitable years, 
 when it may be desired not to disclose the fact that the profit 
 earned has been less than usual, or perhaps even insufficient 
 to cover the proposed dividend. 
 
 Opinions differ greatly as to the extent to which the forma- 
 tion of secret reserves is permissible; but it is thought that, 
 within reasonable limits, the matter is one resting with the 
 directors rather than with the auditor, so long as there is no 
 suspicion of bad faith. It is when it is sought to have recourse 
 to a secret reserve by writing up the assets which have hitherto 
 
204 AUDITING. 
 
 been undervalued that the position requires the most serious 
 consideration of the auditor. 
 
 With regard to the position of the auditor generally, it would 
 appear that, in the absence of mala Mes, he incurs but little 
 responsibility. He should, however, be very careful about the 
 good faith with which the valuations or re-valuations are made, 
 and although he has no power to influence the management 
 in the exercise of their bona iide discretion, yet it would appear 
 to be clearly his duty, in cases of doubt, to sufficiently acquaint 
 the stockholders with the facts of the case to enable them to 
 intelligently exercise their own discretion as to whether they 
 will pass the accounts in the form in which they are presented 
 to them or not. Thus, where the assets are stated below their 
 certainly-known value (forming a secret reserve), or above 
 their certainly-known value (forming a secret deficit), at least 
 the bare fact should be mentioned in the auditor's report. 
 Again, there are limits to the extent with which a secret re- 
 serve should be played with, for the sake of equalizing divi- 
 dends ; and it is very undesirable that valuable assets should be 
 omitted from the balance sheet in ioto, because in such a case 
 the auditor is very liable to omit to verify their existence. In 
 some balance sheets a note is appended to the effect that 
 certain (specified) assets have not been included. Such a 
 course appears to remove the most weighty objections that can 
 be raised against the reduction of valuable assets to zero, but 
 it does not altogether justify the course adopted. 
 
 FOREIGN EXCHANGES. 
 
 The treatment of foreign exchanges in books of account 
 appertains to bookkeeping rather than auditing, and the sub- 
 ject will accordingly be found fully dealt with in the author's 
 "Advanced Accounting." From the point of view of the audi- 
 tor, all that is necessary is that the accounts should properly 
 disclose the true position of affairs. For this purpose it is 
 only necessary to bear in mind that the trial balance (from 
 which the accounts are compiled) is a summary of transactions 
 
205 
 
 that have actually taken place, temporarily recorded, for the 
 sake of convenience, in the medium of a foreign currency. To 
 determine their proper valuation in dollars it is necessary that 
 the nature of these various records should be inquired into; 
 that the revenue account (whatever its precise form) should 
 correctly show, under suitable headings, the totals of the vari- 
 ous kinds of transactions on account of revenue, and that the 
 balance sheet should fairly state the assets and liabilities — those 
 of a current nature at their realizable cash value, while the 
 fixed or permanent items may be maintained at the original 
 amount, subject only to such provision for depreciation as may 
 be necessary in view of their wasting character. If this posi- 
 tion of affairs be correctly comprehended, there is no more 
 difficulty in auditing accounts figured in a foreign currency 
 than in auditing accounts the narration of which is expressed in 
 a foreign language. The medium of expression in neither case 
 affects the nature of the facts. 
 
 ULTRA VIRES. 
 
 It is a question of some nicety as to how far an auditor is 
 expected to concern himself with the validity of the trans- 
 actions that come under his notice. It may be taken that, in 
 general, the auditor is not constituted a judge of the conduct 
 of the directors in their administrative capacity; and that, so 
 long as the accounts are in order, and in accordance with such 
 statutory provisions as may affect the particular undertaking, 
 and its articles of association (or their equivalent), the audi- 
 tor need not concern himself with questions which his profes- 
 sional training has not especially qualified him to solve. It is 
 clear, however that when the auditor is aware that irregu- 
 larities have been committed, it becomes his duty to report the 
 whole circumstances to the stockholders. 
 
 "AFTER DISCOVERED EVIDENCE." 
 
 The question has sometimes been raised as to how far, if at 
 all, an auditor should take cognizance of events transpiring be- 
 
206 AUDITING. 
 
 tween the date of the balance sheet which he is to certify and 
 the date he actually completes the audit. It has been con- 
 tended by some that the auditor should view the accounts in the 
 same way he would have done had he actually made his audit 
 (which, of course, he would be unable to do) on the day with 
 which the audit period closed and that he should not be influ- 
 enced by circumstances which were unknown at that time. 
 
 This contention is short-sighted and ultra-technical. If the 
 auditor, prior to certifying to the accounts, comes into posses- 
 sion of information indicating a material difference between 
 the books and facts as they actually were at the date of the haU 
 ance sheet (even if the true facts have only been ascertained 
 since that time) and he certifies to a balance sheet drawn from 
 the books without any adjustment being made to bring it into 
 accord with the facts, he is certifying a balance sheet which is 
 not correct according to the best of his information. 
 
 It should, however, be borne in mind that these remarks 
 apply only to circumstances transpiring in the interval which 
 throw light on the actual condition of affairs at the date of the 
 balance sheet and do not, of course, apply to events which may 
 have occurred in the intervening period to the detriment of a 
 company's financial condition — such as a fire loss exceeding the 
 amount of insurance recovered — which have no connection 
 with a prior period. 
 
 FORM OF ACCOUNTS. 
 
 In the audit of private accounts and most corporations it is 
 usual for the auditor to recommend the particular form in 
 which the accounts shall be cast. In the case of national 
 banks, however, the auditor has no power to dictate the form 
 in which the accounts shall be stated, consequently he need not 
 concern himself with the consideration as to whether or not 
 the form adopted is the most suitable one under the particular 
 circumstances of the case ; but, if he is convinced that the form 
 adopted is one calculated to mislead, he should not hesitate to 
 
FORM OF ACCOUNTS. 20/ 
 
 modify his report accordingly. Nevertheless, the whole ques- 
 tion is one of considerable interest and accordingly it has been 
 thought desirable to deal with it at some length in the following 
 chapter. 
 
 Where a statutory form of accounts (as is the case, in some 
 States, with railway and insurance companies) has been pro- 
 vided, the auditor should see that the accounts are prepared 
 in accordance with that form, or as nearly in accordance there- 
 with as circumstances will permit. 
 
CHAPTER VII. 
 
 FORM OF ACCOUNTS AND BALANCE 
 SHEETS. 
 
 It has already been clearly stated that, in general, the auditor 
 is not responsible for the form of accounts which he certifies. 
 The consideration of the form that such accounts should prop- 
 erly take is, therefore, not strictly a matter within the scope 
 of the present work. Still, it is none the less true that, as a 
 matter of fact, auditors are frequently asked to settle questions 
 of form ; and although in the case of certain undertakings like 
 banks and insurance companies, where departmental forms are 
 prescribed, they will often be only prudent if they decline to 
 accept a responsibility that properly devolves upon the direc- 
 tors, there can, it is thought, be no possible objection in the 
 case of the accounts of private firms. Moreover, it cannot be 
 denied that the subject is at all times one upon which the 
 auditor should have definite and well-matured opinions. 
 
 The form of accounts to be submitted by public service cor- 
 porations has received much more attention than the form of 
 the accounts of industrial corporations. This is due in part to 
 the efficient work done by the various societies and associations 
 of accounting officers, such as the Association of American 
 Railway Accounting Officers and the Street Railway Account- 
 ants' Association, which devised uniform systems of accounting 
 and urged their adoption. The governmental regulation of 
 railroads and public utilities which necessitated the use of pre- 
 scribed forms of report has also been a factor. Further- 
 more, it should be remembered that these undertakings lend 
 themselves more readily to uniformity of statement than 
 
 208 
 
OBJECT OF REVENUE ACCOUNTS. 209 
 
 industrial enterprises wherein the conditions existing, even 
 in the case of concerns in the same line of business, 
 are frequently so dissimilar. The American Association of 
 Public Accountants has also been active in this direction; one 
 committee has submitted forms for Standard Schedules and 
 Uniform Reports upon Municipal and Public Service Corpora- 
 tions, w^hile during the New^ York insurance investigation of 
 several years ago a joint committee of the Association and the 
 New York State Society of Certified Public Accountants pre- 
 pared model forms for the reports of life insurance companies 
 which are a great improvement over the forms in use by the 
 Insurance Departments of the various States. 
 
 With regard to the published reports of industrial corpora- 
 tions great divergence of form still obtains and some of them 
 seem to be prepared with the thought that the less shown the 
 better, otherwise the stockholder may really learn something 
 about the operations and financial condition of his company. 
 It is hoped, however, that the growing custom of submitting 
 the accounts to Certified Public Accountants for audit will 
 result in considerable improvement in this respect, and that, 
 while it is not to be expected that there will be uniformity of 
 detail, there will be more uniformity as to principle and the 
 essentials which such reports should contain. 
 
 In Appendix D are presented a number of forms of ac- 
 counts which have been gathered from different sources and 
 which will indicate what has been accomplished in this direc- 
 tion. 
 
 It may be stated at the outset that the accounts with which 
 it is now proposed to deal are those which are ordinarily pub- 
 lished as " the audited accounts " — ^viz., the Revenue Account 
 (or its equivalents) and the Balance Sheet. 
 
 OBJECT OF REVENUE ACCOUNTS. 
 
 Taking first the account which in diflFerent undertakings is 
 variously called the trading account, the manufacturing ac- 
 count, the profit and loss account, and the revenue account, the 
 first point to be considered is the real object of preparing such 
 
210 AUDITING. 
 
 an account. This may be stated to be for the purpose of 
 showing — 
 
 First, the amount of business done in each of the vari- 
 ous branches in which business is carried on ; 
 
 Second, the amount of expenditure in each of the 
 branches, or departments, necessary for the carrying on 
 of that business; and, 
 
 Third, the amount of surplus, or profit — or loss, as 
 the case may be — which arises from the carrying on of 
 the business. 
 
 The object of the information is doubtless primarily to ascer- 
 tain the amount of ultimate profit or loss, but beyond this 
 there is also the further object — which, perhaps, is only fully 
 appreciated by those skilled in accounts — of comparing the cor- 
 responding items of various periods, with a view to ascertain 
 how income may be increased and expenditure reduced, or, 
 on the other hand (so far as possible), why income has become 
 reduced and why expenditure has increased. 
 
 It will thus be seen that the efficiency of this account depends 
 very materially upon the skill with which the income and 
 expenditure have been distributed over the various headings 
 employed, and consequently it becomes necessary to discuss the 
 nature of the various headings under which the items of this 
 account should be divided. 
 
 It goes without saying that, inasmuch as this account details 
 the summarized result of the transactions recorded in the 
 books, its exact nature will very materially depend upon the 
 precise business which is being carried on. It therefore be- 
 comes necessary to further consider the subject under the 
 headings of various classes of business. 
 
 COMMERCIAL ACCOUNTS. 
 
 Taking first commercial concerns (which undoubtedly rep- 
 resent the great majority of the undertakings which are now 
 
COMMERCIAL ACCOUNTS. 211 
 
 being considered), it will be found that the transactions con- 
 sist in the buying of goods and the selling thereof, either in 
 the precise form in which they were purchased (as in the case 
 of traders), or in an altered form (as in the case of manu- 
 facturers) ; in both cases there being the further expenditure 
 incidental to the carrying on of the undertaking. 
 
 ACCOUNTS OF TRADERS.— The accounts of traders are 
 naturally of a simpler nature than those which require to be 
 kept by manufacturers. A trader's revenue or profit and loss 
 account should show clearly at least three things : 
 
 I St. The gross business or turnover during the period. 
 
 2nd. The gross profit thereon and the ratio of one to the 
 other. 
 
 3rd. Whether the volume of business has been large enough 
 to produce a gross profit sufficient to provide for the selling 
 and administrative expenses and a net profit. 
 
 It would be very difficult to find an exact definition of the 
 term " gross profit," inasmuch as the items from which it is cal- 
 culated will be found to vary in different undertakings; but 
 seeing that the whole business of a trader is based upon the 
 calculation of a fixed percentage of gross profit upon each 
 different class of goods dealt with, it necessarily follows that 
 any form of accounts which does not recognize the existence 
 of such a thing as "gross profit" fails to afford the trader that 
 assistance which he is entitled to look for from his accounts, 
 and consequently to a very great extent fails to justify its 
 existence. 
 
 It has been argued by many experienced accountants that 
 gross profit cannot be considered to arise until such things 
 as rent of warehouse, salaries of warehousemen, &c., have 
 been debited to the trading account; but as it is the almost 
 universal custom of traders to reckon their percentage of 
 
212 AUDITING. 
 
 gross profit entirely from the cost price of their goods (al- 
 though, as a matter of convenience, they actually make the cal- 
 culation backwards from their selling price) it would seem 
 that, however correct it may be in theory, it is in practice 
 nothing more than pedantic to include in this first section of 
 the account anything more than " Sales " upon the credit side, 
 and the opening " Stock " plus " Purchases " and minus the 
 closing " Stock " upon the debit. It is, of course, quite possi- 
 ble to argue that the resultant credit balance means absolutely 
 nothing at all; but, even if this were so, the fact remains 
 that unless the account be so prepared it is impossible to see 
 whether the aggregate transactions of a period actually result 
 in the percentage of gross profit which the trader had been 
 calculating upon throughout that period; and, therefore, 
 whether it is thought best to call the balance of this first section 
 *' Gross Profit," or to employ the indefinite term " Balance," 
 the overwhelming weight of advantage lies in bringing the 
 account — in this respect at least — into accord with the custom 
 of every trader, and so enabling him to ascertain whether 
 during any period he has actually achieved the results which he 
 anticipated. 
 
 In the second section of the revenue account may be in- 
 cluded all items of income and expenditure relating to the 
 business. These expenses should be grouped in convenient 
 subsections, so that the effect of each group upon the whole 
 may be readily perceived. This is useful both for the pur- 
 pose of seeing how far the net profits of a concern have been 
 affected by purely financial reasons, and how far by com- 
 mercial reasons, and also on account of the convenience it 
 affords if it should at any future time be decided to convert the 
 venture into a corporation. 
 
 MANUFACTURERS' ACCOUNTS.— Passing on to the 
 accounts of manufacturers, it is first necessary to subdivide 
 this heading in accordance with the various classes of business 
 that fall heretmder. There is first of all the class of manu- 
 
COMMERCIAL ACCOUNTS. 21 3 
 
 facturers but slightly removed from the trader — ^that is to 
 say, the manufacturer who does not require to sink a large 
 proportion of his capital in expensive plant and machinery, 
 the most typical examples of which are, perhaps, that of the 
 small manufacturing jeweler and the small manufacturing 
 tailor — both of whom, by the way, are fast dying out. In 
 this class, as with traders pure and simple, the selling price is 
 based upon a percentage of so-called " Gross Profit," the out- 
 lay in this case being the cost of materials, together with the 
 wages spent upon manufacturing; and, therefore, although 
 the method is clearly indefensible from a theoretical point of 
 view, the division between the first and second sections may 
 conveniently be drawn exactly where it is drawn by the manu- 
 facturer himself in his mental calculations. Those who wish 
 to have their accounts as complete as possible may prefer in 
 addition to make a further subdivision of this account in the 
 second section, separating the expenses of manufacturing 
 (such as rent of factory, wages paid for supervision of work- 
 ers, depreciation of plant, &c.) from those expenses which 
 relate more particularly to the storing of goods and the sell- 
 ing thereof; but inasmuch as the balance shown by this break 
 would correspond with nothing in the mind of the manufac- 
 turer it appears to be superfluous, and it will probably be 
 thought sufficient to merely show separate totals for these 
 classes of expenditure in the same section. 
 
 The manufacturers belonging to the next class are those 
 whose transactions consist in the manufacture of one or more 
 classes of goods involving expensive plant, which goods are 
 first manufactured and then warehoused before being sold. 
 These undertakings are naturally upon a much larger scale 
 than those which have just been considered, and consequently 
 it will be found that the accounts are, as a rule, more scien- 
 tifically kept, and the method of costing more complete. 
 
 The first section of the account thus becomes divided into 
 two parts upon what may be called parallel lines, viz : — 
 
214 AUDITING. 
 
 The manufacturing account, which deals with the con- 
 version of raw material into manufactured articles, and 
 shows the cost of manufacture and the stock of raw. 
 materials on hand. 
 
 The trading account proper, drawn upon the same 
 lines as the first section of a trader's profit and loss ac- 
 count. 
 
 The second section of the account does not present any new 
 features that call for consideration. 
 
 The expenses included in the manufacturing account will 
 (as a rule) be those which are dealt with in the cost accounts, 
 and those only. It is quite likely, therefore, that factory ex- 
 penses would be debited to the manufacturing account, rather 
 than to the profit and loss account, although the effect of so 
 doing will be to obscure the percentage of (so-called) gross 
 profit. 
 
 CONTRACTORS' ACCOUNTS.— The next class of man- 
 ufacturers to be dealt with consists of those that may con- 
 veniently be summarized under the head of " Contractors," 
 f. e., those manufacturers who only make articles which have 
 already been sold for an agreed price. To this class belong 
 builders and many engineers. 
 
 It is in this class as much as anywhere that the absolute 
 necessity of proper cost accounts is so evident. Indeed, all 
 contractors' accounts may be regarded as incomplete which do 
 not provide, in addition to any ordinary profit and loss account, 
 a " Summary of Cost Account," showing the same results. 
 This being done, the chief interest centres round the cost ac- 
 count rather than the profit and loss account itself, and there 
 is thus less necessity for the latter to be unduly elaborate. It 
 is therefore usually best to state this latter account in one 
 section only. 
 
 It is, perhaps, unnecessary to add that, in practice, an abso- 
 lute agreement between the profit and loss account and the sum- 
 
MINING ACCOUNTS. 215 
 
 mary of cost account is hardly to be expected ; but a very close 
 approximation must be arrived at before either can be safely 
 relied upon. 
 
 STATISTICAL INFORMATION.— In connection with 
 all the preceding accounts it will usually be found of the very 
 greatest assistance to add statistical columns, for the purpose 
 of showing the relation which each item bears to the amount 
 of trade done. This relation will usually be expressed in the 
 form of a percentage on the amount of the sales, but where 
 the business deals with articles of a uniform or similar char- 
 acter — as, for instance, in the case of collieries, brickyards, and 
 the like — the percentage will probably be based upon some 
 quantity, or unit, of the goods dealt in, as " per ton of coal " 
 or " per thousand bricks," and in these cases it is usually 
 thought more convenient for the unit to be the production 
 rather than the sale. 
 
 In published accounts it is also somewhat usual, and very 
 convenient, to pubHsh, side by side with the figures for the 
 current period, those for the next preceding period, for the 
 purposes of comparison. For the sake of clearness the figures 
 for the current period appear first, and sometimes it is desir- 
 able to have the figures of the preceding period appear in red 
 ink or italics, or some other type which may be readily distin- 
 guished from that in which the accounts for the current year 
 or period are printed. 
 
 MINING ACCOUNTS. 
 
 Another very important class of accounts, which can hardly 
 be said to come under any of the previous headings, is that 
 relating to mines. These accounts are best dealt with in two 
 sections : one to include all items relating to the actual work- 
 ing of the undertaking ; and the other, those appertaining more 
 particularly to finance. Cost accounts would be made weekly 
 or monthly, but they would usually form no part of the an- 
 nual accounts. 
 
2l6 AUDITING. 
 
 "NET PROFIT." 
 
 This is, perhaps, the proper place to offer a protest against 
 the method adopted by many companies of stating in their 
 published accounts a so-called " Net Profit," out of which it 
 is proposed to set aside a certain sum for depreciation. A true 
 net profit can only be arrived at after charging up all expenses 
 — including, of course,' depreciation, interest on bonds, &c., &c. 
 
 BALANCE SHEETS. 
 
 Turning now to the question of balance sheets, perhaps 
 the first point to be disposed of is the question " What arc 
 assets ? " 
 
 WHAT ARE ASSETS ? 
 
 Going back to first principles, it must be admitted that an 
 asset may be fairly defined as " an expenditure upon a re- 
 munerative object," and, indeed, it may be taken as the test 
 of whether any particular expenditure is an asset or a loss to 
 inquire whether as a matter of fact such expenditure was-^ 
 looking back upon it — worth the amount expended upon it. 
 This applies whether the expenditure is in the nature of capital 
 spent in the purchase or construction of any particular prop- 
 erty, or in the purchase of property or labor which was sub- 
 sequently sold to another. In the former case, if — looking 
 back upon it — it is considered that if the opportunity of making 
 the investment a second time should again arise it might rea- 
 sonably be made upon the same terms, it may fairly be said that 
 there is value for the original outlay; and in the latter case, 
 if — looking back upon it in the light of present experience — one 
 would again sell upon trust to any particular individual prop- 
 erty upon which time or money had been expended, it may 
 fairly be said that value is still remaining for the amount with 
 which it at present stands charged. If, on the other hand, it 
 appears that the value remaining for such expenditure is less 
 than the original amount of such expenditure, it is obvious that, 
 as a matter of fact, depreciation has occurred. 
 
FORM OF BALANCE SHEET. 2I7 
 
 NECESSITY FOR DEPRECIATION. 
 
 It appears doubtful as to whether any of our laws compel 
 a company to make provision for depreciation before declaring 
 dividends out of its earnings, although our courts will probably 
 be called upon to pass on this question in the near future, and 
 if the principle involved is clearly stated, it is more than likely 
 that it will be judicially determined that depreciation is a 
 charge against profits. It is unfortunate that the question of 
 depreciation was not raised in the American Malting case. 
 It was not necessary, however, as the other losses were suffi- 
 cient to offset all of the dividends paid. 
 
 The question of depreciation is, therefore, rather one of 
 prudence, or internal administration, than of legal compul- 
 sion. 
 
 METHOD OF PROVIDING DEPRECIATION.— Many 
 companies deem it undesirable to deduct the depreciation from 
 the cost shown in the capital expenditure account, and the 
 method adopted is to accumulate the amount set aside from 
 time to time upon a depreciation (fund) account, or a reserve 
 for repairs and renewals account, which is included as a lia- 
 bility in the general balance sheet (although not necessarily 
 stated separately). On the other hand, the more usual course 
 is to deduct the amount written off for depreciation from the 
 amount at which the value of the asset is stated, and this 
 whether the asset account and depreciation account are kept 
 separate in the ledger or not. 
 
 FORM OF BALANCE SHEET. 
 
 The various items which are ordinarily found upon a bal- 
 ance sheet will now be dealt with in order, and the best form of 
 wording under various circumstances considered. 
 
 The form generally accepted in England places the liabilities 
 upon the left-hand side and the assets upon the right-hand side, 
 commencing upon both sides with the most permanent items, 
 
2l8 AUDITING. 
 
 and leaving those which are most constantly varying to the 
 last. This is, in fact, the form provided in their Companies 
 Act of 1862. 
 
 In the United States, however, while statutory forms prac- 
 tically do not exist, yet the practice of placing the assets on 
 the right and liabilities on the left is without a single known 
 exception reversed, and this may be said to have the effect 
 of law with us. 
 
 Under the Italian system of bookkeeping, which is still prac- 
 ticed in some old-fashioned merchants' houses it is the custom 
 at every period of balancing, after the nominal accounts have 
 been closed, to transfer the balances of the real and personal 
 accounts into one account, usually called in England and in the 
 United States the " Balance Account," and in France the 
 ^'Balance de Sortir," or " Closing Balance." Under such cir- 
 cumstances, the ledger would be actually closed (which, in 
 fact, is never the case under the ordinary system), and the 
 Balance Account so raised would practically be a detailed 
 balance sheet, with the assets upon the Dr. and the liabilities 
 upon the Cr. side, as shown in all of our balance sheets. 
 
 It may be that assets always appearing on the left-hand 
 side of the ledger explains our present system, which also seems 
 to correspond with the Italian method referred to, but in view 
 of the fact that our present practice is settled, and inasmuch 
 as there does not seem to have been a single objection raised 
 on account of its being unscientific, or for any other reason, 
 it would seem unnecessary to discuss the reasons which must 
 have governed those responsible for stating our balance sheets 
 diametrically different from the English method. 
 
 We shall, therefore, first treat of the asset or left-hand side 
 of the balance sheet. 
 
 It might be well, however, before going further, to mention 
 that probably nine out of ten published balance sheets include 
 items under " Assets " and " Liabilities " which certainly are 
 
FORM OF BALANCE SHEET. 219 
 
 not either one. This is to be deplored because professional 
 auditors are looked to not only as authorities on form, but also 
 as authorities on principle. It certainly cannot be successfully 
 contended that a debit balance to profit and loss, or a deficit, is 
 an asset nor per contra is a credit balance to Profit and Loss, 
 or a surplus, a liability. Furthermore the share capital of a 
 corporation is no more of a liability than is partners' capital in 
 a partnership. 
 
 It is only possible to justify the inclusion of any item in a 
 balance sheet, provided — at that time at least — it is reasonable 
 to treat it as an asset, or a liability, as the case may be. 
 
 Inasmuch as these headings are always attached to balance 
 sheets, the incongruity of non-permissible items is emphasized, 
 but it does not seem to have any effect. It may be urged that 
 this course is necessary for the sake of convenience, and that 
 in order to intelligently group the right and left-hand sides the 
 footings must be equal. This reasoning is so opposed to the 
 principles of accountancy that it hardly merits an answer. Per- 
 haps the best illustration of this point is found in the case of a 
 professional auditor who is asked to address a body of account- 
 ant students on the topic, let us say, 'What are Assets and 
 Liabilities ? " It is not supposed for a moment that he will 
 state that actual net losses of operation, represented by a debit 
 balance to profit and loss, should be carried on a balance sheet 
 under the heading of assets, nor will he explain that accum- 
 ulated and unapportioned profits are properly stated under 
 " Liabilities." He may take a middle course with regard to the 
 share capital which, while not a liability so far as creditors 
 are concerned, may be so termed with respect to the com- 
 pany's position to its stockholders. 
 
 Imagine, then, the same students reading a published report 
 containing a balance sheet prepared by the same professional 
 auditor containing the items just mentioned stated boldly as 
 assets or liabilities as the case might be. And all for the sake 
 of convenience ! 
 
220 AUDITING. 
 
 THE ASSET SIDE. 
 
 The order in which assets should be stated on a balance 
 sheet is a somewhat disputed point among American ac- 
 countants. It is the opinion of many leading practitioners 
 that assets should be stated in the order of their convertibility ; 
 that is, cash would be first, followed by accounts and bills re- 
 ceivable, stock and all other " quick " assets, while the fixed 
 assets would be last. One important point urged in favor of 
 this order is that a balance sheet should be framed, so far as 
 possible, for the convenient use of those for whom it is in- 
 tended. The majority of balance sheets are submitted at one 
 time or another to bankers, who almost invariably look first for 
 " quick " assets on one side, and the accounts and bills payable 
 on the other. 
 
 The reverse order is becoming quite general, however, in 
 stating the accounts of railroads and large industrial enter- 
 prises. The practice as to this point is not yet definitely settled, 
 and we shall, therefore, for convenience consider the various 
 items in the same order as they appear in " Table A" of the 
 English Companies Act already referred to. 
 
 FIXED ASSETS. — In the majority of cases the titles of the 
 accounts which represent fixed or capital assets are not illumin- 
 ating, and it is becoming more and more frequent in large cor- 
 porations to include practically all of their assets of this char- 
 acter under one caption, such as " Plant," and it accordingly 
 becomes almost impossible to gain an intelligent idea of their 
 resources. 
 
 Where it is possible to do so, the fixed assets should be 
 divided into land, buildings, machinery, patents, goodwill, &c., 
 and it should be clearly shown whether they are carried at cost 
 or whether proper depreciation has been allowed. 
 
 The chief difficulties in the way of preparing such a state- 
 ment are, first, the over-valuation of assets to balance large 
 capital stock issues, and the consequent temptation to hide the 
 real facts by lumping all the fixed assets; and, secondly, the 
 
THE ASSET SIDE. 221 
 
 large number of cases of holding companies and consolidations 
 where the fixed assets have passed through so many stages 
 that their original identity is lost. 
 
 Professional auditors are not the only ones who criticise 
 such reports, as is evidenced by the numerous comments on one 
 of the annual balance sheets of the Amalgamated Copper 
 Company. 
 
 The following extract from one of New York's leading 
 dailies is representative of the views generally expressed : — 
 
 "An unverified balance sheet is not very satisfying. Of course, 
 there was the usual accountants' certificate of the correctness of the 
 accounts, and no disparagement of that is intended. The point is that 
 something different was called for as a basis for any conviction regard- 
 ing present or future worth. There was, for instance, an entry in a 
 single line of investments of $154,281,303, with no list of them, and no 
 expert appraisal of the physical condition of the properties. The sur- 
 plus is almost wholly balanced by loans to a subsidiary company, the 
 cash on hand is only $2,756,759, and if there has been any writing off 
 upon account of exhaustion of ore through payment of dividends aggre- 
 gating $29,100,000, it is well concealed." 
 
 CURRENT OR " QUICK " ASSETS.— Next in order we 
 find Stock-in-Trade. This point was exhaustively covered in 
 the paper of A. Lowes Dickinson, F.C.A., C.P.A., which was 
 read at the St. Louis Congress of Accountants, where he 
 said : — 
 
 " Stocks on Hand. — Perhaps one of the most difficult questions 
 which accountants have to decide is the correct enumeration and valu- 
 ation of stocks on hand. The theory governing the valuation of this 
 asset is that, inasmuch as no profits can be realized until the goods are 
 actually sold, it is not safe to take credit for any profit thereon until a 
 sale has been effected; that, therefore, it should be carried forward at 
 the exact cost, and no profit thereon brought into the accounts of the 
 fiscal period. On the other hand, it may be found that the prices both 
 of the raw materials and the finished product have at the close of the 
 fiscal year fallen below their cost, and while it is impossible to say until 
 the goods have been sold whether any loss will ultimately be made 
 thereon, at any rate there is a possibility thereof. It is, therefore, con- 
 servative to set aside a sufficient reserve out of profits which have been 
 realized on goods already sold to provide for the accruing loss on those 
 
222 AUDITING. 
 
 which remain in hand. Hence the general rule for valuation of stocks 
 on hand, namely, ' cost or market, whichever is the lower,' has been 
 evolved, and is adopted by the most conservative commercial institu- 
 tions. Unfortunately, in practice, many concerns are unable to ascer- 
 tain the cost of their various products, with the result that their stock 
 valuations are based entirely on estimates of costs made with more or 
 less accuracy. There does not appear to be any legal obligation on a 
 corporation to adopt any particular basis, provided that the price 
 adopted is not in excess of that ultimately realized after deduction of 
 any subsequent cost of completion, storage and sale; but the absence 
 of approximately exact knowledge as to the cost frequently leads to 
 disappointment, both to the directors and stockholders, and even to 
 serious financial loss. It is obvious that a constantly changing basis of 
 cost must lead to serious inequalities in the profits shown between one 
 period and another, but it is not equally obvious to the commercial 
 community that an erroneous basis of valuation consistently adopted 
 year after year, even if that basis be a conservative one and really 
 below true cost, may result in large and unexpected discrepancies be- 
 tween the profits shown in different periods. For instance, if stocks be 
 valued on a basis exceeding cost and the trade, and consequently the 
 materials and products on hand increase very rapidly for one or more 
 years, the profits during those years of increase will be abnormally 
 inflated; but when the trade settles down to a comparatively steady 
 turn-over, there will be a considerable drop in the profits as compared 
 with the preceding year on the same amount of business done — a drop 
 which the management, as a rule, will be unable to account for until an 
 investigation by the public accountant discloses the true cause. On the 
 other hand, if the stocks be conservatively valued considerably below 
 cost, the profits of a year in which a small quantity of goods is carried 
 over at the close of the year in comparison with the beginning will be 
 inflated as compared with a succeeding year, when an opposite condi- 
 tion prevailed, although the sales and profit thereon may have been the 
 same in both years ; thus entirely upsetting all the calculations and esti- 
 mates of the managers. The essentials, therefore, for ascertaining cor- 
 rect profits so far as stocks on hand are concerned are : 
 
 (a) An accurate enumeration of the quantities on hand. 
 
 (b) An accurate ascertainment of the actual cost of the different 
 
 manufactured articles, either completed or in progress. 
 
 (r) A specific reduction in the prices of raw materials of the 
 amount by which the market valuations at the close of the 
 fiscal period fell short of the cost. 
 
 (d) A proper provision for all stock which is old or depreciated, 
 or for any reason likely to be unsaleable. 
 
THE ASSET SIDE. 223 
 
 " The more exactly these different elements are ascertained, the more 
 accurate will be the resulting statements of profits, and if the special 
 reserves be made separately, it will be an easy matter to compare use- 
 fully one period with another. 
 
 "Finally, it should be noted that it is not essential, and, in fact, it 
 will frequently be incorrect, to value materials and products on hand 
 at the end of the fiscal period upon the same price basis as at the com- 
 mencement of that period; all that is necessary or proper is that the 
 basis of valuation — that is to say, the principles on which the values are 
 arrived at — should be the same at the beginning and end) of the 
 period, the actual prices usually varying from one year to another." 
 
 Next come "DEBTS OWING TO THE COMPANY," 
 which are grouped under headings as follows : — 
 
 Debts considered good, for which the company holds notes 
 or other securities. 
 
 Debts considered good, for which the company holds no 
 security. 
 
 Debts considered doubtful and bad. 
 
 It is also provided that ".any debt due from a director or 
 any other officer of the company is to be separately stated." 
 
 It is not usually considered desirable to separately state the 
 amount of the doubtful and bad debts, but the provision for 
 the separate statement of any debt due from a director or 
 other officer is one that should not be lost sight of ; doubtless, 
 it is not intended to apply in the case of debts for small 
 amounts in the regular course of business, but cases will 
 readily occur to the reader in connection with some recent 
 failures where the compliance with this provision might have 
 materially affected the course of events. 
 
 If such a rule had been enforced in recent years with re- 
 spect to loans to directors of national banks, many millions of 
 dollars of depositors' money would have been saved. 
 
 The next item on the Balance Sheet is INVESTMENTS, 
 which should be stated in some detail, and if the investments 
 
224 AUDITING, 
 
 are on account of reserve fund account or sinking fund ac- 
 count, the circumstance should be clearly stated. 
 
 Mr. Dickinson's paper also dealt with this caption in some 
 detail, and his entire comment is reproduced : — 
 
 "Marketable Investments. — The term marketable investments is 
 intended to include only such investments as are part of the circulating 
 as distinct from the fixed assets. The latter class of investments may 
 be defined as those which cannot be disposed of without affecting the 
 operations, for the reason that the ownership thereof in a permanent 
 form is necessary, however remotely, to the business which the cor- 
 poration is carrying on. Their valuation would be governed by the 
 same principles as have been outlined above for other fixed assets. 
 
 Marketable investments, on the other hand, may be either: 
 
 (a) The stock in trade of the corporation, or 
 
 (&) The investment of surplus cash held! in this form until re- 
 quired for ordinary operating purposes, or 
 
 (c) The investment of a reserve or other special fund. 
 
 " In case (a) the rule of cost or market value, whichever is the lower, 
 applied to each individual investment, and not to the group as a whole, 
 is undoubtedly the most conservative. That is to say, no profit could 
 be taken up on any investment until it is sold, but on the other hand, 
 where the value has clearly fallen, some provision should be made 
 therefor. Where, however, the investments all have a definitely ascer- 
 tainable market value at any time, it is, perhaps, fair and reasonable to 
 allow a fall in value of some individual investments to be set off against 
 a rise in value of others, provided that the aggregate valuation is not 
 above original cost or market value, whichever is the lower. 
 
 "In case (b) the usual custom is to value at the mean market price 
 on the last day of the fiscal period for the reason that the investments 
 represent the equivalent of cash, and should, therefore, be maintained at 
 their cash value in the balance sheet. 
 
 "In case (c) any profit or loss, either realized or estimated, would 
 be a credit or charge to that fund, and not to the profit and loss 
 account. But in the balance sheet such investments should either be 
 clearly stated as maintained at cost or preferably be adjusted each 
 year to the aggregate market value if below cost. 
 
 "Another method of dealing with the fluctuations of marketable in- 
 vestments of classes (b) and (c) is to create an investment fluctuation 
 reserve, either out of estimated or realized profits on investments, or by 
 
THE ASSET SIDE. 225 
 
 a charge to profit and loss of such an amount as may be necessary to 
 prevent this reserve from showing a debit balance, and by charges or 
 credits to this reserve to maintain the asset at market value." 
 
 The corporations in whose balance sheets marketable invest- 
 ments play a leading part are insurance companies, banks 
 (more particularly savings banks) and trust compaines. In 
 all states, so far as is knov^n, the solvency of insurance com- 
 panies is 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 December 31, 1907, showed a startling decrease 
 in surplus as compared with the close of the preceding year. 
 This shrinkage attracted considerable attention, and as the cor- 
 porate bonds owned (the fall in whose market quotations was 
 largely responsible therefor) were yielding the same rate of 
 income as when purchased, and as there was no serious ques- 
 tion as to the security 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. 
 
 Mr. John Tatlock, then President of the Washington Life 
 Insurance Company, discussed the matter very fully in a paper 
 " On the Proper Method of Valuation of Fixed Term Securities 
 Owned by Life Insurance Companies " which was read at a 
 meeting of the Association of Life Insurance Presidents. The 
 following paragraphs are quoted therefrom: 
 
 "As is well known, the current practice adopted in the valuation of 
 bonds is to allow values therefor which represent the actual prices at 
 which a few bonds have changed hands on, or as near thereto as may 
 be, the date of accounting. In the case of bonds which have a wide and 
 active market the necessary information is supplied by the record of 
 public transactions; for securities which appear less frequently in actual 
 transactions information is sought from dealers concerned in such trans- 
 actions, the resulting values being based thereby more or less upon indi- 
 vidual opinion and the possible market available to the individual 
 dealer; and bonds which, on account of the extreme infrequency of 
 
226 AUDITING. 
 
 transactions therein, constitute a third and distinctive class, are oft-' 
 times credited at amounts which aptly illustrate the force of a recently- 
 resurrected and adapted epigram to the effect that 'Value is a state of 
 mind.' 
 
 " In seeking to establish the reasons for making objection to the prac- 
 tice of valuing bonds at market values, it becomes proper to look into 
 the cause, or causes, of market fluctuations of the class of securities 
 now under review. Passing over minor considerations, it may be stated 
 that in general these fluctuations depend upon and vary with the mar- 
 ket rate of interest, or the measure of the demand for money for use 
 in the customary channels of trade and commerce. This fact empha- 
 sizes a strikingly anomalous condition in the accounting methods of 
 life companies. Liabilities are calculated and determined on the assump- 
 tion that a fixed rate of interest is to be earned on the assets held to 
 offset these liabilities during the period of continuance of the contracts 
 for which the liabilities are set up. In practice the offsetting assets are 
 periodically valued at varying rates of interest which, at times, may be, 
 and are, set so high that the assets so valued fail to reach in amount that 
 necessary to cover the outstanding Habilities. In other words, they arc 
 valued to provide, for instance, for a return of 6 per cent., or even 7 
 per cent, when they were acquired to give a return of from 3^/^ per 
 cent, to 4j^ per cent, to cover liabilities whose offsetting assets arc 
 assumed to earn 3 per cent, or 4 per cent. From what source is de- 
 rived the bulk of the funds acquired by life companies which necessi- 
 tates investment? It consists of those parts of premiums which con- 
 stitute contributions to the sinking fund known as the ' reserve ' and 
 in the calculation of which no such anomaly, as indicated above, has, 
 nor possibly could have, consideration. It has been stated that the 
 practice of regarding market values of bonds rests upon the supposed 
 analogy between liabilities of life companies and those of banks and 
 similar institutions. In point of fact a wide difference exists. The 
 liabilities of a bank are practically immediate ; it is required, from the 
 nature of its business, to provide for possible liquidation within a short 
 space of time. The liabilities of a life company, on the other hand, are 
 provided by contract to mature over a period of a long term of years ; 
 the amount of Habilities requiring settlement within a given period, or 
 at a given time, can be determined in advance with a high degree of 
 accuracy, and good management can, and does, provide that assets to 
 meet maturing obligations are in hand when needed, irrespective of the 
 ups and downs of market trading in such assets in the meantime. It is 
 submitted that the whole question of solvency of a life company, to say 
 nothing of its function as a profit-making institution, rests directly 
 upon the principles and practice just enunciated. . . . 
 
THE ASSET SIDE. 22/ 
 
 " Criticism and the expression of disapproval of an existing order is 
 rarely justified unless followed by the enunciation of a remedy. Bear- 
 ing in mind that securities are purchased by life companies for perma- 
 nent investment, the nature and occurrence of the liabilities for which 
 they are an offset and the complicated questions which arise in connec- 
 tion with the division of surplus — reference to which will again be made 
 — it is submitted that the method of valuing bonds, by computing their 
 present value on the basis of the effective, or actual, rate of interest, if 
 held to maturity, which is determined by the prices at which they were 
 originally purchased, meets in a satisfactory manner all the conditions 
 of the problem. The method is not new nor original. It rests upon 
 fundamental principles of interest and annuities, and has been used for 
 many years by some life companies and many other financial institutions 
 in fixing the book values of bonds. It is easy of application by means 
 of well-known and generally adopted tables. It contains no elements 
 of mystery or pure assumption and involves in its application no exer- 
 cise of independent judgment. In considering the claims for attention 
 to this method, it is proper to note the nature of that instrument usually 
 called a bond. It consists of an obHgation to pay a fixed sum at a stated 
 future date, which sum is called the face value of the bond, and of a 
 series of obligations to pay other fixed sums at the end of periodical 
 intervals of time, usually less than one year, the dates of which occur 
 before and on the fixed date at which the face value of the bond is due. 
 If the rate of return to be realized on a bond corresponcfc in its pro- 
 ceeds to the amount of the obligation due at the end of each periodical 
 interval, then the present value of the obligations comprised in the bond 
 computed at such rate of return, will, at any date of valuation, be equal 
 to the face value of the bond. Similarly, if the rate of return calls for 
 proceeds which exceed the amount of the periodical obligations, then 
 the present value of the total obligations will, at any time before the 
 face value is due, be less than such face value ; if the rate of return calls 
 for proceeds which are less than the amount of the periodical obliga- 
 tions, then the present value of the total obligations will, at any time 
 before the face value is due, be more than such face value. 
 
 " Bonds are rarely purchased at par or face value. To make the 
 amount of the purchase merge into the amount at maturity demands an 
 adjustment of accounts. So far as life companies are concerned, differ- 
 ent methods prevail. Some, at date of purchase, charge off a premium 
 or credit a discount. Others perform similar operations at time of 
 maturity, carrying the actual cost on their books until that date ; others 
 distribute the difference between the face value of the bond and the 
 purchase price by dividing such difference into instalments in propor- 
 tion to the number of years to maturity, charging off or crediting an 
 instalment each year. All of these methods are open to criticism, be- 
 
228 AUDITING. 
 
 cause at any date of valuation the results attained thereby do not show 
 actual facts, especially those pertaining to the interest account. A few 
 companies use the method which is here advocated, the only method 
 which, for certain reasons, is believed to be wholly defensible and 
 worthy of general adoption. These reasons are as follows : 
 
 " First. The use of this method results that the amount of the invest- 
 ments, as carried on the books of the company, is at maturity exactly 
 equal to the amount then due. 
 
 " Second. This method secures the debits and credits to interest 
 account, at each periodical adjustment of the book value, in accordance 
 with the effective rate of interest, on the basis of which the investment 
 was made. 
 
 " Third, The original book value is the actual cost and, at any date 
 of valuation by this method, the book value represents the cost of such 
 portions of the obligations as have not then matured. 
 
 "Fourth. This method avoids the necessity of making arbitrary 
 charges or credits to profit and loss account. 
 
 " For the sake of completeness, it is proper to remark at this junc- 
 ture that the statements which have been made refer, of course, to 
 bonds which are expected, without question, to be paid in accordance 
 with their terms. As to others, one may be permitted to quote as fol- 
 lows from a comprehensive memorandum, on the subject of valuation 
 of investments in general, prepared by Mr. Leon O. Fisher, Auditor of 
 the Equitable Life Assurance Society of the United States: 
 
 " * Special provision should always be made for any anticipated losses 
 of principal, through the insolvency of the debtor, but such provision 
 should be made by creating special reserves from surplus, rather than 
 by writing down the amortized cost value.' 
 
 "While it may be said that attention, more or less public, is now 
 directed to this question of valuation of assets by reason of present 
 financial conditions, too much emphasis cannot be laid upon other and 
 far more important considerations which demand a radical change in 
 rules heretofore requiring a determination of market values. These 
 are to be found in the course of legislation, accomplished and prospec- 
 tive. The conditions of future surplus determination and division are 
 now laid down by statute, and compliance with these conditions can only 
 be secured by pre-arranged rules and methods. Section 83 of the New 
 York Insurance Law reads, in part, as follows : 
 
 "'Upon the thirty-first day of December of each year, or as soon 
 thereafter as may be practicable, every such corporation shall well and 
 
THE ASSET SIDE. 229 
 
 truly ascertain the surplus earned by such corporation during said year. 
 After setting aside from such surplus such sums as may be required 
 for the payment of authorized dividends upon the capital stock, if any, 
 and such sums as may properly be held for account of existing de- 
 ferred dividend policies, and for a contingency reserve not in excess of 
 the amount prescribed in this article, every such corporation shall ap- 
 portion the remaining surplus equitably to all other policies entitled to 
 share therein/ 
 
 "It will be noticed that, the surplus being once determined, the 
 deductions vi^hich may be made therefrom are specifically named. No 
 other reservation may be allowed. In a year in which a large advance 
 in market values has obtained, no reserve may be set up, out of the 
 surplus therein earned, as an offset to opposite and adverse conditions 
 which may obtain a year later. Under the market value theory, paper 
 profits must be divided and paper losses must be charged against sur- 
 plus otherwise actually earned." 
 
 It is rather curious that since the panic of 1907 the State of 
 New York has enacted a law requiring savings banks (whose 
 deposit obligations may mature on comparatively short notice) 
 to value their fixed term securities on an amortized cost or 
 " investment value " basis, while life insurance companies, 
 (which can calculate the maturities of their contract obligations 
 with a considerable degree of certainty,) are still required to 
 base their valuations of similar securities on market quota- 
 tions. 
 
 Last upon the assets side is the item of CASH, which may 
 be separated into — 
 
 Amount in banks on deposit, including accrued interest. 
 
 Amount in hands of agents or at branches. 
 
 Amount in hand. 
 
 CONTINGENT ASSETS if of sufficient moment should 
 also be noted, together with such explanation as will make 
 clear their nature. These may consist, for instance, of claims 
 for losses sustained by breach of contract which can only be 
 recovered by bringing suit in the courts and the outcome of 
 which action may be too uncertain to permit of the claims being 
 
230 AUDITING. 
 
 definitely treated as an asset, or claims against the government 
 for overcharges in duties on imports due to improper classifica- 
 tion or excessive valuation. 
 
 THE LIABILITY SIDE. 
 
 Turning now to the liabilities, it is convenient to deal with 
 these — as with the assets — under their various heads, and the 
 order also follows that laid down by " Table A " of the 
 English Companies Act. 
 
 CAPITAL. — Upon the liability side of a balance sheet, 
 framed in accordance with the provisions noted above, the 
 most prominent item — in the case of a corporation at least — 
 is the stockholders' capital, which, of course, can only be in- 
 creased beyond its original limit, or reduced, after due com- 
 pliance with impoirtant legal technicalities. In stating the 
 capital account, it is desirable to show first " in short " the 
 nominal capital, i e., the limit sanctioned by the Company's 
 charter ; secondly, the number and value of each class of shares 
 issued and the amount called up thereon, from which should 
 be deducted the amount of calls in arrear, stating the number 
 of shares upon which such calls are due. In France, and also 
 in South America, it is usual to state the full amount of the 
 capital authorized as a liability, and the amount unsubscribed 
 as an asset ; but this is not at all a desirable form to adopt, as it 
 can hardly be said that uncalled or unsubscribed capital is 
 more than a contingent asset. 
 
 BONDS. — Next comes the amount due upon bonds, the 
 amount extended being full amount to be paid, and the rate 
 of interest and year of maturity should be mentioned. 
 
 Mention has already been made of the fact that at one time 
 it was quite customary to capitalize discount on bond issues. 
 It would, of course, be desirable that where bond discount is 
 carried as an asset, such an item should be clearly described, 
 but, so far as is known, it has not been the custom to state the 
 amount of such discount in the published reports of any com- 
 
THE LIABILITY SIDE. 23 1 
 
 panics except in cases where it is being written off periodically. 
 Fortunately, the recognition of the true nature of bond dis- 
 count is becoming more general and it is to be hoped that this 
 will result in an abandonment of the practice of capitalizing it 
 even in the case of private corporations which are not specifi- 
 cally forbidden to do so by governmental regulation. 
 
 The appropriate place for premiums received upon issues of 
 either stock or bonds is in a special reserve account. 
 
 MORTGAGES. — The next item upon the balance sheet will 
 be the amount due upon mortgages, other than those covered 
 by bonds, and which also constitute a preferential liability, and, 
 ordinarily speaking, are practically permanent. The rate of 
 interest should be stated here also. 
 
 OTHER LIABILITIES.— Next come the ordinary liabili- 
 ties of the company, which, according to " Table A," are sepa- 
 rated under the following sub-headings: — 
 
 (a) Debts for which notes have been given. 
 
 (b) Debts to creditors for supplies of stock-in-trade and 
 
 other articles. 
 
 (c) Debts for law expenses. 
 
 (d) Debts for interest upon bonds and other loans. 
 
 (e) Unclaimed dividends. 
 
 (/) Debts not enumerated above. 
 
 Sometimes the item ''(d) Debts for interest upon bonds and 
 other loans " are shown as an addition to the loans them- 
 selves. Since such interest would be covered by the same 
 security by which the principal of the bonds may be protected, 
 this may be the proper place for it from a legal point of view, 
 but inasmuch as interest is a current liability as distinguished 
 from the principal, which is a funded debt, it is preferable not 
 to combine the two. 
 
232 AUDITING. 
 
 RESERVE FUNDS.— The next item upon the Hability side 
 is for " Reserve Fund, showing the amount set aside from 
 profits to meet contingencies." This, perhaps, is as good a 
 definition of a reserve fund as has been offered, and although 
 special reserve funds may be created for the purpose of pro- 
 viding for special contingencies, it may be taken as an axiom 
 that no sum which is not set aside from promts can properly be 
 called a reserve fund. Nevertheless, under the heading of 
 " Reserve " all sorts of items are frequently included which 
 under no possible circumstances can be considered to have 
 been set aside out of profits. This, perhaps, raises the some- 
 what large question as to what are actual profits, but it must 
 at least be admitted that the term " Reserve Fund " is by no 
 means applicable to all the following (although the title Re- 
 serve Account might properly be used in connection with 
 each) : 
 
 (a) A sum set aside to meet depreciation of property, and 
 to provide for its future renewal. This is a charge against 
 profits, rather than a sum set aside out of profits. 
 
 (b) A sum set aside for the purpose of equalizing the 
 charge against profit and loss for repairs and replacement of 
 machinery, &c. This, also, would appear to be a charge 
 against profits. 
 
 (c) A reserve to provide for loss upon bad debts or de- 
 preciation of investments would likewise appear to be a charge 
 against profits, unless, indeed, the amount so set aside was 
 more ample than the circumstances of the case necessitated; 
 and in this case it would probably be a better course to charge 
 against profits what might be considered a fair reserve for 
 loss, and to accumulate any further reserve that might be 
 thought prudent in the form of a reserve fund pure and 
 simple. 
 
 (d) Investment fluctuation account. This is an item which, 
 unless further explained, should never appear upon the face 
 
THE LIABILITY SIDE. 233 
 
 of a balance sheet, and that for the simple reason that its 
 meaning is by no means clear. It may mean that investments 
 have been re-valued at a higher figure than cost price, and 
 the proceeds carried to this account rather than to the credit 
 of profit and loss or reserve fund; or, on the other hand, it 
 may mean that the investments are stated in the balance sheet 
 at a higher figure than their actual value, and that the amount 
 of the investment fluctuation account is an amount set aside 
 in anticipation of future loss. The former is a perfectly 
 legitimate form of special reserve fund; the proper place for 
 the latter (which is, in fact, merely a depreciation account) 
 appears to be in reduction of the stated value of the assets. 
 
 (e) Sinking fund, or an amount set aside (and specifically 
 invested) for the purpose of meeting a future loss upon re- 
 demption of bonds issued at a discount, renewal of leases, &c. 
 
 (/) Compulsory sinking fund for the redemption or ex- 
 tinguishment of bonds, set aside in accordance with the pro- 
 visions of the mortgage. This is a very common requirement, 
 and is looked upon with favor by investors generally. 
 
 Some difference of opinion exists as to the proper treat- 
 ment of the amounts thus raised, and the opinion of Mr. Dick- 
 inson is also of interest in this connection : 
 
 " Sinking funds or debt extinguishment funds are not in theory a 
 charge against profit and loss, for the reason that they do not represent 
 a loss of expense, but the extinction of an existing liability. Inasmuch, 
 however, as in most cases the only source out of which such redemp- 
 tion fund can be provided is the surplus earnings, it is usual to insert a 
 provision in trust deeds that the sinking fund is to be provided out of 
 the profits of the year. The discharge of liabilities involves either a 
 corresponding reduction in assets or the accumulation of other liabili- 
 ties or surplus. A reduction in current assets or the accumulation of 
 other liabilities as a substitute for bonded indebtedness is clearly unde- 
 sirable and it is therefore necessary that the amount applied each year 
 to sinking fund purposes should be transferred from Profit and Loss 
 either to a special reserve fund or in reduction of some fixed asset ac- 
 count by way of provision for depreciation or otherwise. It must, how- 
 ever, be remembered that such provision for depreciation will be to 
 
234 AUDITING. 
 
 that extent represented by capital instead of current assets, and while 
 there is no theoretical objection to this, if the depreciation fund is 
 sufficiently large, the latter necessarily ceases to be available in cash 
 for one of its principal purposes, viz., the renewal of various 
 capital assets from time to time. If, however, part of the fixed 
 assets are of a wasting character, the sinking fund may be quite 
 safely applied in reduction thereof, or it may with equal propriety 
 be applied in reduction of goodwill or patents. The safest way 
 undoubtedly, therefore, in every case is to charge the sinking fund in- 
 stallment to profit and loss each year, and either credit it to a special 
 sinking fund reserve or apply it as depreciation of some fixed asset 
 for the renewal of which no cash expenditure will be required in the 
 future." 
 
 The above, no doubt, is sound reasoning, and is certainly- 
 based on conservative lines. At the same time it sometimes 
 happens that some companies having made ample provision 
 for depreciation, &c., do not consider it necessary to treat the 
 payments to sinking fund as a charge against profit and loss, 
 but simply debit " Sinking Fund " with the cash payments to 
 the trustees. In these cases where there is no provision in the 
 trust deed that the sinking fund shall be provided for out of 
 profits there is no necessity to charge the amount thereof 
 against profit and loss, and the charge may be provided for by 
 a fresh issue of notes or capital stock. 
 
 As a rule, the trustees are not directly accountable to the 
 company for their disposition of the cash which they receive, 
 and can make such investments as they choose, subject in cer- 
 tain cases to restrictions requiring them to first purchase bonds 
 of the same company, provided, of course, that they may be 
 obtainable. 
 
 It seldom happens that these compulsory payments corre- 
 spond in amount with proper depreciation, particularly where 
 the sinking fund is fixed on a sliding scale, and it would not 
 seem to be convenient to attempt to oflfset one by the other, 
 nor, on the other hand, for the reasons urged above, does it 
 seem equitable to compel a company to charge off both depre- 
 ciation and sinking fund instalments. 
 
THE LIABILITY SIDE. 235 
 
 In view of the fact that whenever sinking fund charges to 
 profit and loss are in addition to ample charges for depreciation^ 
 probable losses on bad debts, &c., they really represent undi- 
 vided profits or surplus which will revert to surplus or profit 
 and loss account after the specific purpose for which they 
 have been temporarily set aside (i. e., the redemption of the 
 bonds at maturity) has been fulfilled, it appears that the cor- 
 rect way to state the sinking fund in the balance sheet is as a 
 separate section of the surplus or undivided profits, and not to 
 include it among the actual liabilities. 
 
 {g) The " reserve " of a life assurance company, which is 
 a fund set aside out of the surplus premiums paid by the 
 assured in the earlier years of their insurance to meet the 
 deficiency of such premiums to cover the increased risk of 
 later years, when the expectation of life is shorter and which 
 unless they are separately stated, must also provide for " de- 
 ferred dividends," which are in reality actually allocated to 
 the assured each year, but which are not payable until the expi- 
 ration of the full term of the policy. To a very large extent 
 the reserves of life assurance companies are " premiums paid 
 in advance," rather than " accumulated profits." 
 
 There can be no doubt but that it is improper to state as a 
 reserve fund any sum which has not been actually set aside, 
 out of profits, solely for the purpose of providing against un- 
 foreseen contingencies. 
 
 It might be added that in this book the word " Fund " is. 
 in most cases used in the same sense as many accountants use 
 the words " Fund Account" and where investments of these 
 items are made they are stated among the assets as " Fund 
 Investments." 
 
 Considerable discussion of this question has taken place 
 recently, it being contended by some that a " Fund " can only 
 be an asset, the word itself indicating something which is 
 tangible. The discussion, therefore, hinges largely on the in- 
 terpretation of the meaning of the word, and it is hoped that 
 
236 AUDITING. 
 
 there will very soon be uniformity of opinion on the subject. 
 At present, however, most large corporations use the word as 
 mentioned heretofore. 
 
 THE INVESTMENT OF RESERVE FUNDS.— The 
 numerous failures that occurred during the year 1907, and, 
 in fact, many failures of more recent date, show that the mere 
 existence of a large reserve fund does not in itself suffice to 
 ward off disaster, and hence many unfortunate stockholders 
 have bitterly stated that these paper reserves were " fictitious," 
 and there is much truth in their contention. 
 
 The usual criticism includes a demand that reserve funds be 
 actually invested in securities outside the business itself, and 
 that the balance sheet show them properly " earmarked.'* 
 
 It cannot be too strongly advanced that the question as to 
 whether or not any given reserve fund is represented by assets 
 consisting of marketable securities outside the business, or by 
 less readily marketable assets employed in the business as fixed 
 (or working) capital, is comparatively speaking of little im- 
 portance. The most casual perusal of any balance sheet will 
 show at a glance, even to the least informed, by which class of 
 assets the reserve fund is represented. Consequently the occa- 
 sion does not arise to deal specifically with this point. What 
 is of more importance, and what cannot be gathered usually 
 even by the most expert accountant by a perusal of the pub- 
 lished accounts, is whether the so-called reserve fund is (i) a 
 bona Ude accumulation of divisible net profits set aside (or 
 reserved) merely to provide for unforeseen contingencies, or in 
 general terms because it is thought inexpedient to divide profits 
 up to the Hmit. (2) A reserve set aside out of profits with a 
 view to retaining in the possession of the company assets that 
 may hereafter be applied to a foreseen and specific purpose — 
 as, for example, the repayment of redeemable bonds; or (3) 
 a provision, falsely called reserve fund, set aside by charging 
 from year to year something against profits for the purpose of 
 building up a provision to meet a known or expected deteriora- 
 
THE LIABILITY SIDE. 237 
 
 tion of assets in the future. No mere inspection of a majority 
 of published accounts would enable any one to determine to 
 which of these three classes an item described as " reserve 
 fund " belongs ; hence the extreme importance, from the audi- 
 tor's point of view, of the adoption of a correct nomenclature. 
 The term " reserve fund " without qualification, ought, it is 
 submitted, in all cases to refer solely to class (i) mentioned 
 above. If the reserve fund be an accumulation of divisible 
 profits " earmarked " in advance for a specific purpose, and 
 therefore not properly available for any other purpose (as in 
 the case of class (2), the limitations of that reserve fund ought 
 to be clearly stated upon the face of the balance sheet {e. g., 
 " Reserve Fund accumulated to provide for redemption of 
 bonds in 190 — ," or ** Reserve Fund specifically earmarked"). 
 If a credit balance that properly comes under the definition of 
 class (3) is called " Reserve Fund," it is submitted that the 
 accounts are to that extent false and misleading, and that the 
 auditor should require them to be amended, so that they may 
 properly disclose the true position of affairs. If his reasonable 
 requirement in this respect be refused, his only alternative 
 would appear to be to place a certificate at the foot of the bal- 
 ance sheet, to the effect that his requirements, as auditor, have 
 not been complied with in this respect — dealing, of course, 
 fully with the subject in his report to the stockholders. 
 
 The last paragraph applies specifically to companies operating 
 under the English Companies Acts ; in view of the differences 
 of opinion which exist in the United States as to the proper 
 use of the words " Reserve Fund '* it is considered inadvisable 
 to advocate such a course here. 
 
 UNDIVIDED PROFITS.— The last item upon this side of 
 the balance sheet is the balance of undivided profit. It is 
 thought preferable to show this balance without elaboration 
 upon the balance sheet, and in a " Profit and Loss Apportion- 
 ment Account" (or the last section of the profit and loss ac- 
 count) to show the connection between the balance shown 
 upon the balance sheet and the balance of the profit and loss 
 
238 AUDITING. 
 
 account for the current period. There is, however, no objec- 
 tion to showing the details upon the balance sheet, except that 
 it does not appear to present the facts of the case so clearly. 
 
 CONTINGENT LIABILITIES.— With the question of 
 contingent liabilities it is not necessary to deal at length, be- 
 yond stating that all such liabilities as are known should be 
 noted upon the balance sheet, even if it is anticipated that 
 they will not ultimately result in a claim against the company. 
 
 GENERAL. — It is hardly necessary to enter in detail into 
 the forms of balance sheets required for different classes of 
 undertakings ; the same rules apply in almost all cases, and al- 
 though modifications of detail will appear desirable in almost 
 each particular case, these naturally must be considered and 
 dealt with according to the particular circumstances that 
 obtain, the general principle in all cases being that the accounts 
 must not only be correct, but also so clear as to render mis- 
 apprehension impossible, even among those who do not pro- 
 fess to be skilled accountants. In this respect it is, perhaps, 
 well to bear in mind the particular classes of persons who are 
 likely to be interested in the accounts. Thus, in the case of a 
 building and loan association, lucidity will be the great thing 
 to be aimed at; while in the case of such an institution as a 
 bank, the main object of the balance sheet is, perhaps, less 
 to inform stockholders as to the amount of their profits than to 
 allow the public to form a reliable estimate upon the bank's 
 stability. It may be added that an " account " is not primarily 
 a collection of figures; it is a narration of events and facts; 
 while a person appointed to hear and approve such narration 
 is called an " auditor." The importance of these points lies 
 in the circumstance that, although accounts are now written 
 (or printed) instead of being delivered orally, the narration 
 (or wording) is at least as material as the figures themselves. 
 
 The English Companies Act heretofore referred to indicates 
 the accounts to which stockholders are entitled more clearly 
 than is the case with most of our corporation laws. 
 
CONSOLIDATED BALANCE SHEETS. 239 
 
 The following is an extract from Table A of the act of 1908: 
 
 Section 106. Once at least in every year the directors shall lay be- 
 fore the company in general meeting a profit and loss account for 
 the period since the preceding account or (in the case of the first ac- 
 count) since the incorporation of the company, made up to a date not 
 more than six months before 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 regulated 
 in accordance with sections one hundred and twelve and one hundred 
 and thirteen of the Companies (Consolidation) Act, 1908, or any 
 statutory modification thereof for the time being in force. 
 
 CONSOLIDATED BALANCE SHEETS AND PROFIT 
 AND LOSS STATEMENTS. 
 
 The proper method of stating the accounts of corporations, 
 which are generally know^n as " holding " companies, has re- 
 ceived considerable attention recently because it is believed 
 that the omission on the part of some corporations to take up 
 the losses of subsidiary companies, when they have included 
 among their own earnings all the profits, has resulted in 
 erroneous opinions as to the actual net earnings of the corpora- 
 tions in question. 
 
 Frequently, the balance sheet of the holding company 
 simply gives its own assets and liabilities, and these convey 
 practically no information at all so far as the actual condi- 
 
240 AUDITING. 
 
 tion of the subsidiary companies is concerned. Ift many in- 
 stances very large loans to underlying companies are included 
 in the assets. In the absence of specific information as to the 
 separate earnings or condition of such undertaking, it is 
 impossible to judge whether such an advance is or is not a 
 good asset. It becomes, therefore, a grave matter of principle 
 for the auditor to decide, and the form of the accounts in this 
 instance becomes of unusual importance. 
 
 The opinion of A. Lowes Dickinson, F.C.A., C.P.A., on 
 this subject, as reflected in his paper read at the St. Louis Con- 
 gress of accountants, is of importance, as it is believed that the 
 views there expressed represent the best accountancy prac- 
 tice : — 
 
 " During the last few years the correct statement of the earnings of 
 a company controlling a number of subsidiary companies has required 
 much consideration. Legally, the earnings of such a corporation con- 
 sists of the results of its own operations, together with any dividends 
 which may be declared on the stocks which it owns in the subsidiary 
 companies; and so long as these stocks represent only minority inter- 
 ests in companies which are not in any way controlled or operated by 
 the directors of the holding company, it would seem that a profit and 
 loss account prepared in such a way would be a correct and proper 
 statement from an accounting as well as from a legal point of view. 
 During recent years, however, the practice of consolidating a number 
 of concerns by a control of stock rather than by an absolute purchase 
 of the business has grown into favor, and consequently it is usual 
 to find the holding company owning either the whole or a large 
 majority of the stocks of a number of companies doing a similar 
 business, appointing the directors of these sub-companies, dictating 
 their policy and generally acting in every way as if it absolutely 
 owned the whole property. Under such conditions it is submitted that 
 no statement of earnings can be considered correct which does not 
 show in one account the profits or losses of the whole group of com- 
 panies, irrespective of whether dividends have or have not been 
 declared thereby. If this principle be not insisted upon, it is within 
 the power of the directors of the holding company to regulate its profits 
 according, not to facts, but to their own wishes, by distributing or 
 withholding dividends of the subsidiary companies; or even to 
 largely overstate the profits of the whole group by declaring 
 large dividends in those sub-companies which have made profits, 
 while entirely omitting to make provision for losses which have been 
 
CONSOLIDATED BALANCE SHEETS. 24I 
 
 made by other companies in the group. It is doubtful whether there 
 is any existing law which could legally require a corporation to make 
 up its statement of profits on the basis here suggested, but possibly 
 it may eventually be found that the ordinary rule referred to at the 
 commencement of this paper, of a reasonable valuation of assets, may 
 be made to cover this point for the following reasons: 
 
 " It is clear that whatever the value of an investment in a corpora- 
 tion may be at a particular date, its value at any subsequent date 
 (other things being equal) must be greater or less by the amount of 
 the profits or losses made during the intervening period. Even if other 
 conditions at the two dates are not the same, and, quite apart from 
 any consideration of the earnings or losses during the intervening 
 period, there is a considerable appreciation or depreciation in the 
 investment, that appreciation or depreciation must undoubtedly be 
 more or less, respectively, by reason of profits earned or losses in- 
 curred. In this case the change in value of the asset is at any rate 
 partly due to the result of the operations for the purpose of which the 
 investment is held. On the general principle, therefore, that a profit 
 and loss account should take into account all profits or losses resulting 
 from the trading operations, but should not take into account the 
 profits or losses arising from a revaluation of capital assets, it may 
 eventually be held, on legal as well as on accounting principles, that 
 the statement of earnings presented by a holding company is not 
 correct unless it takes into account by way of either a reserve or a 
 direct addition to or deduction from the capital value of the invest- 
 ment the profits or losses made in operating the subsidiary com- 
 panies. 
 
 " One other difHcult point is the determination of what is or is not 
 a constituent company whose profits and losses should be brought 
 into account in this manner. It is suggested that this depends partly 
 on the proportion of stock owned and partly upon the degree of con- 
 trol exercised by the holding company. When the latter owns at least 
 a majority of the stock, operates the company, dictates its policy and 
 practically treats its property as its own, subject only to the right 
 of the minority stockholders to receive a share of the profits, the 
 conditions would appear to be such as to require the proportion of 
 profits and losses corresponding to the stock owned to be taken up; 
 while, on the other hand, a mere majority ownership of stock without 
 any effective control of the management and operation might properly 
 be treated as an investment, only subject to the same rules as other 
 investments of a similar character." 
 
 Very little need be added to the above except that the last 
 clause may possibly be misunderstood. It is quite correct that 
 
242 AUDITING. 
 
 its proportion of profits, only, should be taken up, but in many 
 cases a holding company owning, say, ninety per cent, of the 
 stock of another company, which is being operated by it in 
 connection with other companies, should take up all the loss of 
 the latter rather than its proportion only, which in this case 
 would be ninety per cent. The reason for this is obvious. If 
 the subsidiary company is an important or necessary link in 
 the group usually operated by holding companies, and is losing 
 money in its operations, it almost invariably happens that the 
 parent company will be compelled to make cash advances suffi- 
 cient to cover the losses sustained. These advances will be 
 carried as assets by the holding company, and should be scru- 
 tinized as carefully as other accounts receivable. Obviously, 
 advances, especially those without security, to a company whose 
 finances are unsatisfactory or whose operations have been uni- 
 formly unprofitable, cannot be looked upon as good unless a 
 critical examination proves this to be a fact. 
 
 If the suggestion that the entire loss be taken up in the man- 
 ner advocated above is not acceptable to the directors, it 
 might be stated in another way, viz., treat the ninety per cent, 
 and the ten per cent, as separate items, covering the latter by 
 charging profit and loss and crediting a reserve account in 
 the same way that other bad or doubtful debts are treated. 
 
 Where the earnings of subsidiary companies have been car- 
 ried into the books of the holding company, it follows, of 
 course, that either some asset account, such as that represent- 
 ing the investment in the subsidiary company, has been corre- 
 spondingly increased, or else it will be debited to an account 
 called " Profits of Subsidiary Companies," and the holding 
 company's current profit and loss account credited. Fol- 
 lowing out the same line where a loss has been made, the In- 
 vestment Account (or any other account which represents the 
 cost of the underlying property), or the account "Profits of 
 Subsidiary Companies," should be correspondingly decreased 
 and the current profit and loss account of the holding com- 
 pany debited. 
 
CONSOLIDATED BALANCE SHEETS. 243 
 
 The rule that the whole loss on operations of an underlying 
 company must be taken up by the holding company cannot 
 apply where the operations of the subsidiary company result 
 in a profit. The only legitimate way by which the holding 
 company can secure its proportion of this profit being through 
 dividends, it follows, of course, that the minority interests, 
 no matter how small, will receive their share, although thtv 
 can never be depended upon to contribute any proportion 
 whatever of the losses. 
 
 Where it has not been the practice to carry the results of 
 the operations of subsidiary companies into the books of the 
 holding company, but where a consolidated balance sheet and 
 earnings statement is to be prepared, the latter should, for 
 the reasons set forth, take up the entire losses of all companies 
 where the interest is overwhelming. If this is done, there can 
 be no objection to carrying the advances to such companies 
 as good, but if the advances are greater than the aggregate 
 losses taken up, great care must be taken to ascertain that 
 the losses shown by the books of the subsidiary company are 
 accurately determined. 
 
 Of course, this is a matter which naturally varies with the 
 facts in each particular case. In the event of the loss being 
 an extraordinary one, likely to be recouped in subsequent 
 years, the question takes another aspect, as is also the case 
 where the minority interest is considerable, and where the 
 whole burden of advances, &c., does^not fall upon the holding 
 company. 
 
 It might be urged that if the unprofitable company is not 
 a necessary part of the general undertaking, its operations 
 could be suspended and further losses avoided; in such an 
 event, if the losses on operations have, as a matter of fact, 
 been taken care of by the holding company through its ad- 
 vances, the entire amount of such loss will still have to be 
 taken up, because it cannot be assumed in such a case, any 
 more than in a going concern, that the minority interests will 
 contribute their share of the losses. This principle, however, 
 
244 AUDITING. 
 
 does not cover any capital loss which may ensue, and it will 
 have to be dealt with on its merits. 
 
 A full discussion of the accounts of holding companies will 
 be found in the paper, "The Accounting of Industrial Enter- 
 prises," by William M. Lybrand, C.P.A., reprinted in the 1908 
 year book of the American Association of Public Account- 
 ants, and which can be secured from the Accountancy Publish- 
 ing Co. 
 
 CONCLUSION. 
 
 In considering these matters, however, it must be borne 
 in mind that it is very exceptional for the form in which 
 accounts are stated for the stockholders to be actually 
 under the control of the auditor. As a rule, by-laws provide 
 that the accounts shall be rendered in such form as the 
 directors shall think fit, and in such cases it is, of course, im- 
 possible for the auditor to dictate as to the precise form to 
 be adopted. This, however, does not release him from the re- 
 sponsibility of judging as to the fitness of the form in which 
 the accounts are rendered by the directors. In this respect he 
 is placed in a position and furnished with information which 
 is withheld from the general body of the stockholders, for the 
 express purpose of satisfying himself that the accounts submit- 
 ted by the directors to the stockholders are such as will reason- 
 ably disclose the position of the company. Considerations with 
 regard to the form which the accounts should take are fre- 
 quently of a nature which the auditor must of necessity weigh 
 for himself ; for, inasmuch as the stockholders have no knowl- 
 edge of the transactions or position of the company other than 
 that which they gain from a perusal of the directors' accounts 
 and the auditor's report, it stands to reason that if the accounts 
 do not sufficiently disclose these things, it: may frequently hap- 
 pen that the stockholders themselves would have no reason to 
 suspect that the accounts were not all that they should be. It 
 therefore follows that, although the auditor do€S not have the 
 drafting of a company's accounts, it is necessary for him in all 
 
CONCLUSION. 245 
 
 cases to consider the form in which they are submitted for his 
 approval, and not merely to content himself with an examina- 
 tion of their technical correctness. It has been stated by some 
 that, the accounts submitted to the stockholders being the 
 accounts of the directors, they, and they only, are responsible 
 to the stockholders for the form. This is true to the extent 
 that the auditor has no power to compel the directors to 
 modify the form of their accounts; but it is not true in the 
 sense that if the accounts submitted are, so far as they go, 
 correct, the auditor is under no responsibility to specially 
 report in such cases, as they are insufficient to enable any one 
 examining them to obtain a correct idea of the company's 
 position. Were this the case, it would indeed be difficult to 
 see in what respect the stockholders gained by an audit of 
 their accounts, for it is obvious that it would be possible to 
 conceal almost anything in the shape of fraud or unjustifiable 
 extravagance. The stockholders have, however, a clear right 
 to such accounts as will enable them from time to time to judge 
 of the value of their investment ; and it is for the purpose of 
 making the accounts reliable for this purpose that an auditor is 
 appointed. And while there rests with him the serious respon- 
 sibility of concealing such matters of internal detail as would, 
 if divulged, tend to damage the position of the business, yet, 
 on the other hand, he must not fail to remember that it is 
 the stockholders, and not the directors, who are the masters 
 of the fortune of the company, and that (excepting matters of 
 internal detail) they have an undisputable right to the fullest 
 and clearest information. 
 
 There has been a decided advance recently along the line 
 of improved forms. It may be due to a demand on the part of 
 stockholders, but in any event it is encouraging to those who 
 have striven towards it for years. Appendix D to this book 
 contains the more important standard forms now in use. 
 
CHAPTER VIII. 
 
 WHAT ARE PROFITS? 
 
 In the preceding chapters most of the points arising in the 
 course of an audit, with a view to ascertaining that all due 
 precautions have been taken to test the accuracy of accounts 
 before certifying them, have been considered in some detail; 
 but it is advisable to review some of these various questions 
 from the point of view of considering whether or not the 
 amount of profit stated upon the face of the accounts is actually 
 available for dividend. It is most important to remember in 
 this connection, however, that until an undertaking has been 
 actually wuund up, any statement as to the profits earned is to 
 a great extent merely an estimate, or an expression of opinion, 
 and not a stalement of facts. 
 
 ADVANTAGES OF DOUBLE ENTRY. 
 
 The reader will hardly require to be reminded that, in the 
 case of an ordinary corporate undertaking, the amount of 
 profit available for distribution will be represented on the 
 balance sheet by the excess of the assets there disclosed over 
 the liabilities and paid-up capital of the undertaking. But it is 
 desirable for the auditor, in order to make sure of his position, 
 to look at the patter not merely from a balance sheet point of 
 view, but, in the first place, to carefuHy scrutinize the revenue 
 account in order to see that no sources of income have been 
 taken credit for unduly, and that all reasonable expenses have 
 been properly debited, and then to compare the profit shown 
 by such revenue account with the surplus before mentioned, 
 stated to be available on the face of the balance sheet, after 
 
 246 
 
CAPITAL V. REVENUE. 247 
 
 scrutinizing all the assets and liabilities there disclosed. By 
 this means he will have the advantage of looking at the matter 
 from two points of view, which, in so difficult a question as the 
 assessment of actual profits, is of the utmost value. 
 
 CAPITAL V. REVENUE. 
 
 It will be seen from what has been said above that, at all 
 events economically speaking, no profits are available for dis- 
 tribution until provision has been made for keeping the whole 
 of the paid-up capital of the undertaking intact. The ab- 
 solute legal necessity for this provision has, however, been 
 rendered somewhat doubtful by many decisions which have 
 been given in the courts from time to time. The English de- 
 cisions are, of course, more numerous than those which can 
 be found reported in the United States, but in view of the 
 fact that each case necessarily is decided on its merits, it is 
 scarcely worth while to review all of them in this volume. 
 The student, who may be specially interested in this branch 
 of accountancy, however, finds much of interest in the very 
 full law reports which are reviewed in Dicksee's "Auditing," 
 Seventh English Edition. 
 
 It may be stated in this connection, however (although 
 necessarily briefly and incompletely), that the effect of all these 
 English decisions was that under certain circumstances it 
 might not be necessary for a company, before declaring a 
 dividend out if profits alleged to have been earned, to provide 
 in that year's accounts for the whole of the loss caused by 
 the shrinkage in intrinsic value of the whole or a portion 
 of its assets. In one case* it is true that the actual facts dis- 
 closed did not place it beyond doubt that the fixed assets of 
 the company were in fact less valuable than when they were 
 taken over in the first instance; but in other cases the fact 
 that some depreciation had occurred was undisputed, and al- 
 though some provision had been made for this depreciation 
 
 *Leev. The Neuchatel Asphalte Company, Limited (1889) (Dicksee's Auditing, 
 Seventh English Edition, page 610). 
 
248 AUDITING. 
 
 in two reported cases,* it was not seriously contended that 
 a sufficient sum had been written off to cover the whole of the 
 loss. 
 
 On the other hand, it is very desirable that no undue im- 
 portance should be attached to these decisions, for it must 
 be remembered that several of the cases arose out of a motion 
 upon the part of one or more stockholders to obtain an in- 
 junction against the directors of a company, restraining them 
 from declaring a dividend; and that, in the absence of any 
 evidence that creditors would be defrauded, or the rights of 
 one or more classes of stockholders seriously prejudiced, the 
 courts would naturally not lightly interfere with the deliberate 
 action of the directors, endorsed by a resolution of the com- 
 pany passed in general meeting, in regard to a matter which 
 would certainly appear to be essentially one of internal admin- 
 istration. 
 
 The most difficult questions that arise under this heading 
 proper occur in the case of a company which has sold a part 
 of its undertaking, but the general principles to be applied in 
 such cases have been fairly well defined by the courts. In one 
 English case,t it was decided that so long as it was not ultra 
 vires the company, a profit made on the sale of part of the 
 undertaking was available for dividend — upon the principle, 
 apparently, that there was nothing in the English Companies 
 Acts themselves to prevent a company declaring that one of the 
 " objects " for which it was incorporated was to from time to 
 time, as opportunity offered, sell at a profit undertakings 
 which had in the first instance been acquired not for the pur- 
 pose of re-sale, but with the idea of working them for revenue 
 purposes. That is to say, tbere is no statutory provision to 
 prevent a company from changing its mind, and deliberately 
 converting fixed assets into floating assets. To some extent, 
 
 * Wilmer v. McNamara & Company, Limited (1895) (Dicksee's Auditing, Seventh 
 English Edition, page 628, and Dovey v. Corey (1901) (Dicksee's Auditing, Seventli 
 English Edition, page 767). 
 
 t Lubbock V. British Bank of South America, Limited (1892) (Dicksee's Auditing, 
 Seventh English Edition, page 618). 
 
CAPITAL V. REVENUE. 249 
 
 however — although to no unreasionable extenii — ^this some- 
 what general decision was limited by another case decided 
 some years later.* Briefly stated, the position here was that 
 the company had in the first instance acquired a number of mis- 
 cellaneous assets for a lump sum, and had — doubtless in the 
 exercise of a bona fide discretion vested in the directors — 
 apportioned the purchase price over the various assets so 
 acquired. One of these assets seems to have been a book 
 debt of an extremely doubtful nature, which was valued at 
 nil, but which eventually produced to the company the sum 
 of $130,000. The directors sought to regard the whole of this 
 sum as profit, doubtless on the footing that the asset in ques- 
 tion had cost the company nothing, and that, therefore, what- 
 ever it actually realized was clear profit. On a motion on 
 behalf of debenture-holders and a stockholder to restrain the 
 application of these moneys to the payment of a dividend, the 
 judge made an order in the terms applied for. In doing so, 
 however, he said " It is clear, I think, that an appreciation in 
 the total value of capital assets, if duly realized by sale or get- 
 ing in of some portion of such assets, may be a proper case to 
 be treated as available for purposes of dividend ; " but he held 
 — and accountants will doubtless agree with his holding — ^that 
 so material a disproportion between the directors' original 
 apportionment of the purchase-price among the assets acquired 
 and the realizable value of one of those assets clearly suggested 
 that, before any such alleged profit as that referred to can be 
 safely treated as true profit, the whole business of the appor- 
 tionment of the purchase-price ought to be gone over afresh. 
 Had the directors been prepared to re-value all their fixed 
 assets, and after such re-valuation to only treat as profit the 
 excess of the bona fide value of the fixed assets retained plus 
 the proceeds of assets realized, over the original cost of all 
 assets as profit, there can, it is thought, be but little doubt that 
 the judge would have sanctioned a di\'idend paid out of profits 
 so computed. 
 
 * Foster v. The New Trinidad Lake Asphalte Company, Limited (1900) (Dicksee's 
 Auditing, Seventh English Edition, page 754) 
 
250 AUDITING. 
 
 It is hardly likely, however, that many of the English de- 
 cisions will be followed in this country, because our corpora- 
 tion laws are not only radically different from theirs, but 
 usually some provision will be found in most of our statutes 
 which bears directly on the subject. It is true, however, that 
 most of the English decisions as to what are, or what are not, 
 profits are based on the rules of the common law of England, 
 and in the majority of our States the same rules or usages are 
 followed. 
 
 The most notable American decisions along this line are 
 those against the directors of the American Malting Co., 
 rendered during the years of 1903 and 1904, which not only at- 
 tracted attention from the fact that the directors were com- 
 pelled to pay back to the company something in excess of one 
 million dollars but they were also of interest on account of 
 the accountancy principles involved. 
 
 One of the cases arose in the New Jersey courts, and one in 
 New York. The latter is fully reported in Appendix " C." 
 The following brief resume of the principal points in the New 
 Jersey decision appears properly at this point. 
 
 APPLETON V. AMERICAN MALTING CO. 65 New 
 Jersey Equity, page 375. Court of Errors and Appeals New 
 Jersey. March 11, 1903. Section 30 of the Corporation Act 
 of New Jersey provides as follows : 
 
 " 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 
 dividend, to the corporation and its creditors, in the event of its 
 dissolution or insolvency, to the full amount of the dividend made 
 or capital stock so divided, withdrawn, paid out or reduced, with in- 
 terest 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 
 
CAPITAL V. REVENUE. 2$ I 
 
 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." 
 
 Certain directors of the American Malting Company 
 voted for dividends which were paid out of capital in violation 
 of the above statute. 
 
 Thereupon certain stockholders filed a bill in equity to com- 
 pel the directors of the company to pay back said dividends 
 into the treasury of the company. 
 
 The directors contended that they were liable only in case 
 of the dissolution or insolvency of the company, and that as 
 their conduct had not resulted in either the dissolution or the 
 insolvency of the company, they were not liable. 
 
 The court, however, held them liable, delivering the follow- 
 ing opinion: 
 
 "It is argued by the demurrants (directors), as has been already 
 stated, that the statute, so construed, is grossly unjust and inequitable, 
 in that it requires the directors to pay into the treasury of the corpora- 
 tion, for the benefit of the stockholders, the amount of the deficit, 
 although the stockholders, not the directors, have in their pockets the 
 portion of the capital which has been withdrawn. The argument 
 assumes that there will be no transfer of the stock of the company 
 during the period of the liability of the directors. The assumption is 
 unwarranted. The very declaration of the dividend, evidencing, as it 
 does, the apparent prosperity of the company, creates a desire on the 
 part of outsiders to become holders of the stock. It, at the same 
 time, decreases the actual, while increasing the apparent, value of the 
 stock. The result is to afford unscrupulous directors, and stockholders 
 who are cognizant of the illegal action of the board, an opportunity to 
 unload their holdings upon innocent purchasers at fraudulently inflated 
 prices. It is eminently just that the persons, whose wrongful act has 
 caused loss to those who have been induced by it to become stock- 
 holders, should make good that loss, but is it inequitable that stock- 
 holders who have innocently participated in the distribution of the 
 illegal dividends should have their stock restored to its normal value by 
 contribution from the directors who have impaired the capital, without 
 
1 
 
 252 AUDITING. 
 
 being first required to pay back the dividend so paid to them? The 
 ordinary purchaser of corporate stock holds it as an investment. He 
 rightly considers and treats the dividends paid upon it as income. 
 In many instances the income is required to meet the expenses of 
 living, and is entirely expended for that purpose. To say that a 
 person who has been unwittingly induced to exhaust his principal, by 
 the mistaken or fraudulent representation of those to whom he has 
 entrusted it that what has been paid to him as income, suffers no 
 injury, is absurd. To refuse him redress, except upon condition that 
 he return the moneys which he has expended in the belief that his 
 capital was intact — notwithstanding that by such expenditure he is 
 rendered penniless is to put a premium upon fraud in corporate man- 
 agement." 
 
 From the auditor's standpoint the New York decision is of 
 far greater importance, and the entire text is well worth read- 
 ing. 
 
 It should be noted that the New Jersey law (already quoted) 
 requiring dividends to be paid only from profits, is similar to 
 the New York statute. Section 23 of the (New York) Stock 
 Corporation Law provides : 
 
 "The directors of a stock corporation shall not make dividends, 
 except from the surplus profits arising from the business of such cor- 
 poration; 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 section, the directors under whose adminis- 
 tration 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 corporation and 
 to the creditors thereof to the full amount of the capital of such cor- 
 poration so divided, withdrawn, paid out or reduced." 
 
 The court in passing on the question of " What are Net 
 Profits?" quotes the following definition from the Century 
 Dictionary: "What remains as the clear gain of any business 
 after deducting the capital invested in the business, the ex- 
 penses incurred in its management and the losses sustained by 
 its operation." 
 
CAPITAL V. REVENUE. 253 
 
 It will be noted that the main controversy in the case arose 
 over the question as to whether the company had a right to 
 declare dividends from book profits which were largely, if 
 not wholly, anticipated. Referring to this point the court said : 
 
 " To calculate months in advance on the result of the future transac- 
 tions, 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 expectation of a future delivery at a favorable price of what is not 
 yet in existence, under the statute," and further on : " 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 direc- 
 tors, fiduciary officers as they are, that they should obey the law of 
 their incorporation and not bring their companies to the verge of 
 bankruptcy and ruin by the payment of quarterly dividends on pre- 
 ferred stock out of capital instead of net earnings." 
 
 It might be added that, although the company had made no 
 allowance for depreciation, the point was not raised by the 
 plaintiffs, and the court was, therefore, not called upon to 
 pass upon it. 
 
 The EngHsh Companies (Consolidation) Act, 1908 (8 Edw. 7, 
 Ch. 69), contains the following provisions with respect to divi- 
 dends and reserves. 
 
 Dividends and Reserve. 
 
 TABLE A. — Section 95. The company in general meeting may de- 
 clare dividends, but no dividend shall exceed the amount recommended 
 by the directors. 
 
 Section 96. The directors may from time to time pay to the mem- 
 bers 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. 
 
 Section 98. Subject to the rights of persons, if any, entitled to shares 
 with special rights as to dividends, all dividends shall be declared and 
 paid according to the amounts paid on the shares, but if and so long 
 as nothing is paid up on any of the shares in the company, dividends 
 may be declared and paid according to the amounts of the shares. No 
 
254 AUDITING. 
 
 amount paid on a share in advance of calls shall, while carrying inter- 
 est, be treated for the purposes of this article as paid on the share. 
 
 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 reserves which shall, at the discretion of the 
 directors, be applicable for meeting contingencies, or for equalizing 
 dividends, or for any other purpose to which the profits of the company 
 may be properly applied, and, pending such appHcation, 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. 
 
 Section 100. If several persons are registered as joint holders of 
 any share, any one of them may give effectual receipts for any dividend 
 payable on the share. 
 
 Section lor. Notice of any dividend that may have been declared 
 shall be given in manner hereinafter mentioned to the persons entitled 
 to share therein. 
 
 Section 102. No dividend shall bear interest against the company. 
 
 DEFINITION OF "PROFITS." 
 
 In connection with the question as to what are " profits 
 available for distribution,'' it is of interest to note the definition 
 given in Buckley, 8th Edition, pages 584 and 585, which is as 
 follows : 
 
 "The profits of the business of the company are the credit balance 
 of a profit and loss account properly prepared, having regard to the 
 definition of the business in the memorandum of association. They 
 are the excess of revenue receipts over expenses properly chargeable 
 to revenue account. As to what expenses are properly chargeable to 
 capital and what to revenue it is necessarily impossible to lay down any 
 general rule. In many cases it may be for the shareholders to deter^ 
 mine this for themselves provided the determination be honest and 
 within legal limits." 
 
 It will probably be admitted that this is one of the most 
 diplomatic definitions that has ever been given upon a sub- 
 ject of such vast importance ; inasmuch as it leaves the inquirer 
 exactly where he started, for it still remains for him to define 
 what receipts are apportionable to capital and what to revenue, 
 
255 
 
 and what expenses are chargeable to capital and what to rev- 
 enue. Could these questions be definitely answered in each 
 case, it is obvious that the question of what the actual profits 
 have been would be one capable of the most ready solution. 
 In view of the close relation of the whole subject of " profits " 
 to the decisions of the courts it becomes necessary to ascertain 
 the legal meaning of the word. In many undertakings the 
 judgment of the professional auditor as to the question of 
 actual profits may differ from most lawyers but it 'is neverthe- 
 less important to have in mind all that may be said on the sub- 
 ject by competent authorities, and the following extract from 
 a leading law text-book (Cook on Corporations. 5th Edition, 
 page 1 164) is therefore in order: — 
 
 " In view of the rule that dividends can be made only from profits, it 
 becomes important to ascertain what part of the income of a cor- 
 poration constitutes * profits ' which may be used for a dividend. This 
 question has caused the courts considerable difficulty. There have 
 been various definitions, explanations, and different states of fact in- 
 volved in the cases which have come before the courts. The Supreme 
 Court of the United States has said that 'the term "profits" out of 
 which dividends alone can properly be declared, denotes what remains 
 after defraying every expense, including loans falling due, as well as 
 interest on such loans.' An English court says that profits are *the 
 excess of the current gains over the working expenses as shown 
 by revenue accounts as distinguished from capital accounts.* A clear 
 idea of what constitutes profits available for dividends can be obtained 
 only by a study of the cases themselves. 
 
 "There are some general principles connected with this subject 
 which have been established by the adjudications. It is not necessary 
 for a railroad or other corporation to use its profits to pay its funded 
 or bonded debt instead of using those profits for a dividend. But it is 
 necessary to pay the interest on such bonded debt before any dividend 
 is declared. 
 
 "The floating debt should be paid or funded before a dividend is 
 declared. A corporation often owes large debts and still has its 
 capital stock intact. So also outstanding and disputed claims need not 
 be first paid. 
 
 "A proper sum must first be expended or set aside for repairs 
 and reconstruction to replace depreciation due to wear and tear. In 
 other words, the fund available for dividends is ascertained by taking 
 
256 AUDITING. 
 
 into account the cost of repairs and a reasonable allowance for depre- 
 ciation, giving credit for all actual permanent improvements. But in 
 the case of a company owning patent rights, or of a mining company 
 whose product when once used can never be replaced, it is not neces- 
 sary to set aside funds for the purpose of purchasing new patents or 
 a new mine. 
 
 " In estimating the profits for a year for the purpose of declaring 
 a dividend, it is not necessary to take into account the decrease in the 
 value of the assets and the impairment of the capital stock of the 
 company prior to that year. The fact that in a year prior to the 
 declaration of the dividend some portion of the capital has been lost 
 and has not since been made good affords no ground for restraining 
 the payment of a dividend out of profits subsequently earned. A 
 corporation ' which has lost part of its capital can lawfully declare or 
 pay a dividend without first making good the capital which has been 
 lost.' Thus, although a mining company for several years is obliged 
 to pay the interest on its debts out of the capital stock, nevertheless 
 in subsequent years, when large profits are earned, it may use such 
 profits for dividends in any year after paying the interest on the debt 
 for that year. The company need not first restore the capital stock. 
 
 " In Connecticut it is held that dividends may be declared on pre- 
 ferred stock where the net earnings since the issue of the stock are 
 sufficient, even though prior to such issue the capital stock had been 
 impaired, but that ordinarily, in declaring dividends, the directors are 
 not justified in assuming that the value of property which was origin- 
 ally received in pa3mient for stock is still worth that value, and if such 
 property at the time of the dividend was not actually worth the par 
 value of the stock which was issued for it, the dividend is illegal, and 
 a director receiving such dividend as a stockholder may be compelled 
 to pay it back at the instance of a receiver of the corporation. This 
 rule is, of course, subject to statutory restrictions, as, for instance in 
 New York State, where dividends can be made only from * surplus 
 profits.' A dividend may be declared, although the company has not 
 yet completed its works. In the case of railroads, the cost of addi- 
 tional rolling stock and improvements may be charged to capital ac- 
 count, and need not be paid before a dividend is declared. Where one 
 company buys out another and agrees to pay a certain salary to an 
 officer of the latter, or a lump sum in lieu thereof, such lump sum, if 
 paid, is a part of the capital stock, and need not be considered as 
 expenses. 
 
 " Insurance companies cannot declare dividends out of unearned 
 premiums. Banks cannot declare dividends out of interest not yet 
 
DEFINITION OF '' PROFITS.'^ 257 
 
 received. The question of what constitutes profits applicable to divi- 
 dends arises often in connection with preferred stock." 
 
 Another legal opinion is that in Richardson v. Buhl, 77 
 Mich., 67,2 (1889), the court approving of the following state- 
 ment : — '' That the first thing to be done by any manufacturer, 
 who would ascertain his net earnings during the preceding 
 year, is to take a careful inventory of what he has left, includ- 
 ing his plant and machinery, and then make just and full allow- 
 ances for all losses and shrinkages of every kind that he has 
 suffered in his property during the year, and for all expenses 
 of every kind, ordinary or extraordinary, that have occurred 
 during the year; and, having made such inventory, and de- 
 ducted such losses and shrinkage of every kind, his net earn- 
 ings will be the difference between all his investments in his 
 business and all his expenses of every kind on the one hand, 
 and this new inventory, with the deductions properly made, 
 and all that he has received of every kind, on the other hand ; 
 and if his books are properly kept and proper deductions made, 
 these net earnings will finally appear on the balance sheet to 
 the credit of the profit-and-loss account." 
 
 The foregoing opinions are exceedingly interesting, and 
 with the exception of a few of the statements made, corre- 
 spond very closely with the rules followed by the best Amer- 
 ican practitioners. 
 
 The reference to the necessity for charging depreciation 
 before ascertaining profits available for dividends should be 
 noted, and it would not be out of place for an auditor to quote 
 from the opinions of the court when reporting to the board of 
 directors of a company who have shown a disposition to 
 ignore the question of depreciation. 
 
 It would seem to be clearly set forth in the law books and 
 some of the opinions (even if not specifically stated) that de- 
 preciation must be provided for in ordinary undertakings be- 
 fore the fund available for dividend can be stated, and in view 
 of the decisions in the ''Malting'' case (as bearing upon the 
 
258 AUDITING. 
 
 necessity of profits being actually earned before dividends can 
 be paid) reference thereto might effect a change in the minds 
 of some directors, more particularly with respect to New York 
 and New Jersey corporations. 
 
 REVENUE RECEIPTS. 
 
 These somewhat exceptional points being thus disposed of, 
 the right conception of the effect of more ordinary transactions 
 may now be considered. For this purpose it will be convenient 
 to classify the various items appearing upon both sides of a 
 revenue account, which in the aggregate show the profit alleged 
 to be available for dividend. Upon the credit side these items 
 may be conveniently classified under the following headings : — 
 
 (a) Profit on transactions completed but not yet received 
 
 in cash. 
 
 (b) Profit on transactions not completed, whether received 
 
 in cash or not. 
 
 (c) Profit on transactions completed and received in cash. 
 
 (d) Profit arising from an estimated rise in the value of 
 
 fixed or floating assets. 
 
 (e) Profit not properly incidental to the nature of the busi- 
 
 ness carried on. 
 
 With regard to (a) it is hardly necessary to add to what 
 has been already said in the preceding chapters, but the prin- 
 ciples there enunciated may be summarized as follows: 
 
 It is necessary to consider 
 
 (i) Whether it may be fairly and reasonably anticipated 
 that the debt will be discharged in due course. 
 
 (2) Whether any allowance or discount is likely to be 
 
 claimed when the debt is discharged; and 
 
 (3) Whether it is necessary to allow for the loss of interest 
 
 incidental to the deferred payment of such debt. 
 
REVENUE RECEIPTS. 259 
 
 The points which arise on (b) have already been very fully 
 considered under the headings of "Work in Progress " and 
 " Goods Sold for Future Delivery." It is, therefore, unneces- 
 sary to go further into detail in the present chapter. It may 
 be added, however, that, in the case of financial companies 
 underwriting issues of shares or bonds, it would appear to be 
 clearly improper to take credit as a profit for any commission 
 upon such underwriting in respect of that portion of the issue 
 which had been allotted to — and still remained in the hands 
 of — the company by reason of the subscriptions from the gen- 
 eral public being insufficient. The nature of an underwriting 
 agreement is that, in consideration of a certain commission, 
 the underwriter agrees to take a certain portion of the issue if 
 the pubHc do not subscribe enough among them to take up the 
 whole amount among themselves. In the event of the public 
 subscriptions being insufficient, therefore, the contract has the 
 effect of the underwriter acquiring a certain portion of the 
 issue at a discount ; and that is the view which, it is submitted, 
 the auditor should take of the transaction. If this view be 
 adopted, it necessarily follows that until such shares or bonds 
 are disposed of they should appear as an asset in the accounts 
 of the underwriter, not at their face value, but at cost price ; 
 that is to say, the underwriting commission should be dealt 
 with, not as a profit, but as a reduction from the actual cost 
 of the shares or debentures, as the case may be. A fortiori 
 if assets are sold for payment in '* paper," no profit should 
 be taken credit for until that paper is actually realized in cash. 
 
 (d) Although it was held in one English case and is the 
 opinion of some of the most prominent American lawyers that 
 a company may take credit for an assumed rise in the value 
 of its floating assets, should it think it expedient so to do, it 
 is thought that accountants, as a body, will be more inclined 
 to take the view that any profit arising in respect of dealing 
 in such assets should only be taken credit for in the period 
 during which such dealing actually occurs. That is to say, 
 assuming that such floating assets have risen in value, the 
 
260 AUDITING. 
 
 proper time to take credit for the profit is not when the rise 
 may in point of fact have occurred, but at the time when such 
 assets are sold. 
 
 The views referred to above, however, do not apply to an 
 assumed appreciation in the value of -fixed assets, and it need 
 not be urged that good practice would never permit taking 
 credit for the apparent profit so arising. 
 
 Full consideration of this point would, however, appear to 
 be more conveniently dealt with under the following heading: 
 
 (e) In some undertakings it may happen that earnings may 
 airse from unusual transactions, and the question, therefore, 
 arises as to the proper treatment of these earnings. 
 
 Leaving upon one side the most usual source of profit of 
 this description — ^viz., the sale of a portion of the company's 
 undertaking — which has already been dealt with, the most 
 ordinary classes of profits to come under this heading would 
 be premiums received upon stocks or bonds, and cash which 
 has been paid on shares forfeited. The usual custom with 
 both these sources of profits is to credit the amount to reserve 
 fund, and it would be difficult to improve upon this. But, 
 at the same time, it has already been pointed out that — in the 
 absence of special by-laws, and in the absence of a by-law 
 specially so providing — there is nothing to prevent a company 
 transferring the whole, or a portion, of its reserve fund to 
 profit and loss account, and declaring a dividend out of the 
 increased balance so available. 
 
 REVENUE EXPENSES. 
 
 Turning now to the expenses recorded upon the debit side 
 of the revenue account, these may be conveniently classified 
 under the following headings : — 
 
 (a) Expenses that are properly chargeable to the period 
 under review. 
 
REVENUE EXPENSES. 261 
 
 (b) Expenses which may properly be spread over a term 
 
 of years. 
 
 (c) Undisclosed and contingent liabiHties. 
 
 (d) Depreciation. 
 
 (e) Losses arising by fluctuation of current assets. 
 (/) Losses arising by fluctuation of fixed assets. 
 (g) Reserves for losses. 
 
 (h) Preliminary expenses. 
 
 With regard to (a), it is obvious that these amounts should 
 all be charged up against the current year's revenue, and the 
 steps which have been indicated in the preceding chapters 
 should be taken to see that everything coming under this head- 
 ing has been so charged. 
 
 (b) It should be remembered that the onus rests upon the 
 directors and auditor to justify this class of expenditure not 
 being included as a charge against the current profits, and 
 that the auditor must therefore, before passing the accounts, 
 satisfy himself as to the sufficiency of the reasons advanced 
 for its exclusion. Examples of items which may be properly 
 held in suspense are dead rents paid in excess of royalties by 
 colleries and similar undertakings where there is reasonable 
 ground for supposing that they can be redeemed out of future 
 earnings, and also special expenditure in the way of adver- 
 tising some new venture or undertaking, which expenditure, 
 it is estimated, need not be maintained after the venture has 
 been once established. With regard to the latter, however, 
 especial care is necessary, with a view to seeing that a sufficient 
 sum is written off annually, as it not infrequently happens that 
 the expectations of the managers are not realized, and that the 
 permanent cost of advertising is far more than has been antic- 
 ipated. 
 
 A decided stand should be made against any distribution 
 over future years of ordinary operating expenses merely be- 
 
262 AUDITING. 
 
 cause they may be of unusual amount. If the accounts of a 
 street railway, for instance, have been kept without making any 
 provision for depreciation of plant, and the time finally arrives, 
 as it is bound to do, when it is necessary to make extensive 
 renewals, it is manifestly improper to carry forward any part 
 of the cost of such renewals. It is obvious that the renewals 
 are due to past operations — which should have been charged at 
 the proper time with the expense eventually to be caused 
 thereby — and have no connection whatever with future opera- 
 tions. The foregoing statements do not apply to such portion 
 of the cost of renewals or replacements as might represent an 
 improvement in type or increased capacity above that of the 
 construction replaced; such portion of the cost could quite 
 properly be carried forward. 
 
 Nor would it be proper — to use another illustration — in the 
 event of a disastrous accident which entailed extraordinary 
 large disbursements for damages, to carry forward as a de- 
 ferred charge a portion of such disbursements merely because 
 they were much larger than usual and would consequently dis- 
 turb the continuity of the results ordinarily shown. As the 
 accident is an incident in the period's operations if a sufficient 
 reserve to provide therefor does not exist, the income of the 
 period must be charged with the expense caused thereby and it 
 is hardly necessary to add that a dividend could not be prop- 
 erly declared on the basis of an income account which omitted 
 to charge a considerable sum actually disbursed, or for which 
 the corporation is liable, for damages incident to operation. 
 
 It is unnecessary to add anything upon either (c) or (d) 
 to what has already been said in the preceding chapters, where 
 both matters have already been very fully dealt with. 
 
 Passing on to (^), it may be pointed out that, inasmuch as 
 the definition of " current assets " is that class of assets which 
 it is the object of the undertaking to convert with all con- 
 venient speed into cash, it is obvious that, so far as possible, 
 nothing in excess of the actual current market value should be 
 
REVENUE EXPENSES. 263 
 
 attached thereto upon the face of any balance sheet, and the 
 conservative rule, " cost or market, whichever is the lower," 
 followed. Special circumstances may occasionally modify this, 
 where at the moment of balancing there has been a wholly 
 unexpected and temporary fall in value which has been recov- 
 ered before the certifying of the accounts. It is probable, 
 however, that it is only in connection with the treatment of 
 foreign exchanges that this principle can generally be safely 
 applied. 
 
 (/) Concerning this item, it is thought that, so long as the 
 permanent earning capacity of the fixed asset has not dimin- 
 ished, it is quite unnecessary for any provision to be set aside, 
 with a view to making good a loss which may have occurred 
 by reason of the fluctuation of the value of such assets. Cer- 
 tainly the legal decisions which have been given in England 
 under similar circumstances would appear to support this view, 
 and the quotation from " Cook on Corporations " also bears it 
 out. It is important to remember, however, that if the views 
 already expressed with regard to fluctuations upwards in fixed 
 assets have been disregarded and credit has been taken for 
 such fluctuations as a profit, then a fortiori it is necessary that 
 fluctuations downwards should be given effect to. 
 
 (g) With regard to reserves for losses, as has already been 
 pointed out, it is very important that ample reserves should 
 be made to meet all reasonable contingencies before allocating 
 profit for purposes of payment of dividend. The only thing 
 that appears to call for attention here is that in some cases 
 — although, of course, quite improperly — what is really a re- 
 serve against loss is described upon the face of a balance sheet 
 as a " Reserve Fund " ; under no circumstances, however, must 
 such so-called reserve fund be encroached upon for the pur- 
 pose of equalizing dividends, unless the auditor is satisfied that 
 a sufficient balance remains to meet any reasonable expectation 
 of loss that may occur. 
 
264 AUDITING. 
 
 (h) Under almost all circumstances it will be found usual 
 to write off a portion of the amount incurred by a company in 
 preliminary expenses say, one-third or one-fifth, in each year's 
 accounts until the amount is wholly extinguished. There is 
 no compulsion, however, that this course should be adopted, 
 although it is certainly one to be recommended ; and it may 
 be added that, should the first year's accounts show a loss, it 
 is distinctly preferable not to obscure the actual facts of the 
 case by increasing such loss by writing off any portion of the 
 preliminary expenses. It is, of course, impossible to write 
 them off except out of profits, and the attempt should, there- 
 fore, not be made upon paper. Per contra, where there is a 
 reserve fund and the accounts for the current period show 
 a loss, a transfer of such loss should be made to the debit of 
 reserve fund, so far as the latter is sufficient for the purpose, 
 it being a contradiction in terms to state a loss upon one side 
 of the balance sheet and a reserve fund (i. e., an accumu- 
 lation of undivided profits) upon the other side. 
 
 In Conclusion, it may be pointed out that although the 
 " cash " basis, as applied to commercial accounts, is in the 
 nature of things most fallible, it has a very substantial utility, 
 as applied to the revision of the results arrived at by means 
 of the ordinary revenue account. The primary object of 
 every revenue account is, of course, to arrive at the true net 
 profit earned during the period under review ; but, in the case 
 of the vast majority of undertakings, by no means the least 
 important use to which the revenue account will be put is to 
 determine the amount of such profits available to he drawn out 
 of the business and distributed among the proprietors in the 
 case of a company or a partnership, or spent by the sole pro- 
 prietor in the case of a business owned by an individual. The 
 terms " net profit " and " profit safely divisible " are by no 
 means interchangeable ; for unless the working capital be abun- 
 dant, profits cannot be prudently drawn out of the business 
 until they have been actually realized in cash. It therefore 
 follows that, in the great majority of cases, a safeguard — and 
 
REVENUE EXPENSES. 265 
 
 at the same time an easily applied rough check upon the accu- 
 racy of the revenue account — is afforded by looking at the 
 balance sheet, and seeing whether it would be practicable to 
 draw out of the business the whole of the profits alleged to 
 have been made, and whether there would then still remain 
 a sufficient balance of " liquid " assets available to meet the 
 ordinary requirements of the business. Unless such a suffi- 
 ciency would remain after dividing profits up to the hilt, it is 
 clear that such profits have not been realized, or else that they 
 have been diverted from their proper course and applied as 
 working capital, in either of which events it would be impos- 
 sible to distribute them without causing financial embarrass- 
 ment. 
 
CHAPTER IX. 
 
 THE ATTITUDE OF THE AUDITOR. 
 
 In the foregoing chapters the object, extent and manner of 
 conducting an audit have been dealt with, and also — so far as 
 the space at disposal permitted, and the general scope of this 
 work appeared to justify — such modifications of and depart- 
 ures from, the normal plan as are necessary to adapt it to the 
 peculiar requirements of any individual audit with which the 
 reader is Hkely to be concerned. The position of the auditor 
 himself will now be more particularly considered. 
 
 WHO MAY BE AN AUDITOR. 
 
 Auditors may, for general purposes, be divided into three 
 classes. 
 
 (a) Amateur auditors. 
 
 (b) Professional auditors. 
 
 (c) Official auditors. 
 
 It may be well to say a few words about each class before 
 proceeding further. 
 
 AMATEUR AUDITORS are a class to whom the author 
 has no great desire to express either affection or respect. He 
 has seen too much of their shortcomings, and of the inexpress- 
 ible misery and distress that have been caused by their scan- 
 dalous incompetency, to feel any desire to deal gently with 
 their failings. Auditing is much too serious a matter to be 
 trifled with; the evil that can be wrought by an incompetent 
 auditor is hardly less vital — and is infinitely more extensive 
 
 266 
 
WHO MAY BE AN AUDITOR. 267 
 
 — ^than that which may be exercised by an unqualified medical 
 practitioner. The latter, if he be the possessor of an extensive 
 practice, might possibly poison a hundred or so patients in the 
 course of a long career ; but the former can, while merely con- 
 fining his attentions to the affairs of one undertaking, readily 
 accomplish the ruin of thousands and the starvation or suicide 
 of scores in a much shorter period. 
 
 Some may think that is overstating the case, and will say 
 that there are many amateur auditors who are both capable 
 and conscientious. It is not attempted to dispute the fact that 
 the number of amateur auditors who are known to have failed 
 to justify the confidence reposed in them is altogether insigni- 
 ficant as compared with the number who are still discharging 
 their functions to the satisfaction of all concerned. It may, 
 however, be remarked that " the satisfaction of all concerned " 
 does not go for much; the auditors of a host of disastrous 
 undertakings in Great Britain and the United States exercised 
 their functions, presumably, " to the satisfaction of all con- 
 cerned " (especially of the criminals) until the moment when 
 the crash occurred; and it is worthy of note that the crash 
 never does occur until the defalcator has taxed his milch-cow 
 beyond its strength, and that when it does occur, it is not the 
 amateur auditor who has brought it about. In fact, until the 
 defaulter is fool enough to kill his golden goose, the amateur 
 auditor always does " continue to discharge his functions to 
 the satisfaction of all concerned " ; but does that prove the said 
 auditor to be discharging his functions either capably or con- 
 scientiously ? Assuredly not. 
 
 Again, is it not a fact that, as a class, amateur auditors 
 have been shown (by indisputable statistics) to be more often 
 concerned in cases of disaster than professional auditors? Is 
 it not almost invariably the case that, where professional audi- 
 tors are concerned, they have themselves detected the frauds, 
 while with the amateur auditors the crash almost invariably 
 comes from without? 
 
268 AUDITING. 
 
 As, however, this work is primarily intended for the use 
 of professional auditors — to whom, alone, the perusal of any- 
 book upon auditing would be likely to confer any practical 
 advantage — the subject need hardly be pursued further. It 
 is of interest, however, to note that, while the number of 
 amateur auditors in England is said to be thinning down each 
 year, we are not justified at present in making a similar as- 
 sertion to cover the United States. 
 
 The American Association of Public Accountants, which 
 includes in its membership practically all the professional ac- 
 countants in the United States, does not yet number one thou- 
 sand members, while the British societies number at least seven 
 thousand members. 
 
 When we consider the vast number of corporations, bene- 
 ficial organizations, savings banks, building and loan societies, 
 and other undertakings where the accounts are submitted each 
 year to " auditors," and when we consider further that the 
 surety companies before renewing the bonds of employees 
 require a certificate to the effect that the accounts have been 
 examined, we gain some idea of the tremendous aggregate of 
 amateur auditing which is being done at the present time. 
 The appalling number of defalcations occurring annually may 
 be traced largely to the fact that the audits conducted by com- 
 mittees of stockholders or members are not only incomplete, 
 but the very fact that the defaulter knows exactly how (Httle) 
 his accounts will be investigated gives him such a feeling of 
 security in his manipulations that he becomes more daring and 
 abstracts larger sums than if no audit were expected. 
 
 As was stated by an English accountant in this connection 
 " the gentlemen appointed have not either the time, the incli- 
 nation or, so to speak, the machinery, for that thorough exam- 
 ination which we know to be essential if an audit is to be 
 effectual and reliable." Constant agitation of the inefficiency 
 of amateur auditors will do much to draw the attention of the 
 business public to the danger of employing them. In justice 
 
WHO MAY BE AN AUDITOR. 269 
 
 to the amateur, however, it must be said that his duties are 
 frequently thrust upon him, and many of them would gladly 
 surrender their nominal positions of honor to more capable 
 hands. Many substitutions of professional auditors have 
 been at the direct solicitation of the amateurs, so that it is 
 hoped that by a simple process of elimination the good ones 
 will soon go of their own accord and the bad ones will be 
 superseded. 
 
 Steps in this direction have been taken by many corpora- 
 tions and societies through the introduction of a clause in their 
 by-laws requiring the employment of Certified Public Account- 
 ants, and the day is probably not far distant when the omis- 
 sion of such a requirement will be the subject of unfavorable 
 comment by the investing public. It is believed that the con- 
 trolling spirits jn our corporations and societies are becoming 
 sensitive enough on this point to warrant the hope that the 
 practice suggested will become general in a short while. 
 
 PROFESSIONAL AUDITORS are a class with whom the 
 reader may fairly be considered to be well acquainted. Both 
 on account of their special training and on account of the 
 fact that their energies are not distracted by other, and dis- 
 similar, occupations, they are par excellence the ideal auditors. 
 Moreover, the peculiar facilities they possess, in the shape of 
 a large staff of specially trained assistants, place them in the 
 position to thoroughly perform audits of a magnitude that 
 could not conscientiously be undertaken by any one man, no 
 matter how skilled. 
 
 On the other hand, it is only fair to state that while an 
 audit, conducted by competent and responsible professional 
 accountants, is the only form of audit that can reasonably be 
 expected to provide those safeguards which every audit ought 
 to secure, there are some, even among the ranks of profes- 
 sional accountants, whose chief anxiety appears to be to dis- 
 claim any such measure of responsibility for their work. Thus 
 it has been asserted in one quarter that " he is the worst friend 
 
270 AUDITING. 
 
 of the (accountancy) profession who seeks to enlarge the re- 
 sponsibilities of auditors " ; while the index of the Eighth 
 Edition of " Auditors, their Duties and Responsibilities," by 
 Mr. F. W. Pixley, F.C.A., does not comprise any such words 
 as " Defalcations," " Fraud," or " Liabilities of Auditors " — 
 thus clearly showing that, although these matters may be dealt 
 with incidentally in the body of the work, they are regarded as 
 of quite second-rate importance. 
 
 It is quite clear that under no circumstances can any profes- 
 sional audit be regarded as so complete a safeguard as to 
 constitute, in effect, an '' insurance " against fraud, and it has 
 been expressly held by the English Court of Appeal that an 
 auditor " is not an insurer." There is, however, a vast dif- 
 ference between holding an auditor liable as an insurer and 
 expecting him to provide such reasonable safeguards as will, 
 under normal circumstances, preserve the undertaking against 
 loss owing to dishonesty. Dealing with the matter first of all 
 from the purely commercial — and therefore from the lowest 
 possible — standpoint, the minimum premium charged by an 
 •insurance company for a guarantee of honesty is thirty cents 
 per hundred dollars, and a higher premium is almost invari- 
 ably charged in the case of employees. A comparison of this 
 figure with most audit fees will show that, if any credit at all 
 is to be given for the actual work of examining the accounts 
 (which work is, of course, never performed by a guarantee 
 insurance company), little, if anything, remains to cover an 
 " insurance " of the honesty of the staff ; while a slightly 
 broader — and, therefore, more common-sense — view of the 
 situation must, of course, show that the risks which insurance 
 companies, with their large paid-up capitals, can afford to run 
 in the ordinary course of their business are far different from 
 the risks that any individual professional man could prudently 
 accept. Thus, on the grounds of law, equity, and expediency 
 alike, it is clear that an auditor does not guarantee his client 
 against all loss by dishonesty. This, however, is, it need per- 
 haps hardly be pointed out, a very different thing indeed from 
 
WHO MAY BE AN AUDITOR. 2/1 
 
 an entire disclaimer of all pecuniary responsibility. The mere 
 fact of an auditor attaching his signature to the accounts of 
 an undertaking, qua auditor, is a distinct " representation " to 
 all whom it may concern that the accounts in question have 
 been audited by him; and all, therefore, who are entitled to 
 rely upon this representation are clearly entitled to the assur- 
 ance (using the word in its popular sense) that the work al- 
 leged to have been performed has been conducted with a rea- 
 sonable amount of skill and care. The exact effect of this " as- 
 surance " in each separate case must, of course, be determined 
 upon the merits of that case; but the safeguard afforded by 
 this personal responsibility of the auditor is, in itself, by no 
 means a negligible quantity. Further, it may be pointed out 
 that, in the case of professional auditors, whose living de- 
 pends upon their reputation for skill and care, a far greater 
 measure of security is provided than the mere legal limit of 
 the responsibility of the auditor. For obvious reasons it 
 would be inexpedient to strain this legal responsibility too far, 
 or the effect would inevitably be to drive men of substance 
 out of the profession; the chief safeguard of a professional 
 audit, and its great superiority over an amateur audit, lies 
 thus not in any increased measure of legal responsibility (for 
 the law recognizes no distinction between professionals and 
 am.ateurs), but in the safeguard afforded by the fact that the 
 professional depends for his livelihood on his business reputa- 
 tion as a careful and skilful auditor, whereas the amateur ob- 
 viously does not. At the same time the efforts that have been 
 made in some quarters to reduce the legal responsibilities of 
 auditors to " vanishing point " cannot be too strongly depre- 
 cated. 
 
 OFFICIAL AUDITORS are a class that need not be con- 
 sidered here at any great length — the author's sole object 
 being to produce a work of practical utility to the profession. 
 
 The term " official auditors " as used here includes all those 
 who are employed to audit the accounts of state and muni- 
 cipal authorities, as well as those appointed by the courts of 
 
27^ AUDITING. 
 
 the various states to examine and pass upon the accounts of 
 decedents' estate, &c. The latter are almost invariably law- 
 yers, and the most important part of their duty appears to be 
 to scrutinize the various transactions, with a view to seeing 
 that they are not ultra vires. This is, of course, a very impor- 
 tant matter, but it is to be regretted that the attention of offi- 
 cial auditors should be — as in point of fact it is — almost en- 
 tirely restricted to a scrutiny of the accounts from this point 
 of view, with the result that, although the accounts are sup- 
 posed to be checked with a view to detecting error and fraud, 
 it has frequently transpired that dishonesty has remained un- 
 discovered for a very considerable period, and that the ac- 
 counts themselves are grossly inaccurate in essential particu- 
 lars. It is suggested that, for the accounts of estates, &c., to be 
 really effectively audited, the investigation of the official audi- 
 tors, with their legal training, should be confined to a scrutiny 
 of the various transactions from this point of view, the actual 
 verification of the accounts themselves being performed by 
 professional auditors, who by their training are far better quali- 
 fied than any lawyer to detect both errors in accounting and 
 dishonesty on the part of those having the handling of money. 
 This, it is thought, is the true solution of the difficulty; but, 
 because these matters are frequently settled on party lines, and 
 rarely on their merits, it is not likely to be adopted. 
 
 Still another class of official auditors includes various em- 
 ployees of national and state departments who almost invari- 
 ably secure their positions through political influence, but upon 
 whom devolves a vast amount of work which more properly 
 belongs to professional auditors. It is altogether likely that the 
 inefficiency of many of these men will lead to reforms in this 
 direction which cannot help increasing the scope and responsi- 
 bility of the work of the Certified Public Accountant. 
 
 It must be taken into consideration, however, that official 
 auditors usually work under disadvantages in that they are not 
 only limited as to the scope of their examinations, but, fur- 
 
WHO MAY BE AN AUDITOR. 273 
 
 thermore, the time at their disposal is ordinarily too limited to 
 admit of a thorough audit in most cases. 
 
 A case in point is that of one of our large insurance com- 
 panies, having over four hundred millions of assets, which 
 had been " audited " regularly by the *' Auditors " of the State 
 Insurance Department, whose report had uniformly been fa- 
 vorable. Disclosures of gross irregularities from within occa- 
 sioned a more searching examination on the part of a commit- 
 tee of directors, as well as an additional examination by the 
 State Department. Both of these, however, proved ineffectual, 
 and, common-sense finally prevailing, two leading firms of 
 Certified Public Accountants were engaged, and a general 
 feeling immediately prevailed that the actual condition of the 
 company in question would at last be ascertained. 
 
 The more prominent of the official auditors included in the 
 last class include National, State and Clearing House Bank 
 Examiners, State Auditors employed by the Departments of 
 Insurance, Charities, &c., and Examiners connected with the 
 Bureau of Corporations of the Department of Commerce and 
 Labor. 
 
 In recent years there has been a strong tendency towards 
 Government supervision, with the consequence that the num- 
 ber of " official " auditors has greatly increased, and in all 
 likelihood the accessions to the ranks will continue. It is not 
 proposed to criticise nor even discuss the work done by these 
 officials, but it is not out of place to call attention to the fact 
 that the salaries attached to the positions are, for the most 
 part, considerably too low to attract first-class men. 
 
 There are, therefore, two reasons at least why official audi- 
 tors are not so competent as professional auditors, one being 
 the fact that many of the appointments are in payment of 
 political debts, with the consequent result that wholly inexpe- 
 rienced and incompetent men are frequently chosen; and, sec- 
 ondly, even if the places were filled solely upon the basis of 
 merit, it is not to be expected that capable men will be found, 
 
274 AUDITING. 
 
 in any great number at least, occupying positions of great re- 
 sponsibility but with small salaries attached. 
 
 THE AUDITOR'S QUALIFICATIONS. 
 
 Upon this point a considerable quantity of professional lit- 
 erature already exists. The subject has been touched upon in 
 a great number of addresses and magazine articles. It is not, 
 therefore, proposed to consider the subject at any great length 
 (for, there being no essential difference of opinion upon the 
 matter, such a course appears to be uncalled for), but rather 
 to briefly indicate the qualities that go to make an efficient and 
 a successful auditor. 
 
 First, then, it is very generally conceded that an exhaustive 
 knowledge of every department of bookkeeping is the very 
 " A B C " of the auditor's art. 
 
 Second in importance, probably, is a thorough acquaintance 
 with various statutes regulating the different undertakings in 
 which the auditor may be concerned. 
 
 Thirdly, although this point has been bitterly contested by 
 some, a sufficient knowledge, not only of business generally, 
 but of the especial way in which various particular businesses 
 are conducted. As was expressed by an English ac- 
 countant some years ago : " No accountant can suc- 
 cessfully carry on his practice in all the above-mentioned 
 branches unless he is a person of considerable knowledge, skill, 
 and experience, for he must be not only acquainted with book- 
 keeping, which is to him as the alphabet only; but, to put it 
 very briefly, he must have some general knowledge of various 
 trades and their customs. . . . He ought also to have 
 some knowledge of the practice of the Stock Exchange," and 
 so on. No unprejudiced person would deny the advantage 
 of such a knowledge as is here advocated; the only question 
 being whether the standard set is so high as to be virtually 
 unattainable, and^ consequently, impracticable. The reply to 
 this is that, in accountancy, as elsewhere, it is only he who 
 
AUDIT CLERKS. 275 
 
 aims at absolute perfection who can expect to attain even to 
 a decent mediocrity. A complete knowledge of everything- is 
 not readily attained in threescore years and ten, and is not 
 expected as the result of the limited period of study preceding 
 the various State examinations. Only let the accountant make 
 the most of his opportunities — and he will find that his general 
 practice, as well as audits, will afford him many — and he will 
 be surprised at the amount of knowledge he can acquire, even 
 in a short time, and perhaps even more astonished at the vast 
 amount of service such knowledge will be to him in his 
 profession. 
 
 Lastly, but not least, may be placed those desirable qualifi- 
 cations of the auditor which are not acquired by careful study, 
 but, rather, by living. Tact, caution, firmness, fairness, good 
 temper, courage, integrity, discretion, industry, judgment, pa- 
 tience, clear-headedness and reliability. In short, all those 
 qualities that go to make a good business man contribute to 
 the making of a good accountant; while that judicious and 
 liberal education which is involved in the single word " cul- 
 ture " is most essential for all who would excel. Accountancy 
 is a profession calling for a width and variety of knowledge 
 to which no man has yet set the limit; the foremost account- 
 ants are not ashamed to say that, like Epaminondas, they 
 " learn something in addition every day " ; let us, therefore, 
 see no shame in following their example. 
 
 AUDIT CLERKS. 
 
 It will not be amiss, before leaving this subject, to con- 
 sider, very briefly, the desirable qualifications of an audit clerk. 
 Conscientiousness may be placed in the foremost rank. A 
 large amount of uninteresting detail must inevitably form a 
 part of the clerk's daily routine ; and the fact that the greater 
 portion of such work may generally be " skimped," without 
 any great danger of detection, affords considerable tempta- 
 tion, both to the naturally slow worker and to the gentleman 
 of elastic conscience who wishes to make a little time for 
 
276 AUDITING. 
 
 himself. Reliability is the first requisite in a clerk, and the 
 clerk who wishes to get on must endeavor to earn a reputation 
 for being " safe." Next, the clerk would be wise — especially 
 the young clerk — not to get too friendly with his client's staff. 
 Let him be cautious of accepting favors, and most cautious of 
 accepting presents — which might easily drift into bribes. In 
 this respect clerks may sometimes find themselves in a very 
 difficult position (more, perhaps, from force of circumstances 
 than from weakness of character), and the possibility of such 
 an occurrence adds another reason to those mentioned in the 
 first chapter, to the desirability of occasionally changing the 
 rounds of the audit clerks. Imagination (under proper con- 
 trol) is another very desirable quality in a clerk; for, with- 
 out it, he is apt to become a mere machine and consequently 
 next to absolutely useless to the auditor. 
 
 THE AUDITOR'S POSITION. 
 
 The position of the auditor varies to a certain extent with 
 the nature of his appointment, and it will, therefore, be well to 
 consider the circumstances separately. 
 
 THE AUDITOR TO AN INDIVIDUAL will, in almost 
 every instance, receive his appointment from such individual 
 in person; the appointment being — in the absence of stipula- 
 tion to the contrary — for the period covered by the revenue 
 account, but renewable upon the same terms for each suc- 
 cessive period, unless a contrary agreement be made. The 
 fee for the first audit is sometimes settled beforehand, but 
 more usually left open until the time occupied has been as- 
 certained, the fee for subsequent audits being usually arranged 
 after the completion of the first audit. Naturally, the fee 
 charged will be a matter of arrangement ; but, in the event of 
 no definite sum having been settled, the auditor would — in a 
 case of disagreement — ^be entitled to such sum as a jury would 
 award, which would probably be the usual professional 
 charges. There would be no especial limit to the responsibili- 
 ties of an auditor to a sole trader or manufacturer; if he 
 
THE auditor's POSITION. 2// 
 
 certify a set of accounts as correct, any third party {e. g., a 
 bank advancing money) relying upon his certificate would 
 probably have exactly the same right to expect the accounts 
 to be accurate as though the audit had been performed in 
 pursuit of their own instructions. This is a point that should 
 not be lost sight of, as one is very apt to reply upon the un- 
 supported word of one's own client. At the same time, there 
 is no reason why partial audits (the results of which are not 
 certified) should not be made in the case of individuals or 
 firms, provided there is a clear understanding between the 
 client and the auditor as to the extent of the latter's examina- 
 tion. An auditor may resign his office at any time, but it is 
 doubtful whether he could then claim to be paid for the time 
 occupied upon an uncompleted audit. On the other hand, the 
 client may at any time discharge his auditor, but he would 
 probably be held liable for the whole fee of the current period, 
 if the audit had been actually commenced. 
 
 THE AUDITOR TO A FIRM is usually appointed by the 
 mutual agreement of the partners; but, occasionally, by the 
 articles of partnership themselves, or by one particular part- 
 ner. If appointed auditor to the firm, he must, however, in 
 every case, consider each partner as his client, and protect the 
 interests of each accordingly. The same conditions as to terms 
 of agreement, responsibility, fees and resignation, obtain to 
 the auditorship of firms as were mentioned in the previous 
 paragraph; but it would seem that any one partner would 
 have power to bind the firm as to the amount of the fees— 
 except, perhaps, where the appointment lay in the hands of 
 one partner, when the consent of such partner would prob- 
 ably be required. Probably no one partner could discharge 
 an auditor without the consent of all his co-partners. 
 
 This seems the proper place to point out that in practice it 
 not infrequently happens that the letter, if not the spirit, of 
 partnership agreements is broken from time to time; and, so 
 far as these infractions of the agreement relate to accounts, 
 it is clearly the duty of the firm's auditor to draw attention 
 
278 AUDITING. 
 
 to the position of affairs in his report. The most usual irregu- 
 larity of this description is for one or more of the partners 
 to exceed the amount which they are entitled to draw on ac- 
 count of profits; and, although this overdrawing need not 
 necessarily imply bad faith upon the part of the partner con- 
 cerned, it is important for the auditor to draw attention 
 thereto, if only for the sake of equitably adjusting the respec- 
 tive interests of the partners. Even where the partnership 
 articles do not provide for interest upon either capital or draw- 
 ings, it would be well to point out that, as a matter of equity, 
 it is desirable that interest should be charged upon any excess 
 of drawings over the authorized amount, inasmuch as these 
 are clearly in the nature of a loan from the firm to the indi- 
 vidual partner, and should, therefore — as a matter of right — 
 carry interest in exactly the same way. In England the law 
 provides that loans from the partners to the firm shall carry 
 interest at the rate of five per cent, in the absence of express 
 stipulation to the contrary. Any irregularities of this descrip- 
 tion should, therefore, be reported to all the partners; and, as 
 a matter of convenience, it would appear to be desirable that 
 such report should precede the actual closing of the accounts, 
 so that the instructions of the firm may be taken upon the 
 point and given effect to before the audit is completed. It is 
 very desirable for the auditor to see that the accounts, after 
 being finally agreed to, are signed by all the partners. 
 
 THE AUDITOR ON BEHALF OF CREDITORS.— It 
 not infrequently occurs that a retiring partner, who leaves a 
 portion of his capital in the firm, or a creditor who makes an 
 advance to a firm, stipulates that " Mr. So-and-so shall audit 
 the accounts." Unless the contrary intention be very clearly 
 expressed, the auditor so appointed would act on behalf of 
 both the firm and the creditor. In such a case it is very de- 
 sirable that the amount of the fee be arranged beforehand, and 
 it would not be wise to leave it an open question as to who 
 was to pay it. Under the circumstances the firm could not, 
 of course, remove the auditor without the consent of the credi- 
 
THE auditor's POSITION. 279 
 
 tor; nor, in the absence of a special provision to that effect, 
 could the creditor do so, and in any case he would probably 
 be obliged to indemnify the firm against any extra expense 
 occasioned by his so doing. The position of the auditor, in 
 such a case as this, closely resembles that of the company audi- 
 tor, except that the creditor would be entitled to the fullest 
 possible information, while it is sometimes a question as to 
 whether stockholders have an equally extensive right. 
 
 In the fourth English edition of this work attention was 
 drawn to a serious abuse in connection with company pros- 
 pectuses. These frequently put forward the name of a certain 
 firm as the auditors of a company; but although the putting 
 forward of a firm as auditors in this manner implies a certain 
 measure of responsibility — moral if not legal — it conveyed to 
 the firm in question no security that the directors of the com- 
 pany would subsequently confirm the appointment. This, 
 however, has now been remedied by a provision in the English 
 Companies Act, 1900, which requires every director to sign the 
 prospectus before it is published. The directors thus become 
 responsible for the accuracy of a statement that the firm 
 named are the auditors of the company. In the United States 
 it has not been customary to mention the names of proposed 
 auditors, but certain recent events warrant the belief that this 
 step will practically be forced upon company promoters here- 
 after, or the investing public will not be so keen to purchase 
 the securities offered. 
 
 THE AUDITOR OF COMPANIES other than those un- 
 der national or state regulation is subject to the rules and 
 regulations of the company concerned, and to such further 
 statutory provisions, if any, as may apply to the particular 
 class of undertaking. The usual practice is for him to be ap- 
 pointed by the directors, although in many instances he is re- 
 tained by the officers. 
 
 While it may seem rather far fetched to criticise an officer 
 of a company for securing the services of a professional audi- 
 
28o AUDITING. 
 
 tor, particularly where, as is frequently the case, the stockhold- 
 ers and directors exhibit no interest whatever in the matter, 
 yet an appointment under such circumstances is frequently re- 
 sponsible for placing the auditor so engaged in an unenviable 
 position. It is not unnatural that a president, or a treasurer, 
 who has, of his own volition, departed from the past policy 
 of his company and called in a professional auditor, should 
 feel some resentment if his own acts when under review do 
 not meet with the approval of the auditor. This resentment 
 is even more marked when the auditor has received the ap- 
 pointment largely as a matter of friendship (which is also of 
 frequent occurrence), and the acts of his sponsor are made 
 the subject of criticism. It is expected that the custom of an 
 auditor being appointed by the stockholders, as provided by 
 the English Companies Act, will shortly extend to the United 
 States, and instead of the practice being followed by perhaps 
 a dozen or two American companies, as is now the case, all 
 or nearly all, of our corporations will shortly have a by-law 
 containing this requirement. 
 
 It would seem that the shortest way to bring about such a 
 desirable state of affairs would be by amending the general 
 corporation acts of the several States, and it is hoped that such 
 legislation will shortly be instituted. 
 
 In this connection it is of interest to note the following bill, 
 which was introduced in the 1905 session of the Pennsylvania 
 Legislature at the request of the President of the Pennsyl- 
 vania 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 state- 
 ment issued by any corporation of this State or by any foreign cor- 
 poration or corporation of other States, doing business in the State 
 of Pennsylvania, for public information 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 
 
THE auditor's POSITION. 281 
 
 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, semi-annual or annual 
 statements of the condition or business of such corporations, or any 
 financial statements given to the newspapers, financial agencies, or 
 other financial statements for the purpose of pubHc information in the 
 State of Pennsylvania or upon furnishing statements to the officials of 
 the State of Pennsylvania, for the purpose of taxation, shall be re- 
 quired to have such statements verified by a Certified Public Account- 
 ant 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 con- 
 viction thereof shall be fined not more than one thousand dollars, nor 
 less than five hundred dollars, and any officer, agent or employee of 
 such corporation furnishing a false statement, or any Certified Public 
 Accountant certifying to the correctness of a statement issued by any 
 corporation, when it is vitally incorrect or misleading, the officer, 
 agent or employee making such false statement, and the Certified 
 Public Accountant certifying to such false statement shall be deemed 
 guilty of a misdemeanor, and on conviction thereof shall be sentenced 
 to imprisonment for a term not exceeding two years and not less than 
 one year, or a fine not exceeding five thousand dollars, nor less than 
 three thousand dollars, or both. 
 
 It is, perhaps, needless to add that the bill did not pass. It 
 was contended by some accountants that it was too drastic and 
 that a statute requiring the certification of a Certified Public 
 Accountant to the annual statements of corporations would be 
 of more real value than any attempt to compel more frequent 
 examinations. 
 
 Unless the remuneration of the auditor is fixed at the time 
 of his appointment, he is entitled to reasonable remuneration; 
 but if the by-laws provide that he shall be appointed at the 
 annual meeting and receive " such remuneration as the stock- 
 holders may think fit/' he is entitled to such sum as the gen- 
 eral meeting may award him — and no more. Directors have 
 no power to dismiss an auditor, if once appointed; but, ap- 
 parently, an auditor may resign at any time, although probably 
 
282 AUDITING. 
 
 at the loss of his fees for the uncompleted work. If appointed 
 by the stockholders a casual vacancy can be filled by an ap- 
 pointment at an extraordinary general meeting, but usually the 
 directors would have power to fill a casual vacancy. 
 
 To a great extent it rests with the directors to decide how 
 much information shall be supplied in the published accounts, 
 but the auditor must not lose sight of his individual respon- 
 sibility. He should be particularly careful to guard against 
 juggling with words, and so appearing to give a full certi- 
 ficate, when in reality he is " making himself safe," or *'hedg- 
 ing " behind a certificate which, when carefully analyzed (and 
 only then), is found to be most qualified. He must, in every 
 case, be satisfied in his own mind that the accounts are correct, 
 and fairly stated. 
 
 RESIGNATION OF AUDITORS.— There is nothing 
 whatever in connection with this subject in the English Com- 
 panies Acts, 1862-1908, nor in any of our own corporation laws. 
 Any right that the auditor may have to resign is, therefore, 
 entirely founded upon custom. It is not for a moment dis- 
 puted that an auditor would at any time have a right to 
 resign his position, and were he to do so the " casual vacancy " 
 which is referred to in the English Acts would, of course, 
 arise; but it is surprising that the matter should not be dealt 
 with more explicitly. 
 
 A point of considerable interest to all accountants is the 
 question as to what an auditor ought to do when he finds him- 
 self in hopeless disagreement with the directors upon a ques- 
 tion as to what ought to be done in the way of treating certain 
 items in the company's accounts. Only too frequently the 
 course adopted is for the auditor to resign, so that the directors 
 can fill up the casual vacancy thus caused, by appointing some 
 one who happens to agree with their own view, and so the 
 whole matter is hushed up, and never comes to the knowledge 
 of the stockholders at all. It is obvious that this procedure 
 effectually detracts from the independence of an audit. If 
 
THE auditor's POSITION. 283 
 
 there is any advantage at all in having an auditor, independent 
 of the management, to supervise the accounts of a company, 
 it is that in the event of his discovering anything which he 
 thinks should come to. the knowledge of the stockholders, then 
 that something will be placed before them. Under the 
 circumstances existing prior to the passage of the Com- 
 panies Act of 1908, it was probably not once in ten times that 
 an occurrence of this kind was ever found out by the stock- 
 holders. All that they knew was that the accounts had been 
 audited. They had probably quite forgotten the name of the 
 previous auditor, and no intimation was made to them of the 
 fact that a change had occurred. 
 
 The Companies Act of 1908, however, has remedied this 
 condition to a very considerable extent as far as our English 
 brethren are concerned. This act provides, inter alia, that 
 only the retiring auditor shall be eligible for appointment for 
 the coming year, unless notice of intention to make another 
 nomination has been given previous to the annual meeting, a 
 copy of such notice having been sent to the retiring auditor, 
 and all the stockholders likewise notified, prior to the date of 
 the meeting. This course of procedure protects the auditor 
 as the proposal to change auditors would naturally cause in- 
 quiry to be made as to the reason therefor, thus giving the 
 auditor an opportunity to acquaint the stockholders with the 
 facts. 
 
 Until it becomes the custom in the United States for stock- 
 holders to appoint the auditor of a corporation, the auditor will 
 always be at more or less of a disadvantage as the directors — 
 in the case of a disagreement between themselves and the 
 auditor or in the event of the auditor criticising any of their 
 actions — can simply publish the accounts without the auditor^s 
 certificate and the average stockholder be none the wiser. 
 
 "PRIVILEGE" OF AUDITORS.— Another reform in 
 this connection which is earnestly needed is absolute " privi- 
 lege " upon the part of an auditor in his reports. To a certain 
 
284 AUDITING. 
 
 extent he, no doubt, has this privilege at the present time ; but 
 the point is not free from doubt, and it should be absolutely 
 clear. If the auditor is of the opinion that something which 
 has been done by the directors, or by any outside persons, calls 
 for the attention of the stockholders, he should be in such a 
 position that he need feel no hesitation in expressing his view. 
 He ought also to have a clearly defined right to circularize the 
 stockholders, if need be, at any time ; and more particularly, 
 in the event of his having resigned, as to the reasons for his 
 resignation. It will, of course, be said that, were this done,, 
 many sound companies and many honest boards of directors 
 would be placed at the mercy of unscrupulous auditors ; but 
 there is at least no more harm in a company being at the mercy 
 of unscrupulous auditors than its being at the mercy of un- 
 scrupulous directors, and unquestionably the latter are more 
 common than the former. Besides, the auditor would always 
 be liable to be called upon to justify the position which he 
 had taken up; and nothing could protect him in the way of 
 " privilege " if it could be shown that he had not been actuated 
 by motives of good faith. 
 
 REMOVAL OF AUDITORS.— Passing on to the ques- 
 tion of the removal of an auditor. Under the English Com- 
 panies Act, this can only be done by the company at its annual 
 general meeting — that is to say, the only practical way of re- 
 moving an auditor is not to re-elect him when his year of 
 office has expired. As, however, most companies only require 
 the services of their auditors immediately before such annual 
 meeting, this for all practical purposes amounts to an ap- 
 pointment at will ; and, in view of the fact that, under any but 
 the most abnormal circumstances, the directors of a company 
 can always secure a majority at a poll, it will be seen that the 
 auditor practically holds his appointment from the directors, 
 even although he may nominally receive his appointment from 
 the stockholders. That section of the Companies Act of 1908 
 to which reference has been made under " Resignation of 
 
THE auditor's POSITION. 285 
 
 Auditors " secures to a certain extent the auditor's tenure of 
 office. 
 
 Of course, under the present practice in the United States 
 (where an auditor is appointed by the directors, or the officers, 
 for a specific purpose)- the question of his removal rarely 
 arises. 
 
 DUTIES OF AUDITORS.— With regard to the question 
 of the duties of an auditor while in office. There being, up 
 to the present at all events, no very definite provisions with 
 regard to this matter, the question is largely one of contract 
 between each individual auditor and the company. The basis 
 of that contract will be construed by the courts chiefly from 
 the facts of each individual case. 
 
 In this connection it may be pointed out in passing that, 
 even with regard to such important questions as the value of 
 assets, provision for depreciation, the assessment of profits 
 earned, and the distribution of unrealized profits, the courts 
 have shown a marvelous disinclination to lay down any gen- 
 eral rules which could be regarded as principles for the safe 
 guidance of auditors in the future. In carefully and labori- 
 ously shirking their duties in this respect, however, the courts 
 have been most ably seconded by the legislatures, which have 
 been particularly cautious in abstaining from laying down any 
 exact rules as to what the duties of an auditor may be. No 
 doubt they have acted wisely in adopting this course, however, 
 because any attempt to state explicitly what the duties of 
 auditors are in all cases would inevitably fail in not a few, 
 and would afford the best possible excuse for the insufficiency 
 of the audit that had been performed in such cases. Any 
 legislative act which attempts to classify the duties of an 
 auditor under stereotyped headings must at least profess to 
 be at the same time exhaustive, and as the latter is impossible, 
 it seems to follow that the former is very inexpedient. 
 
 RIGHTS OF AUDITORS.— The rights of a company 
 auditor may be very shortly dismissed. He has but few. He 
 
286 AUDITING. 
 
 has the right, when appointed by the stockholders, to hold 
 office till the next annual meeting of the company, and in the 
 absence of notice prior thereto of other nominations for the 
 office, the sole right to appointment for the coming year. He 
 has also the right to reasonable remuneration, or at such a 
 rate as the company is general meeting may be pleased to 
 allow, where he is acting under a specific provision to that 
 effect. When appointed by the stockholders, he has the right 
 to examine the books and accounts of the company at all rea- 
 sonable times (which, unless coupled with a reasonable scale 
 of remuneration, is, perhaps, rather more of a curse than a 
 blessing). 
 
 When appointed by the directors, he usually has the right to 
 make inquiries from any of the officers of the company. 
 
 When appointed by the president of a company, who is, per- 
 haps, the officer usually charged with selecting the auditor, he 
 usually has the right to make inquiries from any of the other 
 officers, and sometimes he may interrogate the president him- 
 self! 
 
 When appointed by the treasurer, who is also frequently 
 authorized to employ the auditor of his own accounts, he must 
 simply discharge his duties and accept his full measure of re- 
 sponsibility, even though he cannot help seeing that a certain 
 kind of report is equivalent to notice that his services will not 
 6e required at the next audit. 
 
 In this connection it may be interesting to note some of the 
 provisions with respect to auditors which are contained in the 
 English Companies (ConsoHdation) Act, 1908 (8 Edw. 7, 
 Ch. 69). 
 
 Section 112. — (i) Every company shall at each annual general meet- 
 ing appoint an auditor or auditors to hold office until the next annual 
 general meeting. 
 
 (2) If an appointment of auditors is not made at an annual general 
 meeting, the Board of Trade may, on the application of any member 
 of the company, appoint an auditor of the company for the current 
 
THE auditor's POSITION. 287 
 
 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 shareholder 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 advertisement 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 audi- 
 tor 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 meeting 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 con- 
 tinuing auditor or auditors, 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 com- 
 pany, 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. 
 
 (2) The auditors shall make a report to the shareholders on the 
 accounts examined by them, and on every balance sheet laid before 
 
288 AUDITING. 
 
 the company in general meeting during their tenure of office, and the 
 report shall state — 
 
 (a) whether or not they have obtained all the information and 
 
 explanations they have required; and 
 
 (b) 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. 
 
 (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 ref- 
 erence 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, secretary, 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 extracts from the books and accounts of any 
 such branch as have been transmitted to the head office of 
 the company in the United Kingdom ; and 
 
 (b) 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 of those directors, and where 
 there are not more than three directors by all the directors. 
 
 Section 114. — (i) Holders of preference shares and debentures of a 
 company shall have the same right to receive and inspect the balance 
 
THE auditor's POSITION. 289 
 
 sheets of the company and the reports of the auditors and other reports 
 as is possessed by the holders of ordinary shares in the company. 
 
 (2) This section shall not apply to a private company, nor to a com- 
 pany registered before the first day of July, nineteen hundred and eight. 
 
CHAPTER X. 
 
 THE LIABILITIES OF AUDITORS. 
 
 THE LIABILITIES OF AUDITORS. 
 
 Turning now, again, to the general aspect of the question, 
 it will be well to consider the extent of the auditor's liability 
 in connection with accounts that he has certified. 
 
 The question appears to be capable of division under two 
 heads, viz.: — 
 
 ( 1 ) What is the actual extent of the auditor's certification ? 
 
 (2) What is his legal responsibility in case of an error 
 
 being subsequently discovered in accounts that have 
 been passed by him? 
 
 To take these two points separately: 
 
 THE EXTENT OF AN AUDITOR'S CERTIFICATION. 
 
 Unfortunately, this is a matter upon which the profession is 
 by no means agreed ; while, on the other hand, the cases that 
 have been decided by the courts are so few, and the questions 
 actually at issue so narrow, that sufficient precedents are not 
 even yet available to definitely settle the matter. At the same 
 time, it is well to remember that, however desirable it may be 
 to know exactly the bare extent of the legal responsibility, the 
 real professional responsibility to clients ought always to be 
 the ideal ; and, further, an auditor will be the worst of friends 
 to his profession if he studiously exert himself to narrow the 
 responsibilities, and so to dwarf the importance of his position. 
 
 290 
 
THE EXTENT OF AN AUDITOR'S CERTIFICATION. 29I 
 
 The responsibility involved in certifying a balance sheet to 
 be absolutely correct would be so great, so limitless, that 
 many have preferred to discard all claim to such a position of 
 certainty, and prefer merely to certify a balance sheet as being 
 " in accordance with the books/' Auditors, however, will 
 hardly require to be reminded that an investigation which had 
 been limited to the comparison of a balance sheet with the 
 books would be, for every purpose, absolutely valueless. So 
 obvious is this conclusion that no professional auditor would 
 ever think of confining his investigation to this particular 
 point, yet many experienced auditors appear to be afraid to 
 make any certification as to the result of such further investi- 
 gation as they know to be essential. Such a state of affairs 
 is unsatisfactory to the client and discreditable to the auditor. 
 Again, it is a very open question whether so unsatisfac- 
 tory a certificate would ever have the effect of limiting the 
 legal responsibility of the auditor to the exact points certified. 
 It is, at least, possible that our courts would view the matter 
 from a broader aspect, and consider that the man who had 
 accepted the position of auditor to say nothing of the fees 
 incident thereto — had also undertaken the responsibilities of 
 that position — and that it would be disposed to form its own 
 opinion as to the real extent of such responsibilities. Such, 
 indeed, appears to have been the view taken in an English 
 case by Justice Stirling, in the case of The Leeds Estate, &€., 
 Society. (Pages 310, 358 hereof.) It would appear, therefore, 
 that the auditor who does not consider his investigation has 
 been sufficiently searching escapes no liability by issuing a 
 carefully modified certificate ; and, indeed, such a course is 
 somewhat dishonest. These are strong words, but not stronger 
 than the circumstances appear to require. 
 
 But it is not intended to convey the impression that an 
 auditor who through no fault of his own, has been unable to 
 make a satisfactory investigation, and who makes no attempt 
 to conceal the actual facts in his certificate, is censurable. He, 
 of course, has not issued a " carefully modified " certificate. 
 
292 AUDITING. 
 
 The English Companies Act of 1908 requires the auditors 
 to make their quahfications, not at the foot of the pubHshed 
 accounts, but in a report which the directors are required to 
 have read at the general meeting. This report may — and, 
 of course, should be — as lengthy and as detailed as circum- 
 stances may require, and there is thus — now, at least — no 
 excuse for cryptic certificates which may mean anything or 
 nothing. While there is no statutory requirement in effect 
 in the United States governing the form of auditor's reports, 
 it is suggested that the auditor should so word them as to 
 encourage by every means that lies in his power, an intelli- 
 gent and active interest on the part of stockholders in the 
 accounts of the company, and in its finances generally. 
 
 A very careful search of the Supreme Court Reports of 
 each State in the Union fails to reveal a single case bearing 
 on the liabilities of professional auditors. We must, there- 
 fore, resort to the English decisions, which are fairly numer- 
 ous. 
 
 It may be added that the English standard is by no means 
 too high, and may be accepted as a proper criterion for Ameri- 
 can practitioners. Furthermore, it is altogether likely that 
 until a line of American decisions has been established the 
 identical cases here reported will be used as precedents for 
 the American cases which may arise. 
 
 Many years ago a prominent English accountant expressed 
 himself as follows : " I know perfectly well that a proper 
 auditor must go further (than comparing the published ac- 
 counts with the books) and see that the books themselves 
 do correspond with facts," and this view appears to be endorsed 
 by the legal decisions to be considered later on. As to how far 
 it is possible for this standard to be carried into practice, there 
 is, perhaps, room for some difference of individual opinion, but 
 the general statement is absolutely unassailable. 
 
 In actual practice, however, the question naturally arises: 
 How is the auditor to ascertain the actual facts? To which 
 
THE EXTENT OF AN AUDITOR'S CERTIFICATION. 293 
 
 it may be replied : In the same manner as a judge or jury — 
 by sifting evidence. The chief evidence is, of course, the 
 books (and it may be remarked incidentally, that it is clearly 
 the auditor's duty to see that the accounts he certifies, in 
 addition to being correct, are in accordance with the books), 
 but the books must not be considered the sole source of evi- 
 dence ; the fact that a statement appears in the books is prima 
 facie evidence only, and must be verified, either by internal 
 cross examination, or by reliable and independent evidence, 
 whether documentary (vouchers, &c.) or oral (explanations). 
 
 The result of such an investigation will be that the auditor 
 has proved to himself that certain statements represent abso- 
 lutely indisputable facts, and that certain other statements, in 
 his opinion, appear to represent facts. Beyond this — not be- 
 ing omniscient — he cannot go, and should never attempt to 
 go. Let him, therefore, report that he has thoroughly exam- 
 ined the accounts, that they are in accordance with the books, 
 and are, in his opinion, correctly stated ; he will then be occupy- 
 ing a logical, manly position — far more in keeping with the 
 dignity of his profession than that afforded by the most 
 skilful of word- juggling. 
 
 The view laid down in the two preceding paragraphs is that 
 which appeared in the first English edition of this work, which 
 was published in 1892, before the London and General Bank 
 had failed, and before the celebrated case in connection with 
 that failure was thought of ; but nothing that has since occurred 
 has in any degree tended to discredit the line of argument then 
 taken. On the contrary, the judgment of Lord (then Lord 
 Justice) Lindley fully endorses the author's view. This judg- 
 ment, together with that of the late Lord Justice Rigby, will be 
 found fully reported in Appendix "A " ; but for the sake of 
 clearness, and on account of its extreme importance, it has 
 been thought desirable to reproduce here the following extract 
 from Lord Justice Lindley's judgment: — 
 
 " It is no part of an auditor's duty to give advice either to directors 
 or shareholders as to what they ought to do. An auditor has noth- 
 
294 AUDITING. 
 
 ing to do with the prudence or imprudence of making loans with or 
 without 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 discharges his own duty to the share- 
 holders. His business is to ascertain and state the true financial posi- 
 tion 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 discharge his duty by doing this without inquiry and 
 without taking any trouble to see that the books of the company them- 
 selves show the company'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 ascertain- 
 ing what they do show, but also for the purpose of satisfying him- 
 self 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. Shephard, in z^ Chancery Division, page 802. 
 An auditor, however, is not bound to do more than exercise reason- 
 able 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 a book from him. His 
 obligation is not so onerous as this. 
 
 " Such I take to be the duty of the auditor ; he must he 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 sus- 
 picion, very little inquiry will be reasonable and sufficient ; and in prac- 
 tice, I believe, business men select a few cases at haphazard, see that 
 they are right, and assume that others like them are correct also. 
 
 * This is clearly a lapsus lingua;: it is no part of an Auditor s duty to prepare 
 accounts, but to examine and report upon accounts prepared by, or on behalf of, 
 the directors. 
 
THE EXTENT OF AN AUDITOR^S CERTIFICATION. 295 
 
 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 suspicion; and he is perfectly justified in acting 
 on the opinion of an expert, where special knowledge is required. 
 
 " Mr. Theobald's evidence satisfies 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 
 balance 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 reasonable 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 per- 
 formance of this part of his duty. It is satisfactory to find that the 
 legal standard of duty is not too high for business purposes, and is 
 recognized as correct by business men.'* 
 
 The reasons why their Lordships felt constrained to give 
 judgment against the defendant, notwithstanding the fact that 
 they could " see no trace whatever of any failure by him in 
 the performance of this part of his duty," will be considered 
 under the following sub-heading. 
 
 Since the second English edition of this work was published 
 several important decisions with regard to the liability of 
 auditors have been delivered by the English Courts, which — 
 to a certain extent, although still very unsatisfactory — tend to 
 further define the extent of an auditors' certification. It is 
 thought that the points raised in these various judgments can 
 be more conveniently dealt with under the heading of the 
 liabilities of auditors. It may be mentioned here, however, 
 that, in the Kingston Cotton Mills case, it was decided by Mr. 
 (now Lord) Justice Vaughan Williams that although the di- 
 rectors of a company were justified in accepting the certificate 
 of the managing director as to the amount of stock in hand, 
 the auditors were — at all events in that particular case — not 
 so justified, and that although their certificate was qualified 
 accordingly; but this decision was overruled by the Court of 
 Appeal. 
 
296 AUDITING. 
 
 An interesting side-light upon the exact extent of an audi- 
 tor's certification is afforded by the proceedings of the Select 
 Committee of the House of Lords appointed in 1896 to in- 
 quire into Company Law Amendment, upon the occasion of 
 the examination of Mr. Frederick Whinney, F.C.A. The 
 following extract from the published report of these proceed- 
 ings will be found of no little interest, but it is important to 
 remember that, although some of the Law Lords have here 
 expressed themselves in terms that appear to be widely differ- 
 ent from those which have from time to time been used by 
 other judges, they were not speaking ex cathedra; and further 
 that, although the distinct suggestion is that, should a case be 
 brought before it, the House of Lords might see fit to overrule 
 some of the decisions already given by the Court of Appeal, 
 it does not necessarily follow that their Lordships would 
 adhere to those views (as expressed below) when the time 
 came : — 
 
 " Passing to clause 29, which deals with the appaintment of auditors^ 
 he suggested the addition of words to the efifect that, unless it was 
 otherwise provided by the articles of association, one of the auditors 
 or the auditor, if there was only one, should be a professional account- 
 ant, 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 audi- 
 tor, 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 meeting. That, he said, was brought forward with the ob- 
 ject 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 necessary 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,. 
 
THE EXTENT OF AN AUDITOR S CERTIFICATION. 297 
 
 and the section would be quite sufficient to meet the difficulty without 
 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 impossible for the auditors to do that in the case of large com- 
 panies, where the debtors numbered, say, 1,000. In the case of banks, 
 for instance, where the number of debtors was very large, it was 
 found necessary 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 men- 
 tion the debtors numbered 750,000. (Laughter.) It should be suffi- 
 cient if they gave a certificate to the effect that they had used all rea- 
 sonable 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 assets are properly valued ?" — " 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 exercise all reasonable care and skill to ascertain that 
 that which he certifies is true, and to exercise all reasonable care and 
 skill in ascertaining the truth." 
 
 Lord Farrer : " That is all very well ; but what is the truth which 
 he is to ascertain?" Lord Davey: "Yes; that is it. Can he, for in- 
 tance, 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 ? " — " 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 ? " 
 — " Not altogether with the directors. There are the managers of the 
 company." 
 
298 AUDITING. 
 
 Lord Farrer : " Do you wish to place the auditor in the position of 
 an administrator, who is to check the directors in their management 
 
 Lord Davey : " Is not the sounder principle this — ^that the auditor 
 is bound to know everything the books tell him, to have all the sus- 
 picions that the books suggest, and to make all the inferences to what 
 he finds in the books would lead him ? " — " 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 shareholders in such a form that they themselves can ex- 
 ercise their judgment upon it." 
 
 "The next suggestion he had to make was that the pains and pen- 
 alties 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 connivance, 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 Chan- 
 cellor : " To me it is a startling suggestion that for an innocent mis- 
 take an auditor should be liable." 
 
 The view expressed by Lord Davey above was, it will be 
 seen, that the auditor is bound to know everything the books 
 tell him, to have all the suspicions the books suggest, and to 
 make all the inferences to which all that he finds in the books 
 would lead him. This, taken by itself, is a somewhat nar- 
 rower view than had been previously suggested in the course 
 of this chapter — namely, that the books must not be considered 
 as the sole source of evidence — ^but it is thought there is very 
 much less difference between these views than is at first appar- 
 ent, and that Lord Davey's view that the auditor should " have 
 
auditor's liability for defalcations. 299 
 
 all the suspicions which a careful examination of the books 
 would give him " amounts to very much the same thing as the 
 opinion, already expressed in these pages, that the books them- 
 selves are prima facie evidence only, and must, in all cases of 
 •doubt, be verified by independent inquiry. 
 
 AUDITOR'S LIABILITY FOR DEFALCATIONS OF 
 EMPLOYEES. 
 
 The question as to whether — and if so, to what extent — 
 an auditor is liable to his clients for defalcations committed 
 by their employees, is one of very considerable importance, 
 but, unfortunately, the English precedents upon the subject 
 are not sufficient to satisfactorily establish any general rule, 
 and so far not a single American precedent can be found. 
 The reports in Wilde v. Cape & Dalgleish and Martin v. Isitt 
 (both of which will be found in Appendix "A") may ad- 
 vantageously be consulted in this connection; but it cannot be 
 pretended that there is any degree of finality about them. 
 Pending further decisions, however, it may, perhaps, not un- 
 reasonably be assumed that, in this (as in other) respects, the 
 auditor will be liable, in most of our States at least, to be 
 proceeded against by way of action for negligence in the dis- 
 charge of his duties ; and, if it could be shown that the defal- 
 cations had resulted from the negligence or incapacity of the 
 auditor, the probability is that he would be held liable in dam- 
 ages accordingly. The most interesting of the two cases in 
 question is undoubtedly that of Martin v. Isitt, in which the 
 plaintiffs claimed damages by reason of the fact that the 
 monthly audit, which the defendants had contracted to per- 
 form, had been allowed to fall into arrear, and that the defal- 
 cations had remained undetected for a longer period than, 
 in their view, was reasonable. The case was eventually set- 
 tled without any definite expression of opinion upon the part 
 of the judge as to its merits; but doubtless, in so far as the 
 delay in the monthly audit was unreasonable, the auditor would 
 be responsible for any loss incurred by his clients in conse- 
 
300 AUDITING. 
 
 quence. The question is obviously, therefore, one of the verjr 
 greatest importance to American practitioners, as showing 
 the extreme desirabiHty of monthly and other periodical audits 
 being punctually proceeded with, and the case cited might 
 profitably be re-read at intervals, particularly by auditors who 
 make a specialty of periodical audits. On the other hand, a 
 reasonable margin would, no doubt, in all cases be allowed. 
 It would be manifestly impossible for an auditor to commence 
 his investigations in all cases immediately after the period 
 had elapsed, and consequently it is only reasonable to suppose 
 that some elasticity would be used in applying the general rule ; 
 otherwise the position of professional auditors, say, in the 
 month of January, would be a serious one. 
 
 With regard to the later decision upon the liabiHty of audi- 
 tors in the event of defalcations on the part of employees 
 given by the Irish Court of Appeal in the case of the Irish 
 Woollen Co., Lim. (a report of which appears in Appendix 
 A), it is important to bear in mind that the decisions of this 
 court are not legal precedents in England, and would have 
 little weight with our own courts ; but, be that as it may, it is 
 thought that the proposition previously advanced can now be 
 entertained with even less doubt than before — namely, that 
 where loss is incurred through the defalcations of employees, 
 which defalcations might have been discovered or prevented 
 by the exercise of due diligence the auditor will be liable. It 
 may also be mentioned that in this case stress was laid on 
 the agreement between the auditor and the company that there 
 should be a " monthly " audit, although there appears to have 
 been some conflict as to what was actually intended by this 
 arrangement. The circumstances were as follows: 
 
 Dividends had been paid out of capital on the faith of ac- 
 counts which were afterwards discovered to have been falsi- 
 fied, and the charge against the auditor may (in eflfect) be 
 divided into three headings : — 
 
 (i) That he failed to discover that the stock had been over- 
 valued. 
 
AUDITOR^S LIABILITY FOR DEFALCATIONS. 3OI 
 
 (2) That he failed to discover that the book debts had been 
 
 overvalued 
 
 (3) That he failed to discover that the trade liabilities had 
 
 been understated. 
 
 With regard to (i), the case would appear to be upon all- 
 fours with the decision in the Kingston Cotton Mills case, and 
 for much the same reasons the decision of the court was in 
 favor of the auditor. 
 
 (2) Here, again, the court decided in the auditor's favor, 
 on the ground apparently that he could not be held responsible 
 for the insufficiency of the reserve provided against bad debts, 
 nor for the omission to provide for cash discounts. With 
 regard to bad debts, it is quite clear that all an auditor can do 
 is to make reasonable inquiries as to the sufficiency of the 
 provision made, and the final responsibility must in all fair- 
 ness rest with the directors and managers ; but it would appear 
 to be the duty of an auditor to form a reasonable opinion as to 
 the sufficiency of the reserve, and to qualify his report if in his 
 opinion such reserve is inadequate. Upon the subject of cash 
 discounts it would not have been surprising if the court had 
 held that a proper provision ought to have been made for the 
 amount which it was expected would eventually be deducted 
 on payment of the various accounts, although, of course, per 
 contra cash discounts might properly be deducted from the 
 trade liabilities. In this respect the decision of the Court of 
 Appeal is, perhaps, more favorable to the auditor than might 
 have been expected. 
 
 (3) It was in respect of his failure to discover that the 
 trade liabilities were understated that the auditor was held 
 liable for negligence. There would seem to have been a sys- 
 tematic falsification of the books in this respect, and had this 
 falsification been discovered at an earlier stage, it would have 
 been clear that the dividends paid had not been earned. In- 
 cidentally, the discovery of falsification in the books under this 
 heading would naturally have aroused suspicion as to the 
 
302 AUDITING. 
 
 accuracy of the records under headings (i) and (2). With- 
 out having the actual books before one it is difficult — if not 
 impossible to express any opinion as to whether or not a 
 reasonably careful and skilful auditor could have discovered 
 the frauds; but the report of the case distinctly suggests that 
 there were points which would call for careful inquiry, and 
 upon which in point of fact inquiry was actually made by the 
 auditor. He would appear to have noticed that certain in- 
 voices were not entered in the books until after the period 
 to which prima facie they related, and to have inquired as to 
 why this course was pursued. The explanation given, appar- 
 ently, was that the goods relating to these invoices had not 
 been included in stock. The explanation is by no means un- 
 reasonable, as such a practice is certainly not contrary to the 
 custom of many perfectly honest undertakings. In the King- 
 son Cotton Mills case it was stated that " auditors must not be 
 made liable for not tracking out ingenious and carefully-laid 
 schemes of fraud when there is nothing to arouse their sus- 
 picion, and when these frauds are perpetrated by tried ser- 
 vants of the company, and are undetected for years by the 
 directors." It may be thought that these remarks would 
 apply equally well to the Irish Woollen Company case ; but it 
 may be pointed out that the practice of " holding back " in- 
 voices because goods have not been taken into stock, although 
 perhaps in itself permissible, is one which — considerations of 
 fraud apart — ^might easily lead to mistakes. So that, if any 
 means are available for checking the recprds of the transac- 
 tions, such means ought not to be neglected by a reasonably 
 careful auditor. It appears that the suppression of invoices 
 would have been at once discovered, had the auditor taken 
 the precaution of comparing the purchase ledger balances with 
 the statements of account forwarded by the various creditors ;. 
 and, that being so, it seems reasonable to have held that he 
 was guilty of negligence in omitting to take this precaution. 
 Taken by itself, however, this would hardly afford grounds 
 for a suit for damages. It is true that the " stock-taking " 
 
AUDITOR S LIABILITY FOR DEFALCATIONS. 303 
 
 statements would only have disclosed " suppressed '* invoices, 
 and would not have thrown any light upon the invoices " car- 
 ried over " ; but the discovery of a large number of invoices 
 altogether suppressed would at once arouse suspicion in the 
 mind of any careful auditor, and throw upon him the onus of 
 further and more exhaustive inquiry. In the " soft goods " 
 trade it is customary in England for creditors to be asked 
 to send in " stock-taking " statements to be compared with 
 the purchase ledger balances, so that particularly in the case 
 of a concern carrying on such a business as that of the Irish 
 Woollen Company, Lim., does it seem reasonable that the 
 auditor should have been expected to take this precaution? 
 
 The most recent decision in conection with the liability of 
 an auditor for failure to detect defalcations is that in the case 
 of the London Oil Storage Company, Lim., v. Seear, Hasluck 
 & Co. ( vide Appendix "A"), which came before the Lord 
 Chief Justice and a special jury in June, 1904. To the casual 
 onlooker this case would appear to be quite straightforward, 
 but Lord Alverstone devoted so much care to his summing 
 up that it seems clear the matter struck him as being one of 
 more importance and more difficulty than to the ordinary ob- 
 server to be the case. The principles governing the matter 
 were, he said, clear, but the practical application of those prin- 
 ciples to any individual case a matter of the very greatest 
 difficulty. This admission is to be welcomed, as affording a 
 most acceptable contrast to the manner in which the courts 
 regarded the views of auditors a dozen years ago; but if the 
 situation in the case referred to is so difficult as to seriously 
 tax the intelligence of a special jury, it is clear that the author 
 was by no means overstating the case when — in the fourth 
 English edition of this work — he expressed the view that such 
 important and such highly technical matters ought not, in 
 fairness to auditors, ever to be decided by a single judge. 
 Briefly stated, the points at issue here were as follows : Dur- 
 ing a number of years the defendants had never taken any 
 steps to verify the amount of cash in hand appearing on the 
 
304 AUDITING. 
 
 balance sheet. During those years the amount of this bal- 
 ance had very materially increased, and during the latter part 
 of the period had not been shown separately from the balance 
 at bank. Eventually, owing to the illness of the responsible 
 cashier, it was discovered that the bulk of this balance was 
 non-existent, with the result that the company sustained a loss 
 of some hundreds of pounds. On behalf of the defence it was 
 argued (i) that in the absence of suspicious circumstances an 
 auditor was entitled to rely upon the statements of trusted 
 employees (vide Kingston Cotton Mills case) ; (2) that there 
 were no suspicious circumstances here; (3) that the directors 
 had not had their suspicions aroused, and, therefore, if the 
 case was one for suspicion, they were at least equally negHgent ; 
 (4) that there was no evidence to show that the whole of the 
 deficiency in the cash balance did not occur since the date of 
 the last audit, in which case clearly the auditor could not be 
 responsible. The jury found that during the last four years 
 the auditor had committed a breach of his duty, and they 
 assessed the damage sustained owing to this breach of duty at 
 five guineas, adding as a rider that they considered the direc- 
 tors had been guilty of gross negligence. Upon the whole, 
 this verdict seems to be a very fair one, and certainly it can- 
 not be said to err upon the side of severity. It is thought, 
 however, that the defendants made their case worse by adopt- 
 ing too low a view of auditorial responsibility. There are, of 
 course, many things that an auditor must from time to time 
 take upon trust; but under normal circumstances the balance 
 of cash in hand seems to be the one asset in a balance sheet 
 that is really capable of absolute and unconditional verifica- 
 tion. In the absence, therefore, of very exceptional circum- 
 stances — as, for example, in the case of an undertaking having 
 numerous branches — the cash in hand should invariably be 
 verified by the auditor. The actual enumeration of the balance 
 of cash in hand at each branch may not be practicable, but so 
 far as can be gathered no such difficulty arose here; while 
 again the very considerable increase of cash in hand (an in- 
 crease in no way connected with the actual requirements of the 
 
LIABILITY OF AUDITORS FOR LIBEL. 305 
 
 business) ought, it is thought, to be in all cases regarded by 
 the careful auditor as a matter calling for careful inquiry, if 
 not actually a matter for suspicion. That the directors 
 showed gross negligence in allowing such a large balance to 
 accumulate in the hands of one of the employees of the com- 
 pany goes, of course, without saying ; but it would be straining 
 the decision of the Court of Appeal in the Kingston Cotton 
 Mills case too far to suggest that, however negligent the direc- 
 tors of a company may be, so long as they are satisfied the 
 auditor need inquire no further. Did that really represent the 
 true limit of an auditor's duties, those duties might be re- 
 garded as adequately discharged if the auditor did nothing 
 more than require the directors to sign the draft balance sheet 
 before he did so himself ! It is obviously in the interests of 
 professional auditors that their duties should not be made 
 unduly onerous, and that they should not be held responsible 
 for the absolute accuracy of statements contained in the ac- 
 counts which in the nature of things it is impossible for them 
 to completely verify ; but it is thought that it is equally in the 
 interests of the profession that, within such limits as may be 
 practicable, the full responsibility of auditors for the perform- 
 ance of their duties with reasonable care and reasonable skill 
 should be rigidly enforced. 
 
 LIABILITY OF AUDITORS FOR LIBEL. 
 
 The question of the liability of an auditor for libel or slan- 
 der is one which so far as is known has never yet been seri- 
 ously raised in America or elsewhere, but it would seem that 
 the ordinary rules of law would apply hereto. That is to say, 
 that, when the alleged libel or slander is true in point of fact, 
 and is published by the auditor in good faith and without 
 malice, and in the bona Me discharge of his duty, it would, no 
 doubt, be held to be privileged. So far, the proposition is emi- 
 nently satisfactory ; but there still remains for consideration the 
 position of the auditor, assuming that he were mistaken in his 
 facts, or assuming that he had — in all good faith — gone some- 
 
306 AUDITING. 
 
 what outside the actual scope of his duty in the particular 
 matter. In these cases it is thought that the question would 
 be primarily one for a jury to decide, but that every reason- 
 able indulgence would be allowed to the auditor who had 
 acted in good faith and without malice. Against this, how- 
 ever, it may be mentioned that in the unreported action of 
 Weiner v. Wurtemhurg Electro Plate Company and another, 
 which was decided in England in 1895, the plaintiff claimed 
 damages against the defendants for libel, on the ground that 
 the defendant company had instructed and authorized the co- 
 defendants (a firm of Chartered Accountants) to issue a cir- 
 cular to their customers, stating, inter alia, that the plaintiff 
 was no longer in their employ, and that " the bookkeeper had 
 already been arrested on a charge of felony." Mr. Justice 
 Hawkins (now Lord Brampton, P. C.) summed up very 
 strongly in favor of the defendants, but the jury found a ver- 
 dict for the plaintiff with ±50 damages. The question as to 
 whether or not an auditor would be held liable in any particu- 
 lar case is thus really more dependent upon the vagaries of the 
 jury concerned than upon any settled question of law, and the 
 position is, therefore, a highly unsatisfactory one. 
 
 It may be added in this connection that in England it is set- 
 tled law that, when it is part of the duty of any persons to 
 attend a meeting and to address it, any statements there made 
 by them in good faith are privileged. Whatever an auditor 
 may state in his report to the stockholders, under Section 19 
 of the English Companies Act, 1908, is therefore clearly privi- 
 leged. As to how far this would apply to verbal statements 
 made by an auditor at the general meeting of a company 
 may, however, be reasonably doubted, inasmuch as it is by no 
 means clear that an auditor has any statutory right under their 
 Companies Act to attend general meetings. Indeed, it has 
 been held by a county court judge that he has no such right ; 
 and, although this is a view from which probably some may 
 differ, the point is by no means altogether free from doubt. 
 It has certainly never been settled in the affirmative. 
 
CRIMINAL LIABILITY OF AUDITORS. 3O7 
 
 American laws relating to libel and slander vary with the 
 different States, and can hardly be said to be in harmony; 
 it is, therefore, not feasible to discuss them within the limits 
 of this volume. It is suggested, however, that it would be 
 only prudent for professional auditors to acquaint themselves 
 with the statutes of their own States bearing on these subjects. 
 
 THE RESPONSIBILITY OF THE AUDITOR FOR 
 
 ERRORS. 
 
 Having now discussed the practical extent of the auditor's 
 certification, it is time to pass on to a consideration of his lia- 
 bilities, in the event of his investigation having failed to detect 
 and expose errors or frauds. 
 
 CRIMINAL LIABILITY OF AUDITORS. 
 
 This is a question which need not long detain us, inas- 
 much as the reported cases are few and far between. In the 
 Portsea Island Building Society case, criminal proceedings 
 were instituted against the directors and the secretary of the 
 society, but not against the auditors. The directors were, 
 however, acquitted, and the case is only of interest in this 
 connection, inasmuch as Mr. Justice Hawkins very clearly 
 stated, in the course of his summing up, that the evidence be- 
 fore him had established a civil liability upon the part of the 
 auditor. 
 
 In the case of the Lancaster Building Society, the auditor, 
 among others, was charged with various criminal offences, 
 but was acquitted ; and the judge in his summing-up stated to 
 the jury that, no matter how scandalous the negligence of 
 an auditor might be, they would not be justified in returning 
 a verdict of guilty unless they were satisfied that there was 
 evidence of " not only criminal negligence, but also of fraudu- 
 lent intent."* 
 
 * This, of course, was before the English Companies Act 1900 was passed. 
 
308 AUDITING. 
 
 The auditors of the two Newfoundland Banks which failed 
 in 1894 were also tried, in conjunction with the directors of 
 their respective companies, and likewise acquitted. 
 
 Since the fourth English edition of this work was published, 
 an important decision has been given that supplements, al- 
 though it does not modify, the views already expressed. At 
 the trial of the auditors and certain other officials of Dum- 
 belVs Banking Company, Lim., which was held at Douglas, 
 Isle of Man, in November, 1900 — the prosecution took place 
 under the Manx Criminal Code of 1872, but the wording of 
 this section is identical with that of the English Act of 1862 
 (24 & 25 Vict., c. 96, section 84), so that the precise locality 
 of the prosecution introduced no distinctive element — ^the de- 
 fendants were convicted of having joined in the issue of false 
 balance sheets, knowing them to be false, and with the inten- 
 tion to deceive, and were accordingly sentenced to varying 
 terms of imprisonment. 
 
 If it were necessary to deal at length with the merits of 
 this particular case, much space might be devoted to a dis- 
 cussion of the evidence, with a view to seeing whether the 
 charges put forward were actually proved up to the hilt in all 
 cases; but for the purposes of a general work of reference 
 this is not required. It may be pointed out, however, that 
 under Section 28 of the English Companies Act 1900 any 
 person who '' wilfully makes a statement false in any material 
 particular " in " any return, report, certificate, balance sheet, 
 or other document, required by or for the purposes of " that 
 Act, " knowing it to be false/' is guilty of a misdemeanor, 
 and liable on conviction to fine or imprisonment. This sec- 
 tion goes somewhat further than the Act of 1862, inasmuch 
 as it is no longer necessary to prove intent to deceive or de- 
 fraud; but it is thought that the distinction is more apparent 
 than real, seeing that anyone who wilfully makes a false state- 
 ment, " knowing it to be false,'' would invariably be assumed 
 by an average jury to have made it for some purpose, and it 
 is unlikely in the extreme that the purpose would be an in- 
 
CIVIL LIABILITY OF AUDITORS. 3O9 
 
 nocent one. Practically, therefore, the law probably stands 
 exactly where it did before the passing of the 1900 Act, save 
 that possibly the trial of any person charged thereunder might 
 now be somewhat shortened. 
 
 Another recent criminal case which is of interest in' this 
 connection, although the auditors were in no way involved, 
 is the trial of the Managing Director and Breweries Manager 
 of Showcirs Brezvery, Lim., in March, 1904, on various 
 charges of fraud. The defendants, who were convicted and 
 sentenced respectively to fifteen months' and nine months' im- 
 prisonment, had for many years systematically overvalued the 
 stock-in-trade, and had induced subordinate employees of the 
 company to certify to these valuations on the representation 
 that they were more than covered by existing secret reserves. 
 The case is, it is thought, chiefly of interest to auditors, in that 
 it draws attention to a possible very serious abuse of secret 
 reserves, and emphasizes the importance of an auditor very 
 carefully inquiring into the circumstances under which re- 
 course is had to such reserves during " lean " years to conceal 
 the comparatively poor results then achieved. It has been 
 stated in some quarters that if the False Statements (Com- 
 panies) Bill, 1904, were passed, it would be impossible, in Eng- 
 land, for directors to ever maintain a secret reserve without 
 committing a criminal offence. This, it is thought, is an ex- 
 aggeration. It is, however, important that both directors and 
 auditors should bear in mind that the mere fact that secret 
 reserves exist proves that, to some extent at least, the directors 
 are not entirely candid with their stockholders ; and the absence 
 of absolute candor naturally necessitates at the very least the 
 most scrupulous care in connection with all matters relating to 
 the accounts. 
 
 CIVIL LIABILITY OF AUDITORS. 
 
 In England there are two kinds of procedure under which 
 civil proceedings may be taken against auditors for damages 
 occasioned by negligent or unskilful discharge of the duties 
 
310 AUDITING. 
 
 imposed upon them — namely, by way of action, and by way of 
 misfeasance summons. 
 
 In the United States the latter is, of course, in the absence 
 of laws providing that a professional auditor could under 
 any circumstances be an officer of a company, unknown, but 
 the procedure by way of action is general. There are, of 
 course, differences in practice in the various jurisdictions, but 
 the procedure by way of action is believed to be practically the 
 same. 
 
 As before mentioned, no American cases bearing on this 
 subject have been found, and the English decisions will have 
 to be considered. 
 
 PROCEDURE BY WAY OF ACTION.— One of the lead- 
 ing English cases under this procedure is the Leeds Estate 
 Building and Investment Society, Lim., v. Shephard, which 
 was decided by Mr. (now Lord) Justice Stirling in 1887. This 
 case will be found duly reported in Appendix " A," and should 
 receive the careful attention of the reader on account of its 
 importance. The head-note of the official report is also of 
 considerable interest; it reads as follows: — 
 
 " 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, hut to inquire 
 into its special accuracy, and to ascertain if it contained the 
 particulars specified in the articles of association, and was 
 properly drawn up to contain a true and accurate representa- 
 tion of the company's affairs/' 
 
 That portion of the judgment which more particularly af- 
 fects auditors enforces the same doctrine in even more definite 
 terms : — 
 
 "In each of (these) years, L. (the auditor) certified that the ac- 
 counts 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 the 30th April, 1879, the company was entitled to 
 
CIVIL LIABILITY OF AUDITORS. 3II 
 
 'moneys lent' to the amount of approximately $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 on those years appears to be the natural and immediate 
 consequence of such breach of duty; and I hold L. liable for damages 
 to the amount of the moneys so paid." 
 
 The futility of an auditor attempting to escape his just re- 
 sponsibilities by a limitation of the scope of his certificate is 
 here most forcibly demonstrated ; there are, however, two other 
 points, which must not pass unnoticed. 
 
 First, there was no question, in this case, as to the accounts 
 being false. The matter in dispute was no moot question of 
 depreciation, or of apportionment between capital and rev- 
 enue ; the accounts were indisputably false, and it was not even 
 suggested that the auditor had done his best to verify their 
 accuracy. 
 
 Secondly, the immediate result of his neglect was a pay- 
 ment of dividends, directors' fees and bonuses. Had no such 
 result taken place, it is by no means so certain that any lia- 
 bility would have accrued. 
 
 Before dismissing this case altogether, it may be well to 
 remark that the defendant was allowed the benefit of the 
 Statute of Limitations; but — inasmuch as this point was not 
 disputed by plaintiff's counsel, and was consequently not be- 
 fore the court — it does not follow that a like plea would avail 
 upon another occasion. 
 
 Astrachan Steamship Company Case. — This was an action 
 brought in the Palatine Court at Liverpool to recover damages 
 from the auditors on account of loss sustained by the com- 
 pany through the dishonesty of its manager. A settlement 
 was arrived at by the parties, so that no new point was decided 
 as to the liability of auditors, but it may be mentioned in 
 passing that the Vice-Chancellor expressed some doubt as to 
 his jurisdiction to try the matter, and only proceeded upon 
 
312 AUDITING. 
 
 being satisfied that he did so with the consent of all parties. 
 In this case a group of steamship companies were administered 
 by the same manager, who was eventually adjudicated bank- 
 rupt with a large deficiency, and subsequently convicted for 
 embezzlement. It appeared that he was able to satisfy the 
 auditors as to the existence of the balance of cash in hand 
 in the case of each company by producing to them a sufficient 
 sum of cash, although it would have been impossible for him to 
 simultaneously produce a large enough balance to cover the 
 amount that ought to have been in hand in respect of all the 
 companies that he managed. Apart from this, however, it 
 appeared that he had made entries in the books of the Astra- 
 chan Company, showing that he had borrowed certain sums 
 from that company at interest, and the suggestion was that a 
 transaction of this kind was sufficiently unusual to make it the 
 duty of the auditors to call the attention of the stockholders to 
 the fact, more especially as — there being no board of directors 
 — the stockholders were entirely dependent upon the auditor 
 for protection. 
 
 POSSIBLE LIMITS TO LIABILITY. 
 
 It has already been stated that, in the cases quoted above, 
 the measure of damages incurred by the negligent auditor has 
 been the full amount wrongfully paid out in dividends. This 
 raises the very important questions as to how far these cases 
 can be relied upon as precedents in the event of the auditor's 
 negligence being proved, but 
 
 ( 1 ) No dividend having been paid ; 
 
 (2) A dividend having been paid, and the company having 
 
 since gone into liquidation, but there being sufficient 
 assets to pay all costs and all creditors in full. 
 
 It is hardly to be supposed that in either of these cases the 
 auditor would incur wo- liability, but a very little considera- 
 tion will suffice to show that a different mode of assessing 
 damages would have to be adopted. It may be added here, 
 
POSSIBLE LIMITS TO LIABILITY. 313 
 
 however, that although the practice of the English Courts has 
 hitherto been to give judgment jointly and severally against 
 all respondents held liable for the full amount of dividends 
 improperly paid, with costs (without any corresponding right 
 of contribution inter se), it by no means follows that this 
 course will always be pursued. The language of Section lo 
 is " to repay the money or property . . . or to contribute 
 such sums to the assets ... as the Court thinks just." 
 
 In this connection the decision in re Moxham v. Grant "^ 
 will be found of interest. Here the directors had been found 
 liable to refund to the liquidator of the company certain divi- 
 dends improperly paid out of capital, under circumstances 
 which conveyed to the stockholders a knowledge of the nature 
 of the source from which dividends were declared. It was 
 held that the directors had a right to recover from the various 
 stockholders the amount of their respective dividends. 
 
 To sum up, it does not appear that the conscientious and 
 capable auditor, who has endeavored to conduct his audit 
 upon the lines laid down in this work, need feel much appre- 
 hension as to the legal consequences arising from a bona Ude 
 error of judgment, or from his inability to discover an ex- 
 ceptionally clever fraud. On the other hand, it is doubtless 
 greatly to the advantage of all properly qualified auditors if 
 a reasonable measure of responsibility be expected from them, 
 for there is then some chance of scaring out of the field a too 
 numerous class of so-called auditors, whose extreme ignor- 
 ance of the veriest elements of their profession is only equalled 
 by their utter inability to appreciate the moral responsibility 
 of their position. It is believed that abuses rarely occur, and 
 that, consequently, all competent and reputable accountants 
 may regard the matter as something that does not in any sense 
 intimately concern them. 
 
 In order that the reader who is especially interested in the 
 purely legal aspect of an auditor's responsibility may have the 
 
 *(Dicksee's Auditing, Seventh English Edition, page 689.) 
 
314 AUDITING. 
 
 benefit of the leading English cases, many of them will be 
 found reported in Appendix " A." 
 
 The reported cases are preceded by a general summary, or 
 rules, of the English law as laid down in these decisions, and 
 until an authoritative American case appears the rules so de- 
 duced may be fairly considered as American law. This, at 
 least, is the opinion of the attorney who prepared them. 
 
 It must he home in mind, however, that the authors of this 
 volume advocate far more rigid rules for professional auditors 
 than the law seems to require. The rules of law are simply 
 given for information and not as recommendations. 
 
CHAPTER XL 
 
 INVESTIGATIONS. 
 
 It has been thought desirable to devote a chapter to that 
 special phase of the subject which is usually known as an 
 " Investigation." The subject is one intimately connected 
 with auditing, but possesses many peculiar features which 
 cannot afford to be overlooked. 
 
 PURPOSES OF INVESTIGATIONS. 
 
 An investigation — so far as present purposes are concerned 
 — may be described as "A special audit, undertaken for a par- 
 ticular purpose." The particular purposes for which an inves- 
 tigation is usually made are as follows : — 
 
 I. Upon the sale of an undertaking : j 
 
 (a) To a public company. 
 
 (b) To a private purchaser, or purchasers. 
 
 (c) To a continuing partner, or partners, by a retiring 
 
 partner, or partners. 
 
 II. For the purpose of obtaining special information as to 
 the position of an undertaking: 
 
 (d) On behalf of a committee of investigation ap- 
 
 pointed by stockholders. 
 
 (e) On behalf of a present or prospective creditor. 
 (/) With a view to the discovery of suspected fraud. 
 
 The former group alone claims attention in this work. 
 
 315 
 
3l6 AUDITING. 
 
 EXTENT OF INVESTIGATIONS. 
 
 When making an investigation of any kind it must not be 
 forgotten that those relying upon the accountant's report will 
 naturally, and indeed reasonably take it for granted that, so 
 long as they adequately explain their object in seeking his 
 assistance, it is for him, as an expert, to decide both as to the 
 nature and the extent of the examination itself ; and in the 
 event of its being subsequently discovered that an investigation 
 had failed to achieve its intended object, the accountant would 
 be required to show that such failure did not arise from any 
 cause which could have been prevented by a more complete, 
 or a more exhaustive examination. Cases are not unknown in 
 which a faulty investigation has been attempted to be shielded 
 under the plea that special instructions had been given by the 
 client, and that such instructions had been duly carried out ; it 
 being argued that where the client has given special instruc- 
 tions as to the course to be pursued, the accountant must be 
 exonerated from any mishap arising from the defectiveness 
 of those instructions. This doctrine appears to be a most 
 dangerous one. There can be no doubt that whatever instruc- 
 tions the accountant may have received were intended rather 
 as a description of the object to be effected than as a definite 
 requirement as to the means by which that object was to be 
 attained. It goes without saying that the best authority as to 
 the means to be employed must be the accountant himself (who 
 receives his instructions by virtue of his being an expert in 
 the matters requiring investigation), and it would thus seem 
 that — however desirable it may be that he should receive, and 
 even welcome, suggestions as to the modus operandi of his 
 work — an accountant cannot submit his professional discretion 
 to the dictation of his clients without sacrifice of self-respect 
 and grave danger to his clients' interests. An accountant who 
 undertakes the responsibility of an investigation ought not to 
 seek to shield himself from the implied responsibility of pro- 
 ceeding upon that investigation on the lines which his profes- 
 sional experience convinces him are the proper ones. 
 
DETECTION OF ERRORS IN BOOKS. 317 
 
 The position of the investigating accountant, when only 
 incomplete sets of books are available, is a question of very 
 considerable importance. So long as the books are sufficiently 
 complete to enable the accountant to reasonably arrive at the 
 conclusion that (so far as they go) they are accurate, there 
 can, it is thought, be no objection to his issuing a report con- 
 fined to such matters as the books may show. But there is a 
 danger of the whole system of investigation falling into dis- 
 credit, if accountants go too far, and substitute for certificates 
 of actually accompHshed facts statements so qualified as to 
 amount, in effect, to but little more than a carefully safe- 
 guarded expression of opinion. It should be borne in mind 
 that the object of any form of accountant's certificate or re- 
 port, included in a company prospectus, is to satisfy intending 
 investors, and that such persons do not, as a matter of fact, 
 by any means always carefully study the wording of the re- 
 port, or certificate, referred to. Unless, therefore, an account- 
 ant has really something to certify he should studiously refrain 
 from issuing any statement of opinion, or estimate, in the form 
 of a certificate. 
 
 DETECTION OF ERRORS IN THE BOOKS. 
 
 Before proceeding to consider the subject in further detail, 
 it would appear desirable to clear up a point which is of the 
 greatest importance, and upon which a considerable difference 
 of opinion appears to exist — viz., the position of the account- 
 ant who has certified as to profits which, in consequence of the 
 falsification of the accounts investigated, have subsequently 
 proved to have been overstated. There appears to be no deci- 
 sion directly bearing upon this point; but a case which came 
 before Lord Kyllachy at the Court of Session in Edinburgh, in 
 1892, is of considerable interest. The case was that of the 
 Edinburgh United Breweries, Lim., &c., v. James A. Molleson 
 {Nicholson's Trustee) ^ &c.,* and the question then at issue was 
 as to whether the circumstance that the profits disclosed by 
 
 * Dicksee's Auditing, Seventh English Edition, page 620. 
 
3l8 AUDITING. 
 
 the books of the Palace Brewery, Edinburgh, were in excess 
 of the amount actually made was (in the absence of fraud on 
 the part of the vendors) a sufficient ground for the cancellation 
 of the purchase, or for damages. It will be seen that this case 
 has only an indirect bearing upon the point now being consid- 
 ered ; indeed, the interest which it possesses is dependent rather 
 upon the nature of the evidence than upon the point actually 
 at issue. Especially must it be borne in mind that, although 
 Lord Kyllachy's decision was upheld upon appeal, it was 
 merely upheld because it was considered that the plaintiff had 
 no right of action against the defendant, no opinion being 
 expressed by the Court of Appeal upon Lord Kyllachy's views. 
 At the original hearing of the case it was contended on the 
 one side that books submitted to accountants for examination 
 were to be taken as warranted free from falsification; while, 
 on the other hand, it was argued that it was not the custom 
 for any such warranty to be implied, and that a proper inves- 
 tigation of the accounts should have disclosed the fact that the 
 profits had been, more or less, overstated. In giving his judg- 
 ment, his Lordship stated that it appeared to him that the 
 question was as to whether it was a condition of the contract 
 of sale, expressed or implied, that the books of the brewery 
 were to contain no errors, or, at least, no errors that were 
 not easily to be discovered, and he confessed his inability to 
 discover any reason for so holding. He could find no stand- 
 ard according to which the purchaser's examination of the 
 books was to be conducted, and he was, therefore, unable to 
 hold that the plaintiffs were entitled to re-open the contract, 
 and now raise the question as to whether a condition as to the 
 amount of profits had been fulfilled. The chief point in this 
 decision which is really of interest in the present inquiry is 
 the finding that there does not exist in a contract for sale 
 based upon a statement of profits an implied condition that 
 such statement is correct. Exception must, of course, be 
 taken in the case of a fraudulent mis-statement, for naturally 
 such contracts would be voidable upon proof of fraud. The 
 question remains, however, that if the vendors have acted bona 
 
DETECTION OF ERRORS IN BOOKS. 319 
 
 Me there is no redress for the purchasers if they have given 
 too large a price for an undertaking in consequence of an in- 
 correct statement of profits by the vendors (provided the pur- 
 chasers have had an opportunity of verifying such statement), 
 or in consequence of a statement of profits that has been falsi- 
 fied — it may be by some employee of the vendors, unknown to 
 them. It would therefore appear that, in such a case, an inves- 
 tigation that failed to reveal the actual condition of affairs 
 would have failed to achieve its most important object. In 
 the case of Short & Compton v. Brackett (vide Appendix "A") 
 it was expressly decided by Judge Tindal Atkinson that an 
 investigating accountant is entitled to " assume '' the accuracy 
 of the figures appearing in the books. 
 
 Opinions of Accountants thereon. — It is not proposed to 
 fully discuss the legal position and responsibilities of an inves- 
 tigating accountant under such circumstances, nor to criticise 
 the investigation that was made in The Edinburgh United 
 Breweries' case ; but as there is much that is deserving of atten- 
 tion in the various opinions that were expressed by the expert 
 witnesses who appeared in that case, the opinions of these 
 witnesses are shortly stated here. 
 
 Each of the following extracts represents the opinion of a 
 different accountant: — 
 
 "There is a difference between checking books and investigating 
 profits, and that an investigation of profits, even if properly conducted, 
 would not always reveal an actual misstatement thereof." 
 
 " In making such investigations I do not consider it any part of my 
 duty to go through all the books and vouchers as in the case of a regu- 
 lar audit." 
 
 " In investigating the profits of a business with reference to a sale, 
 my experience is that an accountant is not expected to check the books 
 and entries for the purpose of tracking falsifications. There is a 
 marked difference between an audit and an investigation with a view 
 to profits. The falsifications in this case could not have been discov- 
 ered without a comparison of the postings in one set of books into 
 another, and I hold that is no part of the duty of an accountant turned 
 
320 AUDITING. 
 
 on to investigate profits. Personally, I always insert the words ' assum- 
 ing the accuracy of the books * in my certificate." 
 
 " It is not the custom in such cases to examine the books in detail. 
 Accountants consider that they are entitled to assume the genuineness 
 of the books." 
 
 A leading solicitor expressed the opinion that accountants, 
 when instructed to investigate into the profits of a company, 
 were not expected to go into such details as would have been 
 necessary to discover the falsifications in this particular case. 
 
 On the other hand: — 
 
 " A proper examination would have discovered the falsifications ; 
 I consider that an accountant pursuing an investigation that would be 
 useful would wish to analyze the accounts, and if this had been done 
 the frauds would have been discovered." 
 
 "The falsifications should have been discovered; I consider that 
 an examination of the individual (trade) accounts was necessary to 
 form a correct idea of the nature of a business, and had this been 
 done the frauds would have been discovered." 
 
 It is altogether likely that if expressions of opinion upon 
 this case were requested from the same number of American 
 practitioners the answers would correspond very closely with 
 those quoted above, i. e., support would be given to both sides 
 of the controversy. 
 
 In speaking of the object of these examinations, the writer 
 of an article that appeared in The Accountant at the time 
 says : " What the public seem to want is, not the nearest ap- 
 proach to facts that can be obtained in so many days or weeks, 
 but the nearest approach to facts that is humanly possible." 
 This will be found to accurately express the views of the 
 average layman. 
 
 INVESTIGATION ON BEHALF OF PROJECTED 
 COMPANY. 
 
 (a) For the purpose of pursuing this inquiry in further 
 detail, it is proposed to narrow the field down to the question 
 of investigations made on behalf of a projected company. The 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 32I 
 
 following suggestions will, therefore, also cover sub-heading 
 (b). The most convenient method of dealing with the subject 
 will be to contrast the methods to be adopted in such an inves- 
 tigation with those ordinarily employed in a regular audit. 
 
 From a theoretical point of view there need, of course, be 
 no difference of method; for both audits and investigations 
 aim at a complete disclosure of the facts. In practice, how- 
 ever, it is usual to restrict the inquiry, so far as is possible, 
 without imperilling the efficiency of the examination; and it 
 is because the objects of an audit are not altogether the same 
 as those of an investigation that the method adopted in each 
 case — i. e., the abbreviated, practical method — ^varies some- 
 what. 
 
 LIMITS OF AN INVESTIGATION.— A regular audit 
 professes to discover the true position of affairs. An investi- 
 gation as to profits, made on behalf of a proposed company, 
 professes to discover the position of affairs so far as they 
 affect the particular object in view. In some respects the 
 narrower field of an investigation will permit the accountant 
 to reduce the scope of his examination ; but, on the other hand, 
 there would appear to be many points upon which a greater 
 strictness of inquiry is necessary. Thus, supposing the ac- 
 countant to be acting upon behalf of the purchasers of an 
 undertaking, he may take it for granted that the accounts 
 submitted to him by the vendors do not underestimate the 
 profitable nature of the business, or the strength of its financial 
 position. Consequently, it does not seem necessary that he 
 should inquire with the same exhaustiveness that he would use 
 in the case of an audit into the completeness with which every 
 source of income has been duly accounted for ; neither does it 
 appear necessary for him to consider the validity of the 
 various items of expenditure charged in the accounts, nor to 
 compare such expenditure minutely with the vouchers. On 
 the other hand, if he is acting on behalf of the vendors, it is 
 clearly desirable that both these points should receive careful 
 attention, but in that case the investisration would not differ 
 
322 AUDITING. 
 
 greatly from the complete audit; for it is obvious that he 
 could not authorize the submission of accounts to the proposed 
 purchasers until he was satisfied that such accounts were true 
 in all respects. 
 
 FRAUD IN ACCOUNTS.— Yet another difference between 
 investigations and audits will not fail to strike the observer. 
 An ordinary audit must always aim at the discovery of fraud ; 
 but an investigation as to profits would not appear to involve 
 any such inquiry, except in so far as the assets or profits 
 might have been fraudulently overstated for the purpose of 
 concealing defalcations, or of deliberately making the accounts 
 appear unduly favorable. 
 
 Broadly speaking, there are two ways in which books may 
 be falsified for the purpose of concealing fraud. The first 
 method is by falsifying the balance sheet, either overstating 
 assets or understating liabilities to cover the amount stolen; 
 the second method is by falsifying the revenue account, by 
 understating income or overstating expenses, so that the profit 
 shown by the books may be reduced to the profit which was 
 actually netted by the proprietors, after deducting the amount 
 misappropriated by the defaulter. 
 
 If the first method has been adopted, the purchasers will 
 not necessarily be prejudiced, for the profits shown by the 
 books will have been the profits actually made ; while the 
 assets which appear in the books at an unduly inflated price 
 will usually be guaranteed as to the value by the vendors, or 
 else vouched for by the certificate of an independent valuer. 
 Sometimes, however, the investigating accountant assumes re- 
 sponsibility for the accuracy of the scheduled book debts 
 taken over by the proposed company, and in such cases it will, 
 of course, be necessary for him to carefully inquire into their 
 correctness. 
 
 On the other hand, the defalcations, if considerable, are 
 likely to be concealed by a falsification of balance sheet items 
 rather than of revenue items, for any material understatement 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 323 
 
 of profits, such as would be involved by the last-named form 
 of falsification, would be extremely dangerous, as drawing 
 prominent attention to the existence of a leakage. A falsifica- 
 tion of balance sheet items, wnth a view to concealing defalca- 
 tions, ought not to escape the attention of the investigating 
 accountant ; not, of course, because he is necessarily responsible 
 for the values attached to the various assets and liabilities in 
 the balance sheets of the undertaking about to be purchased, 
 but because he cannot safely include, in his certificate of past 
 profits, profits actually earned by the undertaking which, owing 
 to the dishonesty of its employees, never went into the pockets 
 of its proprietors. 
 
 Under the second method it would appear that the pur- 
 chasers would actually gain by the defalcations of an official 
 of the vendors, for the profits earned would be in excess of 
 those shown by the books, while the latter would form the 
 basis upon which the purchase price for goodwill was calcu- 
 lated; and, as the balance sheet would correctly record the 
 financial position, there would obviously be no injustice done 
 to the purchasers, if these figures were taken as a basis for 
 valuation. It is thought, therefore, that the investigating ac- 
 countant acting on behalf of a proposed company need not 
 trouble to go exhaustively into the question of the bo7ia fides 
 of the various expenses debited, his great object being to make 
 sure that the expenses are completely recorded in the books 
 submitted to him. On the other hand, he will require to look 
 carefully into the bona fides of many transactions, which the 
 auditor would naturally pass either unquestioned, or, at all 
 events, after due representation of the circumstances to his 
 clients. The difficulty of the investigating accountant's posi- 
 tion arises from the fact that his real clients ( i. e., those in 
 whose interests he is acting) are an unknown, and, at that 
 time, non-existent body. It is, therefore, obviously impossible 
 for him to consult them in any way during the course of his 
 investigation, and his only means of acquainting them with the 
 result of his inquiry will be by means of his certificate. 
 
3^4 AUDITING. 
 
 SCOPE OF CERTIFICATE.— In making an investigation 
 as to profits, therefore, the accountant must be careful never 
 to lose sight of the object for which his investigation is being 
 made. That object may be said to be to ascertain 
 
 (a) Whether the business of the vendors is worth purchas- 
 
 ing. 
 
 (b) Whether such business is worth the price asked for it 
 
 by the vendors. 
 
 The accountant is not actually asked to express a definite 
 opinion upon either of these points, for it is obviously the 
 business of each intending stockholder to answer these ques- 
 tions to his own satisfaction before applying for shares, but 
 it is pointed out that the accountant's certificate forms almost 
 the sole basis upon which the stockholder can judge of the 
 prospects of the proposed company, and it is therefore argued 
 that it should be the accountant's aim to so conduct his inves- 
 tigation, and so frame his certificate, that the materials neces- 
 sary for a correct judgment may be placed before the public. 
 At the same time it cannot be too strongly insisted upon that 
 an accountant's certificate as to profits, relating as it does to 
 past events, deals with a subject-matter that ought to be cap- 
 able of absolute verification. The certificate, therefore, should 
 be a clear and unconditional certificate of accomplished facts, 
 and not a mere estimate of possible — or even probable — future 
 results, misnamed a " certificate." To the limited extent 
 already mentioned it may be permissible, and even desirable, 
 lo modify the past results so that they may more usefully serve 
 the purpose for which they are primarily intended — namely, 
 provide a reliable index of future profits. But at the same 
 time a certificate should relate not to the future, but to the 
 past; and intending investors would do well to bear in mind 
 that, unless a definite statement as to the past is provided in 
 a company prospectus, the reasonable assumption is that the 
 past profits have been unsatisfactory. 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 325 
 
 There is yet another point which the accountant must not 
 fail to bear in mind. Inasmuch as he may be required at any 
 future date to substantiate the statements that he has certi- 
 fied, he should not fail to make the most copious notes of all 
 that transpires during the course of his investigation. These 
 notes should not be confined to actual figures and calculations : 
 whatever explanations he may have received in reply to his 
 inquiries should be committed to writing, so that they may be 
 available if required. If this be not attended to, and legal 
 proceedings are subsequently instituted requiring the account- 
 ant to substantiate his report, his position will not be an envi- 
 able one, for he will probably have to go over at least a por- 
 tion of the ground a second time, and perhaps some of the 
 evidence he formerly utilized may no longer be available. 
 
 LENGTH OF PERIOD TO BE INVESTIGATED.— 
 It is generally held that it is no part of the accountant's duty 
 to prescribe the term of years over which his inquiry should 
 extend. It is, however, desirable to bear in mind the im- 
 portance of expressly stating in the certificate the period that 
 has been covered by the investigation; and, further, it is ab- 
 solutely essential that the inquiry should be brought reason- 
 ably up to date. It may be found convenient to report only 
 upon the results of completed years, but the odd months elaps- 
 ing between the date of the last balance sheet and the date of 
 the investigation should not escape notice, and if they show 
 any material falling off, the fact ought not to escape attention. 
 It may be added here that it is very desirable that the ac- 
 countant's certificate should separately state the profits of each 
 year covered by the investigation. 
 
 METHOD OF PROCEDURE.— Standing op Vendors.— 
 Before actually commencing an investigation it is very de- 
 sirable to make inquiries as to the position and character both 
 of the promoters and the proprietors of the undertaking. A 
 man is always apt to be known by the company he keeps, and 
 no one can aflford to be mixed up with persons of more or less 
 doubtful reputation. Moreover, if a man bears a really bad 
 
326 AUDITING. 
 
 character, it may safely be taken as being as least probable 
 that the company in which he is concerned is not likely to 
 prove a very good investment to the public ; and an accountant 
 is not likely to do himself much good by mixing himself up 
 with unprofitable companies. 
 
 System of Accounts. — The next point that claims atten- 
 tion is the general system upon which the books have been 
 kept. And, in this connection, it may be mentioned that — ^in- 
 asmuch as it is very desirable that the accountant should se- 
 cure the co-operation of the employees of the establishment — 
 it is a mistake for him to abuse the system of accounts which 
 he finds in use, in the presence of the bookkeeper. Any such 
 want of tact upon his part is almost certain to put the book- 
 keeper's back up, and then, instead of information flowing in 
 smoothly, it has to be dragged out by a course of cross-exam- 
 ination that involves a heavy expenditure of both time and 
 temper. 
 
 Audited Accounts.— If the books have been regularly aud- 
 ited by a Certified Public Accountant it is a good plan to 
 seek an interview with him, and endeavor to gather the precise 
 extent of his examination, and also his general opinion upon 
 the matter. This course is, perhaps, somewhat unusual; but 
 clearly it cannot be regarded as objectionable, while cases may 
 easily arise in which it might be a most useful course to adopt. 
 For instance, if a thorough audit has been made at regular 
 intervals by a competent and trustworthy accountant, the in- 
 vestigating accountant might feel fairly safe upon most mat- 
 ters of mere arithmetical accuracy, and confine his attention 
 more exclusively to questions of principle and to values. 
 
 Unaudited Accounts. — On the other hand, if there has 
 been no regular audit, and a fortiori if the books have not even 
 been regularly balanced, it seems as though he could not, with 
 safety, neglect an absolutely exhaustive inquiry into all the 
 facts. Of course, objections may be raised to this position, 
 the most important being the objection that such a complete 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 327 
 
 examination would occupy a much longer time than is ordi- 
 narily available for the purpose. It is, however, submitted 
 that it is the accountant's duty to make an effective investi- 
 gation — not the most effective investigation practicable in a 
 limited period of time — and further, that he should so con- 
 duct affairs that he need not shrink from accepting the fullest 
 responsibility as to the extent of his investigations. 
 
 NECESSITY FOR INSPECTING BALANCE SHEETS. 
 — Another general point to which it is desirable to draw at- 
 tention is the danger of looking only to the revenue account 
 for information as to profits. Cases are not unknown in 
 which — the assets being taken over at an agreed valuation — 
 the investigating accountant has confined his attention entirely 
 to the revenue account, without concerning himself with the 
 sufficiency or otherwise of the amounts written off for depre- 
 ciation and bad debts ; the result being that the certified profits 
 " as shown by the books " were greatly in excess of the profits 
 actually earned. The accountant who aims at something more 
 than pocketing his fees and keeping his skin whole will not 
 rest satisfied with that sort of investigation. 
 
 GENERAL COURSE OF PROCEDURE.— Assuming that 
 the accountant is about to commence an investigation into the 
 profits of a manufacturing or trading concern during the past 
 three (or more) years, with a view to its being purchased by 
 a private individual or a corporation ; the land, buildings, plant 
 and stock-in-trade being specially valued for that purpose by 
 an independent appraiser; assuming further that the accounts 
 have been continuously audited by a firm of Certified Public 
 Accountants, who are satisfied as to their correctness, the 
 question arises, What special points will the investigating ac- 
 countant require to examine which do not arise in the ordi- 
 nary course of a regular audit? 
 
 Taking first the several revenue accounts, he will compare 
 these with each other, and see whether or not they indicate a 
 steady or consistent condition of affairs, whether the turn- 
 
328 AUDITING. 
 
 over fluctuates materially, is increasing, at a standstill, or 
 diminishing; whether the percentage of gross profit is fairly 
 constant, and such as is usually earned in such undertakings; 
 and whether the percentages of expenses and net profit to 
 gross turnover are reasonably steady. A marked reduction 
 of expenses during the last year must be viewed with the 
 greatest suspicion, for such reduction, if excessive and not 
 bona Ude, may have a very serious effect upon the future pros- 
 pects of the undertaking. 
 
 So far as is reasonably practicable, the accountant must 
 examine the bona iides of all sales, especially those recorded 
 during the last few months. The prices of at least a portion 
 should be compared with current rates, and any remarkable 
 increase in the amount of sales or in the number of new ac- 
 counts opened should be regarded with suspicion. All entries 
 " on approval " must be disallowed, and where sales are post- 
 dated it seems essential to make sure that they have actually 
 gone out of stock. The entries for the next few weeks after 
 the closing of the books should be carefully scanned, and if 
 they show an exceptionally large number of returns, or an 
 exceptionally small amount of sales, he must draw his own 
 conclusions as to the bona iides of such entries. In dealing 
 with the question of consignments, he must remember that 
 the goods have probably been invoiced out at selling prices, 
 while the unsold balance can only be allowed for in the ac- 
 counts at cost price {plus expenses) at most. Another point 
 which must not be lost sight of is the question of travellers' 
 commission ; care must be taken to charge up commission upon 
 all sales that are included in the accounts. Due allowance 
 must also be made for all outstanding accounts. Due allow- 
 ance must also be made for all outstanding discounts; and 
 empties which are returnable, but not yet returned, cannot 
 safely be taken credit for at the full price charged. 
 
 With regard to the purchases, the problem is similar to the 
 sales, but somewhat simpler, because the accountant can usually 
 get hold of the creditor's statements. It is, however, very 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 329 
 
 necessary to be on ones' guard against the omission of post- 
 dated invoices when the goods have actually gone into stock. 
 
 Where reliable stock accounts and cost accounts have been 
 kept, there exists a very valuable corroboration of the con- 
 tents of the trading account; but where these cannot be ob- 
 tained, the accountant must do his best with the material avail- 
 able. 
 
 It is especially important that the various stock takings 
 should be conducted upon similar lines, i. e., they should be 
 based upon the same scale of prices, due allowance being made 
 for the depreciation of articles no longer in fashion, or in 
 small quantities, or " odd " sizes. 
 
 If the various stock lists have been prepared upon differ- 
 ent scales of prices, they must be recast upon a uniform 
 method, as any such difference may very materially alter the 
 profits shown by the accounts. The valuation of the stock- 
 in-trade made by the appraiser should be compared with the 
 vendor's stock list, and if there is any material difference be- 
 tween the two, the accountant must not fail to examine the 
 effect of such difference upon the accounts. Thus, supposing 
 he arrives at the conclusion that throughout (say) the past 
 three years, the stock has been consistently overvalued, say, 
 15 per cent., and supposing the stock is $50,000 heavier at the 
 present time than it was three years ago, then during those 
 three years the net profits will have been overstated $7,500 
 or (say) $2,500 a year, which is a material difference when 
 one comes to pay eight or ten years' purchase for a goodwill. 
 
 When the stock consists of such articles as cotton, iron, 
 grain, lead, &c., which have a definite but unstable market 
 value, the question of the legitimacy of profits arising from 
 such alterations in value as may have occurred is a considera- 
 tion of no slight importance. This is a point upon which the 
 author would rather not express too decided a view at the 
 present time, but it is his opinion that (i) no profit should 
 be taken credit for upon the rise in value of unsold stock. 
 
330 AUDITING. 
 
 although revenue must be debited with the contingent loss 
 arising from any fall; (2) no profit should be included as 
 part of the trading or manufacturing profits that has arisen 
 out of a " gamble " pure and simple, but that gambling losses 
 cannot safely be ignored; (3) where any material portion of 
 the profits has arisen from favorable fluctuations of value — 
 as opposed to true commercial profits — it is very desirable 
 that the two sources of profit should be distinguished in the 
 accountant's report. 
 
 If there are any further items to the credit of the profit 
 and loss account, he will require to see that the profit has 
 been actually netted, and that it is fairly incidental to the 
 business of the undertaking. Even then, however, a purely 
 exceptional source of profit {e. g., the fact that an important 
 exhibition had been held in that particular industry, or an 
 altogether exceptional contract executed) should always be 
 specially noted in the report. 
 
 Another point of no slight importance may be mentioned 
 here, although it does not immediately arise from the preceding 
 considerations. Where the undertaking is of such a nature 
 that it cannot be advantageously carried on except in the 
 present premises, the accountant should satisfy himself that 
 those premises will be conveyed to the company for a reason- 
 able term. No sensible man would buy the goodwill of a hotel 
 unless he could get a long lease, if not the freehold, of the 
 hotel premises; while the goodwill of a music hall held on a 
 yearly tenancy would not usually be considered a good invest- 
 ment. If the lease to be granted to the company is at an in- 
 creased rental, he must on no account forget to mention the 
 fact. 
 
 Turning now to the expenses debited to profit and loss 
 account, the accountant will require to satisfy himself that 
 every legitimate expense has been actually included. The 
 ordinary current expenses present no especial difficulty; if 
 the accounts for the past three years, or more, are available 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 33 1 
 
 they will show these fairly well, while a study of the accounts 
 since the date of the last balance sheet will probably disclose 
 any outstanding liabilities that have been improperly omitted. 
 Attention has already been called to the danger of a mala fide 
 ruinous curtailment of expenses, so there is no occasion to 
 again dwell upon that point. 
 
 There remain now the questions of bad debts, repairs and 
 renewals and depreciation. For the purpose of dealing with 
 these points the accountant must refer to the balance sheets, 
 as well as the profit and loss accounts; and, inasmuch as he 
 is no longer in the realm of cut-and-dried facts, he must use 
 the greatest amount of circumspection in arriving at his ulti- 
 mate opinion. 
 
 In dealing with bad debts, the circumstance that he is 
 dealing with at least three years' accounts will help him to 
 a certain extent, for it will enable him to strike an average, 
 and he can compare that average with what his experience 
 teaches him to be the average usually obtaining with similar 
 classes of undertakings. Again, the book debts of the first 
 year, at least, are almost certain to be either collected or else 
 written off before the end of the third year, and he can com- 
 pare the percentage of the first year's actual bad debts upon 
 its sales with the percentage written off each year. Such a 
 comparison is of necessity only tentative, but it is useful so 
 far as it goes. Then he can carefully examine the last schedule 
 of book debts; the chances are that he will know a very ap- 
 preciable proportion of the names there set down, and if he 
 finds that the schedule contains names that some of his other 
 clients look upon as bad or doubtful, he must draw his con- 
 clusions accordingly, to the best of his judgment. In any 
 case, and under all circumstances, he will require to satisfy 
 himself that a sufficient provision for bad and doubtful debts 
 has been debited to revenue. 
 
 With regard to the question of depreciation, his position 
 is, perhaps, a little more difficult. Speaking generally, if the 
 
332 AUDITING. 
 
 values set forth in the balance sheet submitted to him exceed 
 the amount of the appraiser's estimate, he may add such differ- 
 ence to the amount of the depreciation debited to revenue 
 during the period under review. The method is not infallible, 
 however, for the valuation at the commencement of the period 
 may have been too high — in which case he will be charging 
 an undue amount against the profits of the current period ; or 
 it may have been too low — in which case he will not have 
 charged enough. There are, however, normal rates of depre- 
 ciation which may be used to verify results, and previous ex- 
 perience, combined with sound judgment, will probably keep 
 him from going very far wrong. Repairs should in all cases 
 be charged up to revenue, but actual renewals need not be, 
 provided due allowance has been made for depreciation. 
 
 If part of the assets taken over consists of shares in other 
 companies, care must be taken to see that these are included 
 in the accounts at their proper value. Where shares (perhaps 
 unquoted shares) have been received in payment of book debts, 
 especial attention is necessary, as the trading results are di- 
 rectly affected. Under no circumstances should revenue be 
 credited with more than normal value of the work done until 
 the shares have been actually sold, and if the profits realized 
 on such shares form any appreciable portion of the total profits 
 the accountant should mention the fact in his report. 
 
 Where patents form part of the proposed purchase, and 
 where such patents have not been submitted to a specialist for 
 valuation, the accountant should make it his business to see — 
 so far as possible — that the inventions purchased are actually 
 protected. In a recent case, a so-called patent that had been 
 purchased by the original proprietors of the undertaking in 
 perfect good faith was not really patented at all. 
 
 ADJUSTMENTS IN PROFITS.— For the purpose of a 
 certificate attached to the prospectus of a new company it is 
 usual to make certain adjustments in the statements of profits 
 which would not ordinarily appear in the accounts of a going 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 333 
 
 concern. This arises out of the difference between an investi- 
 gation and an audit, the former being primarily with a view 
 to verifying the revenue account (and so certifying the normal 
 profit of the undertaking), while the latter is — speaking gen- 
 erally — confined to a verification of the present position of 
 affairs, as shown by the balance sheet. In order to avoid any 
 possibility of misconception, however, it is well to invariably 
 state what adjustments have been made in connection with 
 profits which would not be usual in the case of a going con- 
 cern. 
 
 These adjustments would, in all ordinary cases, include the 
 amounts paid for interest on capital, interest on loans, and 
 partners' salaries, which may all properly be added to the net 
 profits, provided the fact that they have been added is clearly 
 stated. There are, however, other points which are possibly 
 more debatable, and which will now be considered. 
 
 Depreciation. — Under normal circumstances a certification 
 as to the net profits would naturally assume that a reasonable 
 amount had been written off such profits in respect of the 
 depreciation of all assets necessary for the purpose of carry- 
 ing on the business. It sometimes happens, however (es- 
 pecially where a large number of retail concerns are amalga- 
 mated, for the purpose of forming one large company), that 
 the accounts which have to be investigated are incomplete, 
 and that no reliable information can be obtained as to the 
 actual value of the assets upon which depreciation ought prop- 
 erly to be charged ; while it may be added that the normal de- 
 preciation would naturally to a large extent be based upon 
 the actual cost of such assets to the present proprietors, 
 whereas the depreciation which will have to be charged by the 
 proposed company in the future will of necessity have to be 
 based upon the amount which that company actually pays for 
 the assets in question. Under these circumstances — and under 
 all other circumstances where the same conditions apply — it 
 is not merely difficult to assess the actual rate of depreciation, 
 but sometimes actually misleading to deal with it, even where 
 
334 AUDITING. 
 
 it can be assessed. That being so, it is thought better, where 
 these conditions apply, to certify the amount of profits which 
 have been earned without any provision whatever for depre- 
 ciation, leaving the assessment of the amount necessary to 
 provide for this contingency to those who may be interested 
 in the matter. 
 
 Cash Discounts. — Where the concern in question has 
 hitherto been hampered by want of capital, and has therefore 
 not been able to take full advantage of the cash discounts 
 offered, it may be urged that it is permissible, where the scheme 
 of the proposed company provides for sufficient working capi- 
 tal, to take credit for the maximum cash discounts that might 
 have been obtained, had ample working capital been employed, 
 but it is questionable whether this is good practice, as it is 
 introducing a factor which is largely problematical, as the dis- 
 counts have not actually been realized in the past and there is 
 no certainty of their being actually realized in the future. A 
 supplemental note stating the estimated amount which could 
 have been obtained had ample capital been employed would 
 be preferable to including the figure in the statement of 
 earnings. 
 
 EXCEPTIONAL LOSSES AND PROFITS.— It has al- 
 ready been indicated that the main object of any investigation 
 is to arrive at the normal profits of an undertaking; and, that 
 being so, it is important that any exceptional sources of profit 
 should be excluded, while per contra it is permissible that 
 wholly exceptional sources of loss should be excluded. It is 
 very difficult to define exhaustively either profits or losses 
 coming under this category, but the following may be in- 
 cluded. 
 
 Exceptional Losses. — Losses not covered by insurance 
 arising through fire, accidents to employees, or defalcations; 
 provided a sufficient charge against profits is made to cover 
 the amount which such insurance would have cost. Losses 
 arising through actions at law not altogether incidental to the 
 carrying on of the business, as, for instance, through breach 
 
INVESTIGATION ON BEHALF OF PROJECTED COMPANY. 335 
 
 of contract, infringements of patents, &c. ; but, if the losses 
 arising from these causes are excluded it is essential that what- 
 ever profits may have been earned in connection with the sub- 
 ject matter of the action should be also excluded, unless the 
 litigation resulted in favor of -the proprietors of the business 
 being investigated. 
 
 Under the heading of Exceptional Profits which ought to 
 be excluded may be classified all such transactions as it is not 
 reasonable in the ordinary course of events to anticipate will 
 frequently recur in the carrying on of the existing business 
 upon ordinary lines. It is naturally impossible to deal ex- 
 haustively with this class of item, but the following headings 
 may be mentioned: — 
 
 (i) Any profit received from a municipality or railway, by 
 way of compensation for compulsory removal of the 
 business premises. 
 
 (2) Any profit received from an insurance company in re- 
 
 spect of a risk covered by a policy of insurance. 
 
 (3) Any profit received in connection with the sale of a 
 
 portion of the undertaking, as, for instance, the sale 
 of a patent, or of certain limited rights to work a 
 patent, or of any fixed assets that may have been ac- 
 quired for the purpose of working any portion of 
 the concern in question, whether that department may 
 since have been abandoned or not. 
 
 Generally in matters of this description there is always a 
 temptation to emphasize the saving which may be effected in 
 the future by more skilful management, and by the economy 
 which miglit reasonably be expected to result from the amal- 
 gamation of several concerns. These, however, are matters 
 which, it is submitted, ought not to form the basis of any ac- 
 countant's certificate as to profits — as a matter of fact most 
 of the promises of this character which were held out on the 
 flotation of many large industrial combinations a few years ago 
 have not been realized, but, on the contrary, extravagance in 
 
336 AUDITING. 
 
 management seems to have resulted in many enterprises which 
 prior to consolidation had been most economically adminis- 
 tered. Such certificate should be rigidly based upon facts, and 
 although certain adjustments, as already indicated, may be 
 desirable (and even necessary), so that a correct impression 
 of these facts may be gathered, in view of the altered condi- 
 tions which it is expected will obtain under a new company, 
 under no circumstances whatever should the certificate as to 
 profits degenerate into anything which could possibly be de- 
 scribed as an estimate, or a guess of what may under certain 
 circumstances be expected to happen in the future. 
 
 CONCLUSION. — By this time the accountant will have 
 arrived at an opinion as to the amount of profits ordinarily 
 earned by the undertaking he is investigating, but his work 
 does not quite end here. In practically all cases an account- 
 ant pursuing an investigation that would be useful would wish 
 to analyze the accounts. Not only is it thought that such a 
 course is most desirable as a safeguard against fraud (where 
 a regular and satisfactory audit does not practically remove 
 this contingency from the sphere of possibilities), but it is 
 also extremely valuable for revealing the general nature of the 
 business under review. 
 
 The accountant will now have collected sufficient data to 
 enable him to form a fairly complete impression of the busi- 
 ness which he has been investigating. He will have had ample 
 opportunity to study the general mode upon which the business 
 is conducted, and he will have formed his own opinion of the 
 personnel of the management; he will have ascertained the 
 amount of capital required to conduct the business upon its 
 present lines, and have formed his own opinion as to the scope 
 it offers for an increased capital (if such a thing be contem- 
 plated) ; he will have ascertained how far the continued suc- 
 cess of the undertaking depends upon: (a) successful competi- 
 tion; (b) the continuance of a monopoly; and (c) the caprice 
 of public demand ; and have formed his own opinion concern- 
 ing their continuance. In a word, he will be able to gauge the 
 
INVESTIGATION UPON THE SALE OF AN UNDERTAKING. 337 
 
 probable success of the venture. The point now to be consid- 
 ered is how far, if at all, his personal opinion upon these 
 points should influence his report. 
 
 If it be conceded that the object of the accountant's inves- 
 tigation is to supply the place of an independent examination 
 by each proposed stockholder (as the object of a profes- 
 sional audit is to supersede and supply the place of a personal 
 examination by each proprietor) it must be admitted that these 
 opinions are entitled to some expression. Yet the expression 
 of personal opinions should be cautious and not dogmatical, 
 and should be very clearly separated — where expressed at all 
 — from professional opinions given, as experts, in matters of 
 account; and further, it should never degenerate into either 
 estimates or prophecies. It is very difficult to lay down any 
 general rules upon this point; but, so long as the question is 
 considered upon its merits in each particular case, the account- 
 ant will probably not get far wrong. 
 
 Care must be taken that where the accounts of a group of 
 undertakings are reported upon, and where they have been so 
 closely allied that future operations would require each prop- 
 erty to be taken care of, that a consolidated balance sheet 
 and consolidated earnings statement be submitted. Cases 
 have been known where separate reports have been made on 
 each of a group of properties, and use had been made of the 
 statements of the profitable undertakings, while the unprofit- 
 able ones have been suppressed — although an intending pur- 
 chaser would have to operate the losing as well as the profit- 
 able enterprises. 
 
 (c) Upon the Sale of an Undertaking To a Continuing Part- 
 ner, or Partners, by a Retiring Partner, or Partners. 
 
 There are several features connected with this heading 
 which require special attention. 
 
 A " continuing " partner may also be a " liquidating " part- 
 ner in cases where the death of his partner was the moving 
 cause of retirement, or the retiring partner may be withdraw- 
 
338 AUDITING. 
 
 ing from the business on account of sickness, old age, or some 
 other indisposition. In each of these contingencies the con- 
 tinuing partner is charged with a much greater limit of re- 
 sponsibility than the vendee occupies in any other position, and 
 it is therefore incumbent upon the auditor, who may be called 
 in to represent either or both sides, to make a somewhat more 
 thorough investigation than is necessary in (a) or (b). 
 
 Usually the auditor will represent the retiring partner or 
 his representatives, for the continuing partner may be de- 
 pended upon to look after his own interests. We will, there- 
 fore, proceed to discuss the procedure where the auditor has 
 been retained to ascertain the exact financial condition of a 
 concern as at a certain date, and where there are no provisions 
 in the partnership agreement regulating the basis of values at 
 which the assets shall be taken. 
 
 As a rule the accuracy of the revenue account is not so 
 important as the balance sheet in such an investigation, al- 
 though, of course, use must be made of the statement of profits 
 wherever the value to be placed upon goodwill is based 
 thereon. 
 
 Generally speaking, all of the work required of an auditor 
 who is investigating for an intending purchaser will be re- 
 quired to be done for the seller in this case, but we will now 
 proceed to discuss certain further duties. The valuation of 
 the assets should be upon the basis of a going concern, and it 
 devolves upon the auditor to see that they are not under- 
 valued. Obviously, the continuing partner should on his own 
 initiative, even if the representatives of the retiring partner 
 do not suggest such action, secure the services of independent 
 appraisers, who, after being acquainted with the facts, should 
 proceed with their work, having due regard to the rights of 
 each partner. 
 
 In many cases, however, no such action is taken, and the 
 surviving or continuing partner liquidates the business and 
 places his own values upon the assets. It is difficult to lay 
 
INVESTIGATION UPON THE SALE OF AN UNDERTAKING. 339 
 
 down any definite rules for him to follow, but it must be ob- 
 served as a general maxim that in all cases where doubt exists 
 as to values, the absent partner should have the benefit of such 
 doubt. The reason for this is clear, for it must inevitably be 
 true that the continuing partner will be fully alive to all of 
 the advantages which according to his way of thinking belong 
 to him, while on the other hand, death or absence having 
 closed the lips of the retiring partner, his rights, if not clearly 
 set forth, may escape attention entirely. 
 
 It is a well-known rule of law that a liquidating partner 
 must not take the slightest advantage of his position, and this 
 fact alone would compel him to settle all doubts in favor of 
 the absent partner. Probably the most difficult point to de- 
 cide will be the value of the stock-in-trade, and as each case» 
 of necessity, must stand on its merits, no general rules can be 
 laid down. 
 
 Nevertheless, it can be observed that the ordinary conserv- 
 ative rule of pricing stock at "market or cost whichever is 
 the lower " cannot possibly apply here. The liquidating part- 
 ner is bound in law and equity to realize the highest possible 
 price for anything he may sell, and if he is selling to him- 
 self he is assuming the responsibility of putting himself in 
 a position where he says to the world that he has given more 
 for the stock than any one else would have given. In other 
 words, he declares himself to be the highest bidder. This, of 
 course, does not mean a bidder at forced sale, for if the goods 
 have never been offered to the public it is manifestly impos- 
 sible to put a forced sale valuation upon them. The equitable 
 valuation would probably be the cost of duplicating the entire 
 stock as at a certain date, after allowing, perhaps, for " dead *' 
 or unsaleable stock. The latter, however, is a dangerous doc- 
 trine, for the buyer has elected to take the business as it stands, 
 and he should not be allowed to stipulate that part of the stock 
 is good and part bad. 
 
 If the stock consists of staple goods ascertaining the cost of 
 duplication should not be unduly difficult, and if the goods are 
 
340 AUDITING. 
 
 made to order, or the values difficult to estimate, it would 
 seem that the fairest way to secure the valuations would be, 
 wherever practicable, to trace the sales, and by applying the 
 current rates of gross profit thus secure a basis of cost. The 
 accuracy of this would have to be tested, but there should be 
 no difficulty in making the tests. 
 
 If an agreement were reached to take the stock at cost, it 
 should be borne in mind that the proper interpretation of the 
 word " cost '* in this case would be the original price paid plus 
 all charges down to the date of inventory. It is contended by 
 some accountants that these charges include not only freight, 
 insurance, storage, handling, rent, &c., but also interest down 
 to the date of inventory. The contention as to interest is 
 rather a nice question but as it may certainly be classed 
 among the doubtful items, the general rule applicable to this 
 class of cases would seem to require that the point should be 
 decided in favor of the retiring partner. 
 
 The question of the valuation to be placed upon fixtures, 
 Sec., should be decided generally upon the lines laid down 
 above. For the sake of convenience, cost less proper depre- 
 ciation, would seem to be fair. 
 
 Regarding book debts, stocks, &c., the usual custom of 
 " working them out " should be followed. No commission or 
 other compensation to the continuing partner can be allowed 
 for this, but the actual cost of clerical help is a proper charge. 
 
 Of course, the retiring partner is entitled to or responsible 
 for his share of the profits earned or losses incurred in the 
 carrying out of contracts executed before the date of dissolu- 
 tion or winding up. Necessarily all of the expenses of such 
 contracts up to the time agreed upon have been charged to 
 the business; therefore, it would be obviously unfair to the 
 retiring partner to have to pay his proportion of the expenses 
 of making a sale and then be deprived of any share of the 
 profits. This applies with equal force to losses; the continu- 
 ing partner is not liable for anything beyond his own share of 
 
INVESTIGATION UPON THE SALE OF AN UNDERTAKING. 34I 
 
 losses incurred in executing contracts entered into in good 
 faith prior to his purchase of the business. 
 
 It will be noted from the above that all of the expenses for 
 a reasonable period prior to dissolution should be carefully ex- 
 amined to see that none of them are prepayments or apply to 
 the subsequent period. As a matter of course the retiring part- 
 ner will have to bear his full proportion of all liabilities, and 
 it can be depended upon that all expenses chargeable to the 
 old period, no matter how long afterwards they be presented, 
 will be charged back where they belong. 
 
 Another point which will bear watching is discounts and 
 other allowances granted upon book accounts. It may happen 
 that a customer will return goods, upon which claim has been 
 made, and these goods will, of course, not be found in the 
 inventory. In ordinary cases they would be carried into the 
 current stock of the new business, and it is quite likely that 
 they would be overlooked. A careful analysis of all credits 
 to the old customers, other than cash, would, of course, reveal 
 the returns. 
 
 Many other points, such as partners' salaries, interest on 
 partners' accounts &c., will require attention, but it is believed 
 that the above suggestions will suffice to put the auditor on 
 his guard and enable him to sufficiently protect the interests 
 of his client. 
 
 The question may very possibly be raised that the account- 
 ant who pursues the course here advocated is not likely to 
 enjoy a very extensive investigating practice. It is thought 
 that this conclusion offers an injustice to company promoters 
 as a class. The profession of a company promoter is a mixed 
 one, doubtless, but the black sheep — although naturally the 
 most notorious — are decidedly in the minority, and there are 
 very many promoters who would thoroughly appreciate a 
 greater strictness in investigations, which could not fail to 
 strengthen the confidence of the public in corporate enterprise 
 as an advantageous mode of investment. 
 
CHAPTER XII. 
 
 INTEREST. 
 
 Every accountant has in the course of his experience prob- 
 ably had occasion to note the lack of uniformity in the meth- 
 ods of calculating interest. For this reason it has been thought 
 well to insert a short chapter on the various bases of calcula- 
 tion and the relative propriety thereof. 
 
 In every calculation of interest there are three factors, 
 vis. : principal, rate and time. With regard to the amount 
 on which interest is to be calculated, i. e., the principal, no 
 question can well arise as this amount must be definitely fixed 
 beyond the exercise of any discretion in the matter before 
 a calculation can be made. The rate — usually, though by no 
 means invariably, expressed on a per annum basis — is indi- 
 rectly affected by the stating of the time or period for which 
 the interest is calculated, but in itself is really only capable 
 of one application. It is with regard to the third factor men- 
 tioned — that of time — that the greatest divergence of method 
 is found. Hence, it is in order to note the different ways of 
 stating the time in a given period for which the interest is to 
 be calculated, with the related question of the unit period of 
 time on which the calculation is to be based. 
 
 A question on which there has been much debate and differ- 
 ence of opinion and on which there is a divergence in the 
 usages of financial institutions is whether both the first and last 
 days, or only one of them, should be included in stating the 
 time included between two given dates. The following ex- 
 tracts from a digest on the subject from a legal standpoint are 
 of interest (see 49 L. R. A. pp. 193-248) : 
 
 342 
 
INTEREST. 343 
 
 " There seems to be one general rule with reference to. 
 counting the first and last days in the computation of a period 
 of time which, subject to exceptions based upon the language 
 of the provision for time or upon the surrounding circum- 
 stances, seems to have remained the same throughout the 
 whole period of the common law, and which remains prac- 
 tically the same under the statutes and rules of court. That 
 rule is that in the computation of time one of the first and last 
 days of the period shall be included and the other excluded. 
 The question as to which of the two days shall be included 
 and which excluded, however, has been differently decided 
 in different periods and different jurisdictions, and has given 
 rise to much conflict of opinion. The general common law 
 rule as it originally existed was that the first day was to be 
 counted when the computation was to be from an act or 
 event, but that it was not to be counted when the reckoning 
 was to be from a day or from the day of an act or event. The 
 more modern decisions have changed this rule and in the ab- 
 sence of a statute or rule of court controlling the question, 
 the courts now compute time, as a general rule, by excluding 
 the first day and including the last day. 
 
 "... the general rule now existing, whether at common 
 law or under the statutes, probably is that the first day of a 
 period of time is to be excluded and the last day is to be 
 included, but that either or both days may be either included 
 or excluded, if the language of the provision for time is such 
 as to require it, or if by so doing a penalty or forfeiture will 
 be avoided." 
 
 With particular reference to negotiable instruments: — 
 
 " The general rule under the statute, as well as at common 
 law, is that in computing the time that a note payable at a 
 future day has to run, this day of the date is excluded. 
 
 " . . . in computing the time when a note or bill payable 
 at a certain number of months after date will become due, the 
 rule is to exclude the day of the date from the computatien, 
 
344 AUDITING. 
 
 qnd include the day of payment when no days of grace are 
 allowed, and the note will become payable on the same day 
 of the stipulated month as that of its date, 
 
 "... a usage of banks to include the day of the date, of 
 a promissory note in their computation of the time when it 
 becomes due will be recognized only as evidence of the assent 
 of the parties to such usage and of their waiving their legal 
 claims, and not as forming rules for the decision of the court 
 (Blanchard v. Hilliard; ii Mass. 85)." 
 
 It will be noted that the foregoing statements as to nego- 
 tiable paper relate more directly to the determination of the 
 time as affecting maturity or due date of an instrument than 
 to the time for which interest shall be paid thereon. It 
 would seem, however, that the same rule would apply to the 
 determination of either question and that if a note is drawn 
 at three months the interest thereon should be paid for a 
 period of three months, no more and no less. 
 
 The practice among banking institutions in calculating in- 
 terest or discount on loans varies, some including both day of 
 date and due date, others only one of the two, while still 
 others pursue a middle course by including both days when 
 a loan is first made but only one of the two days on renew- 
 als. It will be observed that where the practice is to include 
 both days it results in charging interest twice for the day on 
 which a renewal note is given to take up the one maturing. 
 The argument usually advanced to justify this dupHcation is 
 that the result would be the same if the borrower were to- 
 obtain a loan at another bank (paying interest for both days) 
 and use the proceeds to pay the maturing note. 
 
 Several cases bearing on these points which came before 
 the courts many years ago merit consideration, though it will 
 be noticed that the decisions are directly opposed to each other. 
 
 In 1829 the Supreme Court of Vermont heard the case of 
 Bank of Burlington v. Durkee (i Vt. 399), in which the cir- 
 cumstances were as follows: 
 
INTEREST. 345 
 
 A note for $2,000 payable 64 days from date had been dis- 
 counted by the bank, the interest charged thereon being 64 
 days on the basis of 360 days to the year, $21.33. The de- 
 fendant claimed that as the interest at 6 per cent, (the highest 
 rate permitted by the law of the state) on a 365 -day basis 
 would only amount to $21.04, and there being no statute 
 legalizing the 360-day basis, the bank had taken usury amount- 
 ing to 29 cents. The contention of counsel for the bank in 
 attempting to refute the charge of usury introduced into the 
 case the question of the right to charge for both the first and 
 last days of the period, stating that: 
 
 "The discount received by the bank was $21.33, being the interest 
 on $2,000 for 64 days at the rate of 6 per cent, for 360 days. Now, 
 inasmuch as the borrower received the money on the day of the dis- 
 count, and was not liable to pay the same until he had the use of it 
 for 65 days, including the day of discount, the bank had a right by 
 law to take interest at the rate of 6 per cent, per annum for 65 days, 
 which would in fact exceed the interest taken by 4 cents." 
 
 The court, however, ruled that it was unlawful to charge 
 interest for both the day of discount and the day of matur- 
 ity, stating that: 
 
 "The mode of computing interest in a case like the present is: Ex- 
 clude the day on which the note is discounted and on which it ought 
 for this purpose, if not every other, be considered as delivered. It 
 being discounted on the i6th, any time on the 17th, without regarding 
 the fractions of that day, there would be one day's interest; and so on 
 through the whole 64 days. By this mode of computation, the bank 
 took as interest upon $2,000 for 64 days, 29 cents too much; that is 
 almost, but not quite, one day's interest upon the sum of the note. 
 
 " . . . . The taking of the 29 cents, as above mentioned, is the 
 taking of more than the 6 per cent, allowed by the statute." 
 
 In the case decided in the Virginia Court of Appeals in 
 1834 (Crump V. Nicholas 5 Leigh 251) the opposite opinion 
 was expressed. The circumstances were as follows: 
 
 The Farmers' Bank of Virginia discounted a note for $6,000, 
 payable on its face 60 days after date, it being understood that 
 
346 AUDITING. 
 
 the loan would be renewed indefinitely till it should suit the 
 interest or convenience of either the bank or the borrower to 
 terminate the arrangement. In point of fact the loan was 
 continued on renewal notes from 21st April, 1825, to 4th May, 
 1826. In discounting the first note, the bank deducted inter- 
 est for 64 days, i. e., counting from the day of date to the last 
 day of grace, both inclusive, and in discounting the second 
 note, made on the last day of grace of the first, likewise de- 
 ducted interest for 64 days, counting from the day of date of 
 the second and last day of grace of the first, to the last day of 
 grace of the second note, both inclusive ; and so on upon each 
 renewal note successively to the end of the transaction. Thus 
 the bank received double interest for every 64th day. This 
 was in conformity with the known usage of the Farmers' Bank 
 and of all the banks of Virginia. 
 
 It was held that the transaction was in nowise usurious. 
 The unanimous opinion of all the judges was that the charge 
 of interest for both the first and last days on the first note was 
 lawful, as a borrower, when making a loan, may receive and 
 have the use of the money borrowed early in the morning of 
 the first day, and is not bound to pay until the last moment 
 of the bank day when due, and hence, the law knowing no frac- 
 tion of a day, has the use of the money both days, but a dissent- 
 ing opinion was filed as to the legality of charging double inter- 
 est for the days on which the renewal notes were given. Four 
 judges held that as there was no binding agreement to renew 
 the loan, each discount was a separate and distinct transaction, 
 and the same treatment of the renewals as of original note was 
 permissible. The dissenting judge raised no question as to the 
 propriety of charging double interest for the renewal date per 
 se, but claimed that on the day of each renewal the previous 
 intention or expectation to renew was carried into effect and 
 became an agreement between the parties on that date and the 
 discount and the appropriation and application of the proceeds 
 of the new note to the payment of the maturing note, by con- 
 sent of both parties, were evidence of the agreement and con- 
 
INTEREST. 347 
 
 sequently all the notes excepting the first were tainted with 
 usury. 
 
 " When judges disagree who shall decide? " Before attempt- 
 ing to say what rule would be most equitable to follow — since 
 from the foregoing decisions it seems to depend upon what 
 part of the country one is in as to what rule would be lawful — 
 it would be well to consider the question from another side, 
 banking institutions, which are usually the lenders who charge 
 interest for both first and last days, do not allow interest on 
 deposits on the same basis, hence why pursue an opposite 
 course with regard to interest charged on loans ? As the officer 
 of a large trust company expressed it : " We allow interest on 
 the basis which requires us to pay out the least money," and 
 had he gone on to refer to the basis of charging interest on 
 loans he would doubtless have stated quite as frankly that * we 
 charge interest on the basis which brings us in the most 
 money." Such a course, however, is certainly not equitable. 
 
 On the whole the fairest rule would seem to be that laid 
 down in the paragraphs quoted in the earlier part of this chap- 
 ter, viz., to exclude either the first or last day from the period 
 of time for which a calculation is being made. In Kirkbride 
 and Sterrett's " The Modern Trust Company " (page 84), the 
 rule is stated thus : "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." 
 
 Because of the lack of uniformity among financial institu- 
 tions with regard to interest and discount on loans this has 
 been made more particularly the subject of review in the fore- 
 going paragraphs, but the principle is the same in any business 
 or in any transaction involving interest. Interest on book ac- 
 counts would naturally be calculated on the same principles as 
 negotiable instruments. In commercial houses the custom is 
 to include either the first or last day, not both, in making 
 interest calculations. 
 
34^ AUDITING. 
 
 Among stock brokers there is also some lack of uniformity 
 in charging interest on customer's accounts. The purchases of 
 one day are settled for the following day, which is when the 
 customer's account is debited, and by some brokers both this 
 day and the last day of the month are included in calculating 
 the interest charge for the month in which the purchase is 
 made. For the reasons already stated, however, the charge 
 should only take into account one or the other of the two days 
 in question, though it should be said in favor of the broker 
 that as long as he is compelled to pay interest on his loans 
 payable on the basis of including both days in the calculation,, 
 he would seem to be entitled to charge his customers interest 
 on a like basis. 
 
 A practice on the part of some trust companies of crediting 
 interest on deposits only from the day following the deposit 
 is injecting the factor of exchange into the question; the rea- 
 son for the practice is to allow the trust company one day in 
 which to make collection of the checks which form the bulk 
 of most deposits. In the case of large deposits consisting of 
 items drawn on distant points the credit of interest might, of 
 course, be suspended for a longer period than one day. 
 
 The second question relating to the factor of time is, as has 
 already been mentioned, the unit period on which the calcula- 
 tion is based. Interest rates are usually stated on an annual 
 basis, i. e., they are expressed as a percentage of the principal 
 which is to be added thereto for the use thereof for one year. 
 Even when the rate is not stated as so much " per annum " it 
 is, unless expressly stated otherwise, usually so understood. 
 
 Payments of interest made periodically in pursuance of an 
 agreement do not as a rule raise any question concerning their 
 calculation. If monthly, quarterly or semi-annual payments 
 they are simply one-twelfth, one-fourth or one-half of the in- 
 terest for a full year. 
 
 In the case of interest for fractional or odd periods of time 
 varying methods of calculation are again encountered. Theo- 
 
INTEREST. 349 
 
 retically the correct method would be to ascertain the number 
 of days and take this number of 365th of a full year's interest. 
 Some banking institutions use this method, though by far the 
 greater number base their calculations on a year of 360 days. 
 The latter method is the most convenient when interest tables 
 are not used, but when tables are used one method is just as 
 simple as the other. 
 
 In 1824 the Supreme Court of New York ruled that the 
 taking of interest on the basis of 360 days to the year was 
 usurious. (AT. Y. Firemen Ins. Co. v. Ely 2 Cowen 705). In 
 the case of Bank of Burlington v. Durkee, to which reference 
 has already been made (vide page 344), the Supreme Court of 
 Vermont stated that it was not prepared to go to the same 
 length to which the New York Supreme Court had gone, and 
 said : 
 
 " If a bank commences and carries on its operations in a 
 way pursued by all the banks in the country, and the way that 
 has been pursued by them for 30 years, and even from the 
 £rst establishment of banks in this country, and uses the same 
 tables for casting interest; or, to speak more properly, takes 
 the interest from those tables already cast, for any sum and 
 any term, those same being printed tables and kept for the 
 accommodation of banks and business men; and during all 
 this time the mode of casting and taking interest has been 
 acquiesced in as correct and no resistance made to it in any of 
 the numerous actions in which the defence might be made, if 
 good in any case — under all these circumstances, it cannot be 
 presumed that the bank acted with any intention to oppose or 
 violate the statute. In such a case the bank would have reason 
 "to believe that the statutes of usury had received a construc- 
 tion from the bench that sanctioned this mode of casting inter- 
 est, or at least that it received the universal approbation of 
 mankind. The going in a path so well understood, so long in 
 use and in such general use, precludes all presumption of any 
 intention to evade the statute or do any wrong whatever." 
 
350 AUDITING. 
 
 The court accordingly held that while the bank might have 
 taken usury tlie transaction was made in good faith, in pur- 
 suance of long established usage and with no intent to disobey 
 the law, and the court declined to inflict the extreme penalty of 
 usury, but merely stated that the bank's claim ought to be 
 reduced by 29 cents. 
 
 In a case decided in the Virginia Court of Appeals in 1837 
 (State Bank of North Carolina v. Cowan, etc. 8 Leigh 238) 
 the claim was made that discounts of notes at 6 per cent., based 
 on 360 days to the year instead of 365 were usurious. The 
 court, however, held otherwise. 
 
 Many states have by statute legalized this banking usage, 
 in others it is permitted or obtains merely by force of custom. 
 In the revision of the statutes of New York in 1892 the 
 statute legalizing the 360-day basis of interest was dropped and 
 at present time this method of calculating interest, when the 
 maximum rate is charged, is technically illegal in that state. 
 
 Under an act passed at the 1909 session of the Massachu- 
 setts legislature and approved on March 6, 1909, interest on all 
 loans of money and on all bonds and notes purchased or held 
 by the Commonwealth will hereafter be computed on the basis 
 of 365 days to the year instead of 360 days. The law is known 
 as Chapter 148 of the Acts of 1909 and reads as follows : 
 
 An Act Relative to the Computation of Interest on Bonds and 
 Notes in Dealings with the Commonwealth. 
 
 Be it enacted, &c., as follows: 
 
 Section i. On all loans of money made to or by the Com- 
 monwealth and on all bonds and notes purchased or held by 
 the Commonwealth, interest shall be computed on the basis of 
 three hundred and sixty-five days to the year and not on the 
 basis of three hundred and sixty days to the year. 
 
 In calculating interest for a part of the period for which it 
 may regularly be paid, say quarterly or semi-annually, as on 
 
INTEREST. 351 
 
 bonds or mortgages, it is probably more general to state the 
 time in months and days than entirely in days. In such a case 
 the number of full months from the date to the same num- 
 bered day next preceding the final date should first be deter- 
 mined and then the odd days to the final date. 
 
 The months, irrespective of whether they have 30 or 31 
 days, would be treated as so many twelfths of a year, but as to 
 the odd days there is again a variation in treatment, sometimes 
 being taken as so many 30th of a month (equivalent to a 360- 
 day basis), and sometimes being figured as so many 28th, 30th 
 or 3ists, according to the month in which they occur. With 
 the latter method difficulty arises if part of the odd days are in 
 a month having 30 days and part in one having 31 days, e. g., 
 from 23rd April to 15th May would be 22 days, but shall 
 they be considered 30th or 3ists of a month? Either way of 
 treating them would be to a certain extent arbitrary. Still 
 another method of dealing with the odd days would be to con- 
 sider them as 365th of a year. Either the first or the last 
 method would seem to be preferable, the first (treating them 
 as 30ths) having the merit of consistency, as it brings the 
 treatment of the full months and the odd days more nearly on 
 the same basis, though the last is doubtless more strictly in 
 accord with the law in those states which have no statute legal- 
 izing the 360-day basis. 
 
 The auditor who has occasion to verify interest calculations 
 will naturally first acquaint himself with any special condi- 
 tions or circumstances which may obtain. E. g., savings banks 
 frequently have rules concerning the interest to be allowed on 
 deposits which provide for certain concessions or the reverse. 
 'Deposits made on any day between the first and fifth may be 
 permitted to draw interest from the first of the month, while 
 deposits after the fifth may not draw interest until the follow- 
 ing month. In some cities where the savings banks and trust 
 companies allow a rate of interest on time deposits which is 
 higher than obtains in many other cities, they have rules con- 
 cerning the calculation of interest which result in reducing 
 
352 AUDITING. 
 
 materially the average rate actually paid on deposits. These 
 rules in one large city are : 
 
 That deposits from the 2d to the 15th of the month 
 draw interest only from the 15 of the month; deposits 
 from the i6th to the ist of the following month draw 
 interest only from the latter date. 
 
 Withdrawals during any semi-annual interest period 
 lose all interest accrued thereon since the last interest date. 
 
 The first rule is not any more severe than the rules usually 
 -obtaining, as it is quite a general custom to allow interest on 
 savings deposits only by full calendar months. The latter 
 rule, however, is the one which accomplishes the greatest re- 
 duction in the rate of interest actually paid. A large sum of 
 money withdrawn after having been on deposit for, say five 
 months since the last interest date, receives no interest what- 
 ever for that period. 
 
 It may be of interest to note the rules for calculating interest 
 which obtain in the Treasury Department of the Government. 
 The following is the substance of information furnished by the 
 Government Actuary: 
 
 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. 
 
 When interest is payable semi-annually or quarterly, half or one- 
 quarter of a full year's interest is apportioned to each period. 
 
 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 semi-annual or quarterly period, it 
 is the number of days for which interest runs divided by the number 
 of days in that 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. 
 
 A few words on discount and usury, which are closely re- 
 lated to, or rather form a part of, the general subject of inter- 
 
INTEREST. 353 
 
 est, are in order. Any one who gives the matter any consid- 
 eration can readily see that to collect interest in advance or to 
 " discount," results in a rate of interest, when calculated on the 
 amount actually received by the borrower, higher than the 
 nominal rate. When the nominal rate of the discount is the 
 highest rate of interest permitted by law — and a large majority 
 of the states have fixed the maximum rate which may be 
 charged — technically it becomes a usurious transaction. The 
 following extracts from a review of the legal status of the 
 practice indicate that the courts generally have held that unless 
 used to excess it will be permitted (29 L. R. A. 761-8). 
 
 "In general, it must be regarded as well established that, at least 
 on short-time paper, interest may be taken by way of discount in 
 advance, and at the highest rate allowed by law, although this does 
 in reality make the interest paid, if computed on the amount actually 
 received for use by the borrower, exceed the legal rate by the amount 
 of the interest upon the interest for the time of the debt 
 
 " The right to take interest in advance is expressly given to national 
 banks by U. S. Rev. Stat., §5197, which fixes the rate at 7 per cent, 
 in cases where no rate is fixed by the laws of the state, territory or 
 district where the bank is located, but providing that such banks shall 
 not take greater interest than the local laws permit; except where 
 such laws fix a different rate for the state banks of issue, and then 
 such rate is allowed to the national banks. 
 
 (There have been decisions in which discount or interest taken in 
 advance for a period of one year or even longer have been held to be 
 not usurious.) 
 
 " A note for $8,880, payable one year from date, given in renewal 
 of a note for $8,000, was held usurious under a statute authorizing 10 
 per cent, interest, although interest could be lawfully taken in ad- 
 vance (First National Bank v. Davis, 108 111., 633). Two judges dis- 
 sented from this decision on the ground that the amount of the note 
 was no more than might have been realized from lawful interest had 
 the interest for one year been paid in advance 
 
 " Nearly all cases have upheld payments of interest in advance when 
 interest was paid periodically." 
 
 The laws of New York expressly provide that a bank or 
 banker may deduct interest in advance, as will be noted in the 
 following : 
 
354 AUDITING. 
 
 Section 74 of the Banking Law, as contained in the Consoli- 
 dated Laws of the State of New York, enacted in 1909 (being 
 Chap. 10 of the Laws of 1909 and Chap. 2 of the ConsoHdated 
 Laws of that year in Article III thereof) is as follows: 
 
 "RATE OF INTEREST. Every bank and private and 
 individual banker doing business in this state may take, 
 receive, reserve and charge on every loan and discount made, 
 or upon any note, bill of exchange or other evidence of debt, 
 interest at the rate of six per centum per annum; and such 
 interest may be taken in advance, reckoning the days for which 
 the note, bill or evidence of debt has to run. 
 
 " The knowingly taking, receiving, reserving or charging a 
 greater rate of interest shall be held and adjudged a forfeiture 
 of the entire interest which the note, bill of exchange or other 
 evidence of debt carries with it, or which has been agreed to 
 be paid thereon. If a greater rate of interest has been paid, 
 the person paying the same, or his legal representatives, may 
 recover twice the amount of the interest thus paid from the 
 bank or private or individual banker taking or receiving the 
 same, if such action is brought within two years from the time 
 the excess of interest is taken. The purchase, discount or sale 
 of a bona fide bill of exchange, note or other evidence of debt 
 payable at another place than the place of such purchase, dis- 
 count or sale at not more than the current rate of exchange for 
 sight draft, or a reasonable charge for the collection of the 
 same, in addition to the interest, shall not be considered as 
 taking or receiving a greater rate of interest than six per 
 centum per annum. 
 
 The true intent and meaning of this section is to place and 
 continue banks and private and individual bankers on an equal- 
 ity in the particulars herein referred to, with the national banks 
 organized under the Act of Congress entitled, ' An act to pro- 
 vide a national currency secured by pledges of United States 
 bonds, and to provide for the circulation and redemption, 
 
INTEREST. 355 
 
 thereof/ approved June third, eighteen hundred and sixty- 
 four/' 
 
 In conclusion, the following rules on points concerning 
 which there is a variation in practice, might be formulated 
 as being the most accurate, and most equitable to both the 
 payor and payee of interest. 
 
 1. In stating the time between two dates, include only 
 one of the two days, not both. 
 
 2. For interest payable at regular intervals, as semi- 
 annually, quarterly or monthly, such periods should be 
 considered as one-half, one-quarter or one-twelfth, re- 
 spectively, of the year. 
 
 3. For a fraction of any of the foregoing periods the 
 time should be stated in months and days, each month 
 being considered one-twelfth of a year, and the odd days 
 as 30ths of a month. 
 
 4. When interest is calculated for the actual number 
 of days in a period, it should be on the basis of 365 days 
 to the year. 
 
 5. The foregoing rule may be modified where a definite 
 and well understood custom exists of charging and paying 
 on the basis of 360 days to the year, but the custom 
 should be known to both parties. 
 
APPENDIX A. 
 
 Summary of the Rules laid down by the Courts 
 with respect to, and Reports of Cases dealing 
 with, the Rights and Liabilities of Auditors. 
 
 So far as we are aware, no reported case in America has 
 yet dealt with the liabiHty of professional auditors. We are. 
 therefore, compelled to resort to the English decisions, from 
 which we deduce the following legal rules: — 
 
 It will be observed that the courts have laid down rules 
 of liability which are by no means onerous; and indeed it 
 would seem that the practice which we have advocated in the 
 preceding pages of this book is considerably stricter than the 
 courts require. However, it is always well to be on the safe 
 side, and an auditor can have the satisfaction of knowing 
 that if he follows the practice which we have heretofore laid 
 down, he will be amply on the safe side of the law. 
 
 Remembering then that the following are simple rules of 
 legal liability laid down by the courts, and not rules of prac- 
 tice which the authors would in all cases advocate, we sum- 
 marize the English decisions as follows : 
 
 1. An auditor must do more than ascertain the arithmetical 
 accuracy of the balances. He must see that the books give 
 a true and accurate representation of his clients' financial 
 affairs. 
 
 2. In doing this, the auditor is not an absolute insurer of 
 the accuracy or truthfulness of the books. He is bound only 
 to use reasonable care, the care of an ordinarily skilful audi- 
 tor under the particular circumstances. 
 
 356 
 
APPENDIX A. 357 
 
 3. What is reasonable care in any given case must depend 
 upon the circumstances of that case. Where there is nothing 
 to excite suspicion, very little inquiry may be sufficient. It 
 is legally sufficient for the auditor to select a few cases hap- 
 hazard, see that they are right, and assume that others like 
 them are correct also; check the cash, examine vouchers for 
 payments, see that the bills and securities entered in the books 
 are correct, and take reasonable care to ascertain their value. 
 He is not bound to take stock; he should, however, satisfy 
 himself as to its accuracy so far as he can. As to the other 
 assets and liabilities he must use reasonable diligence in veri- 
 fying them before certifying to the correctness of the balance 
 sheet. 
 
 4. Until the contrary is suggested by circumstances of ob- 
 vious suspicion appearing on the books themselves, the auditor 
 is justified in assuming that the clients' clerks, bookkeepers, 
 officers et al. are honest. 
 
 5. Unless some suspicious circumstance exists, the auditor 
 is not legally bound to communicate with third parties (cus- 
 tomers or creditors) to see if their accounts are accurately 
 stated in the books. Unless he has been elected by the stock- 
 holders, he probably has no right to report to them directly 
 at all. 
 
 6. An auditor's report must plainly point to the client any 
 unsatisfactory features of the account. The auditor does not 
 discharge this duty by simply giving the client so much infor- 
 mation as is calculated to induce the client to ask for more. 
 The auditor must convey information, not merely arouse 
 inquiry. 
 
 The following extracts from the cases are instructive. As 
 heretofore mentioned, these cases are reported in greater de- 
 tail in the Seventh English Edition of this work, and reference 
 thereto should be had if additional information is desired. 
 
358 AUDITING. 
 
 Leeds Estate Building CSi, Investment Society, Lim., v. 
 Shephard, 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 is the auditor's duty not to confine himself 
 merely to the task of ascertaining the arithmetical accuracy 
 of the balance sheet, but to see that it is a true and accurate 
 representation of the company's affairs. 
 
 In examining the balance sheets the auditor was not fur- 
 nished with a copy of the articles of incorp>oration, and he 
 did not comply with their provisions. Held: That it was no 
 excuse that the auditor had not seen the articles when he knew 
 of their existence. 
 
 In Re London CBb General Bank, 1895, 2 Ch. Div. 673. 
 
 An auditor is guilty of misfeasance who, when dissatisfied 
 with the accounts of a company, does not plainly draw atten- 
 tion to the grounds of his dissatisfaction in his certificate. 
 
 The court discusses the matter at length as follows: — 
 
 " 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 without security. It is nothing to 
 him whether the business of a company is being conducted 
 prudently or imprudently, profitably or unprofitably; it is 
 nothing to him whether dividends are properly or improperly 
 declared, provided he discharges his own duty to the share- 
 holders. His business is to ascertain and state the true finan- 
 cial 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 ex- 
 amining the books of the company. But he does not discharge 
 his duty by doing this without inquiry and without taking any 
 
APPENDIX A. 359 
 
 trouble to see that the books of the company themselves show 
 the company'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 cor- 
 rect in that sense. But his first duty is to examine the hooks, 
 not merely for the purpose of ascertaining what they do shozv, 
 but also for the purpose 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. Shephard, 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 in- 
 vestigations. 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 ac- 
 curate 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 a book from him. 
 His obligation is not so onerous as this. 
 
 " Such I take to be the duty of the auditor ; he must b^ 
 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 de- 
 pend upon the circumstances of that case. Where there is 
 nothing to excite suspicion, very little inquiry will be reason- 
 able and sufficient; and in practice, I believe, business men 
 select a few cases haphazard, see that they are right, and as- 
 sume that others like them are correct also. Where suspicion 
 is aroused more care is obviously necessary, but still an audi- 
 tor is not bound to exercise more than reasonable care and 
 
360 AUDITING. 
 
 skill even in a case of suspicion, and he is perfectly justified 
 in acting on the opinion of an expert where special knowledge 
 is required. 
 
 " Mr, Theobald's evidence satisfies me that he took the same 
 view as myself of his duty in investigating the company's 
 books and preparing his balance sheet. He did not content 
 himself with making his balance 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 
 reasonable care to ascertain their value, and in one case ob- 
 tained 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 certifi- 
 cate, and report together, Mr. Theobald stated to the directors 
 the true financial position of the bank, and if this report had 
 been laid before the shareholders, Mr. Theobald would have 
 completely discharged his duty to them. Unfortunately, how- 
 ever, 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 circum- 
 stances under which information given in the shape of a 
 printed document circulated amongst a large body of share- 
 holders 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 discharge his duty, if in- 
 stead of publishing his report in such a way as to enisure 
 
APPENDIX A. 361 
 
 publicity, he made a confidential report to the shareholders, 
 and invited their attention to it, and told them where they 
 could see it. The auditor is to make a report to the share- 
 holders, but the mode of doing so, and the form of the re- 
 port, 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, perhaps, 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. Theo- 
 bald did fail to discharge his duty to the shareholders in 
 certifying and laying before them the balance sheet of Feb- 
 ruary, 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 Sheet 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 se- 
 curities, and it is impossible to read the oral evidence, the 
 report of Mr. Balfour and Mr. Brock, dated the 226. of De- 
 cember, 1 89 1, and the report of the auditor to the directors 
 of the 3d of February, 1892, without coming to the conclusion 
 that the entry of that large sum as a good asset without ex- 
 planation was unjustifiable. It is a mere truism to say that 
 the value of loans and securities depends upon their realiza- 
 tion. We are told that a statement to that effect is so un- 
 usual that the mere presence of those words is enough to excite 
 suspicion. But, as already stated, the duty of an auditor is 
 
362 AUDITING. 
 
 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 ordina'ry 
 people would have their suspicions aroused by a similar state- 
 ment if, as in this case, its language expresses no more than 
 any ordinary person would infer without 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 share- 
 holders, 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 re-appoint 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 company at the end of 1891, and that this 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. 
 
APPENDIX A. 363 
 
 " 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 misleading if explained (as it was to the 
 directors), was seriously misleading in the absence of ex- 
 planation." 
 
 The London ^ General Bank case just cited is a fair ex- 
 ample of facts which charge the auditor with liability. 
 
 In Re Kingston Cotton Mill Co., 2 Ch. Div. 279, decided 
 in the Court of Appeal, May 19, 1896. 
 
 The following extract taken from this case shows facts 
 which do not charge the auditor with liability. 
 
 " 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 company. To decide this question it is neces- 
 sary 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 audi- 
 tor 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 careless. The circumstances are as fol- 
 lows : For several years frauds were committed by the man- 
 ager, who, in order to bolster up the company and make it 
 appear flourishing when it was the reverse, deliberately ex- 
 aggerated 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 ac- 
 count (except the Stock Journal, to which I will refer pres- 
 ently) showing the quantity or value of the cotton or y:am in 
 
364 AUDITING. 
 
 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 certificate.' 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 pre- 
 ceding 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 various heads pur- 
 porting 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 certifi- 
 cate.' The summary always corresponded with the accounts 
 summarized, and the auditors ascertained that this was the 
 case. But they did not examine further into the accuracy of 
 the accounts summarized. The auditors did not profess to 
 guarantee the correctness of this item. They assumed no 
 responsibility for it. They took the item 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. 
 
APPENDIX A. 365 
 
 In this case the auditors rehed 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 accurate 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 direc- 
 tor'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 
 information 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 
 
Z^ AUDITING. 
 
 a cashier who has to account for the cash which he receives, 
 and whose own account of his receipts and payments 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 rea- 
 sonably competent, careful 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 work 
 with suspicion or with a foregone conclusion that there is 
 something wrong. He is a watch-dog, 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 repre- 
 sentations, provided he takes reasonable care. H there is any- 
 thing 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. His Lordship 
 then referred to the circumstances which led to the auditors 
 being deceived, and came to the conclusion that they were not 
 wanting in skill, care or caution, in accepting the figures of 
 the manager, and he concluded as follows: — 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 extended any 
 further than In re The London and General Bank. Indeed, I 
 only assented to that decision 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 difficult 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 unde- 
 
APPENDIX A. 367 
 
 tected for years by the directors. So to hold would make the 
 position of an auditor intolerable." 
 
 Wilde and others against Cape and Dalgleish, decided by 
 the Queen's Bench Division, May 27, 1897 (reported 
 unofficially in the London Times of May 28, 1897; also in 
 the "Accountant" (Eng.), June 5, 1897; also in Dicksee's 
 " Auditing," 7th English Ed., at p. 679). 
 
 Here the court held the whole question to be simply one of 
 fact, to wit: 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 account- 
 ant 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 ? 
 
 Irish "Woolen Company, Lim., against Tyson and others, 
 decided by the Irish Court of Appeal, January 20, 1900 
 (unofficially reported in the "Accountant" (Eng.), Feb- 
 ruary 3, 1900; also in Acct. L. R. 1900, p. 13; also in 
 Dicksee's Auditing, 7th Eng. Ed., p. 702.) 
 
 In this case it was held that when the accounts of a com- 
 pany have been falsified and dividends improperly paid out of 
 capital in consequence, the auditor is liable if the falsifica- 
 tions 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 everything himself. The auditor is bound to give reason- 
 able care and skill, but this can also be exercised by his 
 deputy. I do not think there is anything 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 explana- 
 
368 AUDITING. 
 
 tions. But he is not called on to seek for knowledge outside 
 the company, or to communicate 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 aggre- 
 gate 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 lia- 
 bility 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 dis- 
 count, and, as far as I could gather, the imiversal 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 pros- 
 pective allowance for, bad debts. He has no personal knowl- 
 edge 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 knowl- 
 edge 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 meeting, and said, the ledger 
 was used for the purchases made and for the payments on ac- 
 
APPENDIX A. 369 
 
 count thereof. If, then, all this were rightly done it would be 
 easy for the auditor to ascertain the amounts due to the credi- 
 tors, but, unfortunately, the books were not correctly kept. 
 The creditors' accounts in the ledger did not show all the 
 goods purchased up to the time of the audit, nor could the 
 auditor discover the omissions on account of many of the in- 
 voices being either ' suppressed ' or not put into the book until 
 a later date — sl process described as ' carrying over.' There is 
 some doubt as to whether the deficiency arose from the sup- 
 pression 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 £4,095. 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 the auditor. Once 
 or twice he noticed something, and the explanation that was 
 g^ven 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 in- 
 voices 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 account- 
 ant, 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 ac- 
 count if they were engaged in an ordinary audit. Little time 
 is allowed for doing so ; but in this case there was this systerti 
 •of monthly checking. From the time that Crawford was ac- 
 
37^ AUDITING. 
 
 countant 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 Amer- 
 ica 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 statements 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 was 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 invoices 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 car- 
 ried out. 
 
 " As regards the measure of the duty of a gentleman em- 
 ployed, 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 
 
APPENDIX A. 371 
 
 employed, except one, the peculiar instance of a barrister. 
 The measure of duty is the bringing of reasonable 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 ascer- 
 tained 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 im- 
 posed on him the duty of pursuing his suspicion until he found 
 whether it was or was not well founded. . . . The Eng- 
 glish 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 sus- 
 picion, he is not guilty of negligence, whatever other people 
 might be in their departments, if he does not discover that 
 something was wrong.'* . . . 
 
 (The suspicious circumstance in this case is then referred 
 to by the Court as follows:) 
 
 " 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 
 conclusion 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' statements of account, and 
 at that moment they would have disclosed on the face of them 
 not merely those postdated items, but the suppressed invoices 
 
37^ AUDITING. 
 
 also; and at the instant that this discovery was made there 
 is an absolute conviction of something wrong forced upon the 
 mind of the auditor. It, therefore, occurs to me that, upon 
 these two branches, all that is required, both to show the negli- 
 gence, 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)." 
 
 The converse of the Irish Woollen Co, case is found in 
 
 Short and Compton v. Brackett, Colchester County Court* 
 May 6, 1904 (unofficially reported in the " Accountant " 
 (Eng.), May 14, 1904; also in Acct. L. R. 1904, p. 85; also 
 in Dicksee's "Auditing," 7th Eng. Ed., p. 813). 
 
 There the clerk made out a wage bill each week for a larger 
 amount than was due to the men and kept the balance. An 
 auditor examined the books on behalf of an incoming partner. 
 At the time of the examination there was no suspicion against 
 the clerk, and there was nothing on the face of the books to 
 arouse suspicion. 
 
 Judge Tindal Atkinson held that, having regard to the ob- 
 ject for which they were employed, the plaintiffs were entitled 
 to assume that the figures appearing in the defendant's books 
 as paid for wages were correct, and in view of the fact that 
 at the time there was no suspicion of any defalcation by the 
 defendant's clerk alluded to, he thought there was no negli- 
 gence on their part. Therefore judgment would be for plain- 
 tiffs on the claim with costs. 
 
 It is important to bear in mind here that no audit in the 
 proper sense of the term was ever performed, in that the in- 
 vestigating accountant (being presumably employed by the 
 incoming partner) owed no duties to the existing partners. 
 As pointed out in Chapter XI., in investigations as to profits, 
 the object is to make sure that the profits have not been ex- 
 aggerated, rather than to see whether they have not been 
 understated and the difference misappropriated by employees. 
 
APPENDIX A. 373 
 
 London Oil Storage Co., Lim., against Seear, Hasluck CBi» Co., 
 King's Bench Division, June 1, 1904; unofficially reported in 
 the London Times, June 2, 1904; also in the "Accountant " 
 (Eng.), July 2, 1904; also in Acct. L. R. XXXL, p. 1; also 
 in Dicksee's "Auditing," 7th Eng. Ed., p. 815). 
 
 In this case 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, the bookkeeper having embezzled the differ- 
 ence. The court left it for the jury to find as matter of fact, 
 whether or not the auditor's failure to verify this balance was 
 negligent under the circumstances. The court charged the 
 jury in part as follows: — 
 
 " The auditor most undoubtedly does undertake very con- 
 siderable responsibilities, and is liable for the proper discharge 
 of his duties, and if by the 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 mat- 
 ter 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 ac- 
 counts are concerned, he is not bound to assume when he 
 comes to do his duty that he is dealing with fraudulent and dis- 
 honest people; and there comes in the most important con- 
 sideration 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 suspicion arise, it 
 is the duty of the auditor, in so far as those circumstances 
 
374 AUDITING. 
 
 relate to the financial position of the company, to probe them 
 to the bottom." 
 
 It will be seen that this rather follows the obiter dictum in 
 the Kingston Cotton Ad ill case, p. 363, as to the obvious con- 
 flict between the interest and the duty of a cashier. The point 
 is, of course, made all the clearer by the circumstance that so 
 large a balance of Petty Cash would be unprecedented as to 
 naturally call for inquiry if the least care were being taken. 
 It should be noted that in this case the damages awarded were 
 not at all in the nature of compensation for the loss sustained 
 by the plaintiffs, but merely represent a nominal sum to mark 
 the fact that the audit had not been performed with all due 
 care. 
 
 Herbert Alfred Burleigh against Ingram Clark, Lim., 
 Chancery Division, April 2, 1901 (unofficially reported in 
 the "Accountant" (Eng.), April 27, 1901; also in Acct. 
 L. R. 1901, p. 65; also in Dicksee's "Auditing," 7th Eng. 
 Ed., p. 765.) 
 
 This case decided that an accountant has a lien on such 
 books as he has actually worked upon for the work done upon 
 those books only. The judges also said by way of dictum that 
 an auditor had no such lien. The distinction between ac- 
 countant and auditor, as drawn in this case, is that the ac- 
 countant does work on the books, and the auditor does work 
 in respect of the books. The accountant actually writes in the 
 books themselves, while the auditor merely looks at the book?, 
 and does his work on other pieces of paper. 
 
 Martin v. Isitt, decided before Lord Chief Justice Russell, in 
 the Queen's Bench Division, March 3 and 4, 1898, (unoffici- 
 ally reported in Acct. L. R. 1898 p. 41; also in Dicksee's 
 "Auditing," 7th Eng. Ed. p: 68O). 
 
 Considerable interest attaches to the foregoing case on ac- 
 count of the discussion therein as to the duties of an auditor 
 to attend promptly to periodical audits. 
 
APPENDIX A. 375 
 
 This was an action brought by Messrs. James Martin & 
 Sons, milk and grain merchants, against Messrs. Isitt & Co., 
 Chartered Accountants, for negHgence in not checking the 
 cash book and the bank pass book, whereby a clerk was en- 
 abled undiscovered to embezzle £612 19s. 2d., the property of 
 the plaintiffs. The defendants alleged that they were unable 
 to properly proceed with their agreed work, owing to the 
 neglect of the plaintiffs to give proper facilities, and in par- 
 ticular they complained that the books were not properly 
 posted up and were full of errors, of which the defendants 
 were unable to get the necessary explanations. 
 
 It appeared that in 1887 Mr. Eldrid, now a member of the 
 defendants' firm, agreed with plaintiffs to do certain work 
 which was not material to the present action, and also under- 
 took the *' monthly checking of all your books " for an in- 
 clusive fee of thirty guineas, afterwards increased to sixty 
 guineas. It was not the defendants' duty to audit, but merely 
 to " check " the books. To enable this to be done clerks were 
 sent down to the plaintiffs' head office at Brockley, and they 
 spent there a very considerable number of hours doing the 
 requisite work. The books were written up and posted by 
 the plaintiffs themselves ; with this the defendants had nothing 
 to do. It further appeared that a man named May, in charge 
 of a branch of the plaintiffs' business, received money, and in 
 a weekly statement sent to the plaintiffs credited himself with 
 payments into a bank, which payments should in ordinary 
 course appear in the London and County Bank pass book of 
 the plaintiffs. In fact, from the last week of November, 1896, 
 until the end of March, 1897, he habitually embezzled the 
 money. The plaintiffs would enter in their cash book the 
 amount alleged by May to have been paid into the bank; the 
 pass book, of course, would not agree with cash book, and 
 the plaintiffs complained that this was not discovered until 
 the first days of April, 1897. It was admitted that the dis- 
 covery was made by, and was due to the work of the defend- 
 ants; but it was then alleged against the defendants that the 
 
Z7^ AUDITING. 
 
 discovery should have been made earHer. The reply of the 
 defendants to this was that the state of the books was such, 
 and the queried items — the explanations of which were con- 
 stantly delayed — were so numerous, that they were unable to 
 proceed fast enough to keep pace; and that, in December, 
 1896, they were still engaged in dealing with the entries relat- 
 ing to the summer months of 1896. Further, they said 
 that they were requested by the plaintiffs not to proceed with 
 the work in January, and that the month of February was 
 wasted away to the default of the plaintiffs. The senior mem- 
 ber of the plaintiffs' firm was called, and gave evidence sup- 
 porting his own and negativing the defendants' case, but his 
 cross-examination was not concluded when the court rose 
 for the day. 
 
 Before resuming the hearing next morning, a consultation 
 took place between counsel, and as a result, Mr. Carson stated 
 that he understood that it would not now be contended that the 
 defendants had been negligent or unskilful in the way in which 
 they had done their work, but that the plaintiffs would rest 
 their case on a breach of one term of the contract — viz., the 
 agreement to attend monthly. That being so, and recognizing 
 that the plaintiffs had suffered a loss, the defendants were 
 quite willing to share that loss to a certain extent, and con- 
 sequently terms had been arranged. 
 
 The Lord Chief Justice said that as he understood the case 
 as placed before hirrt, no allegation of negligence or unskilful- 
 ness was now made, but that it was urged that the defendants 
 should have attended somewhat earlier than they actually did; 
 that was a question to be tried, but he thought the action of 
 the parties in arranging the matter to be very proper. 
 
 Smith against Sheard, Liverpool Assizes, May 11, 1906 (re- 
 ported in the "Accountant," L. R. 1906, p. 65; also in 
 Dicksee's ^'Auditing," 7th Eng. Ed., p. 833.) 
 
 Claim was made by the plaintiff that, in consequence of 
 the inefficient auditing of the books by the defendant, the em- 
 
APPENDIX A. 377 
 
 bezzlement of some £700 by the plaintiff's cashier had not 
 been detected. The defense was that no agreement had ever 
 been made for a complete audit, but that the only work contem- 
 plated was the stating of the accounts between partners, and 
 later, after one of the partners had withdrawn, on behalf of 
 creditors, the books being accepted as they stood, and only 
 such auditing done as was absolutely necessary to the prepa- 
 ration of statements. 
 
 The case was tried before a special jury, and the charge 
 of the trial judge seemed to be very favorable to the defend- 
 ant. The jury, however, found for the plaintiff, thus assent- 
 ing to the allegation that there had been an agreement for a 
 complete audit. This case shows the extreme importance of 
 a distinct understanding, not only verbal, but written, when 
 a partial audit is to be made or statements to be prepared 
 without any audit whatever. 
 
 Newton against Birmingham Small Arms Company, Lim., 
 Chancery Division, June 27, 1906 (reported in 22 Times 
 L. R., p. 644 ; also in Dicksee's "Auditing," 7th Eng. Ed., 
 p. 872.) 
 
 The Birmingham Small Arms Company, Limited, had passed 
 a special resolution purporting to alter the company's articles 
 of association, the material part of which read as follows : 
 
 ** In addition and without prejudice to Articles 132 and 
 133 " (which related to the formation of and dealing with a 
 reserve fund), " the directors may in any year in which they 
 shall recommend a dividend to be paid on the ordinary shares 
 . . . of not less than 10 per cent, on the amount paid up 
 thereon set aside (without disclosing the fact) out of the 
 earnings or profits in such year remaining after providing the 
 amounts necessary to pay the dividends payable on preference 
 shares and the dividend which they recommend on the ordi- 
 nary shares such a sum as they may deem necessary or de- 
 sirable in the interest of the company as an internal reserve 
 
378 AUDITING. 
 
 fund or as an addition to such internal reserve fund when 
 formed, which internal reserve fund shall be held upon the 
 terms and for the purposes following, that is to say: (a) The 
 internal reserve fund shall be separate from the reserve fund 
 under Article 132, and need not be shown or disclosed by 
 the balance sheet, and the directors need not give any informa- 
 tion to the shareholders as to the amount, investment, or ap- 
 plication thereof, or otherwise in relation thereto, either in 
 their report or otherwise, (b) Such internal reserve fund 
 may be invested upon such investments (other than the 
 shares of the company) as the directors may, in their abso- 
 lute discretion, think fit, without being liable for any deprecia- 
 tion of or loss in consequence of such investments. . . . 
 (c) Such internal reserve fund may be used and applied at 
 the discretion of the directors for any purpose for which the 
 ordinary reserve fund is available, or for any purposes which 
 the directors in their absolute discretion may consider will 
 serve, protect, or advance the interests of the company, or 
 preserve or promote the value of the undertaking, assets, or 
 goodwill of the company, (d) The directors shall disclose 
 the internal reserve fund and the amount thereof, and all 
 additions thereto, and all other particulars in respect to the 
 said fund to the auditors of the company appointed by the 
 shareholders, whose duty shall be to see that the same is 
 applied for the purposes of the company in accordance with 
 the provisions hereinbefore contained, but not to disclose any 
 information with regard to the same to the shareholders or 
 otherwise." 
 
 The shareholders of the company brought an action, declar- 
 ing that the resolution was ultra vires and invalid, and asked 
 for an injunction to restrain the company and its directors 
 from acting on such a resolution. Particular exception was 
 taken to that part of the resolution which was to prevent the 
 auditors appointed by the shareholders from disclosing any 
 information with regard to the same to the shareholders or 
 otherwise. It was claimed by counsel for the plaintiff that 
 
APPENDIX A. 379 
 
 this would prevent the auditors from properly complying with 
 the sections of the Companies Acts under which they were 
 appointed and under which the auditors had to report to the 
 shareholders. An injunction to restrain the company from 
 acting on this special resolution was granted. In pronounc- 
 ing judgment, Mr. Justice Buckley stated inter alia that he 
 considered it inconsistent with the Act of Parliament (Com- 
 panies' Act of 1900), that the auditor should be bound, even 
 when he thinks that the true state of the company's affairs is 
 affected by facts relating to the internal reserve fund, to with- 
 hold all information with regard to the same from the share- 
 holders. 
 
APPENDIX B. 
 
 Professional Ethics. 
 
 Every profession, which is worthy of the designation, must 
 have a code of ethics which shall be observed by its members 
 in the pursuit of their professional duties. It does not follow 
 that the code need be written, though this has in some cases its 
 advantages, but it is necessary that there be certain well under- 
 stood principles, the violation of which shall mark the violator 
 as unworthy of professional standing. The development of 
 professional standards and the recognition of the underlying 
 principles has taken many years in the older professions. This 
 subject has had the careful attention and consideration of those 
 engaged in the practice of accountancy, who have the welfare 
 and the development of the profession along broad lines at 
 heart. At the St. Paul convention of the American Associ- 
 ation of Public Accountants, held in October, 1907, an ad- 
 mirable paper on " Professional Ethics " was presented by J. 
 E. Sterrett, C. P. A., and in the course of the discussion which 
 followed John A. Cooper, C. P. A., proposed the following: 
 
 CODE OF ETHICS. 
 Service. 
 
 1. To certify to statements, exhibits, schedules or other form 
 
 of accountancy work, the auditing or preparation of 
 which was not carried on entirely under the supervision 
 of himself, a member of his firm, or one of the staff, is 
 wrong. 
 
 2. The use of a practitioner's nam.e in professional work by 
 
 others than partners or employees is wrong in that it 
 implies deception. 
 
 3. To perform accountancy work, payment for which is by 
 
 arrangement upon the contingency of the result of liti- 
 gation or other form of adjustment, is unprofessional. 
 
 380 
 
CODE OF ETHICS. 381 
 
 4. The payment of a commission, brokerage or other form of 
 
 inducement to the laity from professional fees is wrong. 
 
 5. The acceptance of any part of the fees of a lawyer or any 
 
 commercial brokerage, bonus or commission, as an in- 
 cident arising out of a practitioner's service, is wrong. 
 
 6. Active interest in a commercial enterprise while practicing 
 
 as a public accountant is to be avoided, as incompatible 
 with strict ethical principles. 
 
 7. The practitioner should, wherever possible, avoid acting 
 
 as a trustee of special funds or pools as an incideat of 
 his calling. 
 
 8. A practitioner should avoid serving as a director in cor- 
 
 porations in which he is professionally employed. 
 
 Clients. 
 
 1. Upon engagement a practitioner is in duty bound to tell 
 
 his client of all foreknowledge he may have had touch- 
 ing the matter under consideration. 
 
 2. Personal responsibility is a fundamental rule of the pro- 
 
 fession. A practitioner cannot screen himself from the 
 specific acts or laches of his employees ; the responsibili- 
 ties are his and those of his firm. 
 
 3. Information acquired in the course of service is privileged 
 
 and inviolable. Abuse thereof to the detriment of a for- 
 mer client renders a member subject to the severest 
 discipline. 
 
 4. Efforts that tend to invite or encourage legal contest, or 
 
 foster further employment by neglect, manipulation or 
 unfinished service, should be severely dealt with; it is, 
 in fact, barratry. 
 
 5. To recommend or advise clients to a measure or course 
 
 of procedure that may even indirectly give the practi- 
 tioner a personal advantage must be considered as fla- 
 grant professional infidelity and misconduct. It is 
 " maintenance," and is punishable as such at common 
 law. 
 
382 AUDITING. 
 
 Inter-Professional. 
 
 1. Depreciation of opponents in contested matters is unpro- 
 
 fessional and ethically wrong. 
 
 2. Acceptance of an appointment from which a colleague has 
 
 withdrawn from conscientious motives, without previ- 
 ously making direct inquiry of such colleague as to the 
 conditions, is professional discourtesy. 
 
 3. Canvassing the clients of a colleague for business is un- 
 
 professional. 
 
 4. To recognize or affiliate with a society that in its charter 
 
 title assumes the words " Certified Public Accountant," 
 without warrant of law as to its membership, is wrong, 
 and gives countenance to an implied fraud. 
 
 Publicity. 
 
 1. No professional accountant should advertise or display his 
 
 talents as a merchant does his wares. 
 
 2. Professional cards should show in plain inconspicuous 
 
 type the name, occupation, and office address. No 
 strained effect is consistent or dignified. 
 
 3. The same form of card may be used in publications of a 
 
 recognized standard, such as technical magazines, law 
 periodicals, etc. 
 
 4. It is not good professional form to solicit business through 
 
 trade journals, flashy publications, programmes or the 
 daily press, especially under a pseudonym or publisher's 
 index mark. 
 
 5. The use of the public press in discussions or essays on 
 
 matters of technical or general interest is legitimate. 
 6 The use of initials or other insignia as an affix to a prac- 
 titioner's name in his business advertisements other 
 than such as is recognized by statutory enactment in 
 the United States or is authoritatively recognized in 
 other countries is unprofessional. 
 
code of ethics. ' 383 
 
 Corporations. 
 
 1. No member should conceal his personality under a cor- 
 
 porate name, either actual or fictitious. 
 
 2. The skill and knowledge of the profession is individual, 
 
 and cannot be transferred to a corporation, the accruing 
 goodwill is otherwise lost. 
 
 3. Success in any professional career is a matter of person- 
 
 ality. 
 
 4. A corporation '' per se " cannot make an audit which in the 
 
 full intent of the service is a judicial function. 
 
 5. A corporation is without honor, which is the keystone of 
 
 the profession. 
 
 6. Directors cannot direct in a profession of which they are 
 
 not members. It is a prostitution of the financial stand- 
 ing of the directors and stockholders, leading to unfair 
 competition and prejudiced decisions. 
 
 7. The ultimate profit to the lay stockholder or director, 
 
 whether expressed tangibly or otherwise, is an illegiti- 
 mate gain or advantage which the profession cannot 
 countenance. 
 
 8. In the case of legal liability as the result of negligence or 
 
 criminal perversion of logical facts the ultimate respon- 
 sibility rests with the practitioner, notwithstanding the 
 financial support and control of outsiders. 
 
 9. Assurance of secrecy in affairs of clients of such corpora- 
 
 tions cannot be taken seriously. 
 
 10. The profession needs no control or regulation from the 
 
 laity; it is not an industry. 
 
 At the same meeting the following addition to the by-laws 
 of the American Association of Public Accountants, pertaining 
 to professional ethics was adopted. Mr, Cooper is entitled to 
 the credit for this article as with the exception of rule 5 which 
 was recommended by the Committee on Professional Ethics, 
 
384 AUDITING. 
 
 of which he was chairman, it was submitted by him through the 
 Illinois Society of Certified Public Accountants: 
 
 Article VII of By-Laws of American Association of 
 Public Accountants. 
 
 Professional Ethics. 
 
 The following are declared to be the fundamental rules of 
 the Association: for (a) the infraction of any part thereof, or 
 if (b) convicted of felony or misdemeanor, or if (c) finally 
 declared by a court of competent jurisdiction to have com- 
 mitted any fraud, or is (d) held by the Board of Trustees on 
 the written complaint of any person aggrieved, whether a mem- 
 ber or not, to have been guilty of any act or default discredit- 
 able to the profession, or is (e) declared by any competent 
 court or commission to be insane or otherwise incompetent, or 
 (f) fails to pay any subscription, dues, assessment, or other 
 sum owed by him to the Association under its by-laws within 
 three months after such debt has become due : 
 
 A member renders himself liable to be expelled from the 
 Association or to be suspended for a term not exceeding two 
 years by resolution of the Board of Trustees sitting as a Trial 
 Board. 
 
 Rules. 
 
 1. No member shall allow any person not being either a 
 member of the Association or in partnership with him as a 
 public accountant, or in his employ on a salary, to practice in 
 his name as a public accountant. 
 
 2. No member shall directly or indirectly allow or agree to 
 allow a commission, brokerage, or other participation by the 
 laity in the fees or profits of his (the member's) professional 
 work. 
 
 3. No member shall engage in any business or occupation 
 conjointly with that of a public accountant, which in the opin- 
 
PROFESSIONAL ETHICS. 385 
 
 ion of the Board of Trustees is incompatible or inconsistent 
 therewith. 
 
 4. No member shall certify to exhibits, statements, sched- 
 ules, or other form of accountancy work, the preparation of 
 which was not carried on entirely under the supervision of 
 himself, a member of his firm, one of his staff, a member of 
 this Association or of similar association of good standing in 
 foreign countries. 
 
 5. No member shall in his business advertisements use any 
 initials as an affix to his name that is not either authorized by 
 statutory enactment of this country or by the well-known asso- 
 ciations established for a similar purpose in the British' Em- 
 pire, nor shall he affiHate or substantially recognize any society 
 that is designated or in any way sets itself out to be a so-called 
 Certified Public Accountant Society, without the State in which 
 such society is organized having the requisite statutory enact- 
 ment in full force and effect. 
 
 At the 1909 annual meeting the following additional rules 
 were adopted : 
 
 6. No member shall agree to perform accountancy work 
 for parties to commercial ventures or contested cases, either 
 in prospect or instituted, payment of fee for which is by ar- 
 rangement based upon the contingency of the results. 
 
 7. No member shall interfere, or in any way take part in 
 any effort looking to the modification, alteration, or amend- 
 ment of any State laws affecting the profession of account- 
 ancy without the concurrence and co-operation of the society 
 or societies of the State or district concerned, unless such 
 action shall not violate any of the fundamental rules of the 
 Association. 
 
APPENDIX C. 
 
 Report of a Case bearing upon the question of the 
 Liability of Directors for the payment of 
 Dividends out of Capital instead of Profits, as 
 provided in the Corporation Laws of New York 
 and New Jersey. 
 
 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, 92 N. Y. Supp. 70.) 
 
 Liability of director of foreign corporations for making un- 
 authorized dividends — Payment of dividends on preferred 
 stock must be made from profits, not from capital — Expecta- 
 tion of future profits on contracts not to be figured as assets — 
 Effect of absence of director v^hen such unauthorized divi- 
 dends declared — Losses through payment of commissions on 
 sale of bonds. 
 
 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. 
 
 386. 
 
AMERICAN MALTING CASE. 387 
 
 No dividends can be made except from " surplus or net 
 profits." 
 
 Contracts, entered into by a corporation, for future de- 
 liveries 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 cannot be made on a mere 
 hope or expectation of profits. 
 
 Where raw material is bought by weight, and after manu- 
 facture is increased in weight and value, the corporation is en- 
 titled to treat it as an asset at its increased value. 
 
 A director, who is not present when an unauthorized divi- 
 dend is declared, is not liable under the statute, even though 
 he is present at a subsequent 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 divi- 
 dends, 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 Secretary of State of New York to 
 enable it to do business in this State, and received the usual 
 certificate for that purpose. The principal office of the com- 
 pany was situated in the City of New York, at No. 80 Broad- 
 way, from its organization until the fall of 1899, ^"<^ since 
 then it has been situated continuously at East River and Sixty- 
 
388 AUDITING. 
 
 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 stock have been issued. The pre- 
 ferred stock is seven per cent, cumulative, having a preference 
 as to dividends only. The company is engaged in the manu- 
 facture 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 working 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 pur- 
 chase 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 Decem- 
 ber 20, 1897, the board of directors declared a dividend of one 
 and three-fourths per cent, to preferred stockholders, payable 
 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, 1899, 
 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 to $2,800,000 
 in notes; that the officers were unable to negotiate further 
 temporary loans; that the company needed additional work- 
 ing 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 
 
AMERICAN MALTING CASE. 389 
 
 stockholders 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 alle- 
 gations 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. Hutchinson 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 di- 
 rector 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 jus- 
 tice 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 prac- 
 tical embarrassment, that while it was the unanimous deci- 
 sion that the action could be maintained, yet the difference in 
 the grounds therefor means a difference of hundreds of thou- 
 sands of dollars in the judgment I am about to order. As 
 I interpret it that case holds this court has jurisdiction, be- 
 cause 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 aris- 
 ing from the business of such corporation; nor divide, with- 
 draw 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 section, the directors under 
 
390 AUDITING. 
 
 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 corporation and to the credit- 
 ors thereof to the full amount of the capital of such cor- 
 poration so divided, withdrawn, paid out or reduced;" and 
 because section thirty of the General Corporation Law of New 
 Jersey provides : " No corporation shall make dividends, ex- 
 cept 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 insolvency 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 direc- 
 ors 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 sec- 
 tion sixty of the Stock Corporation Law of this State pro- 
 vides : " Except as otherwise provided in this chapter the offi- 
 cers, directors and stockholders of a foreign stock corporation 
 transacting business in this State, except moneyed and rail- 
 road 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 
 
AMERICAN MALTING CASE. 39I 
 
 for: I. The making of unauthorized dividends . . . Such 
 liabiHties 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 re- 
 covery of dividends unauthorized by the State of New Jersey 
 from directors of a New Jersey corporation in the same man- 
 ner and to the same extent as the directors of a domestic 
 corporation. That is, it is the New Jersey statute which makes 
 the dividend unauthorized, but the recovery is to be had ac- 
 cording to the New York statute. What, then, is unauthorized ? 
 " No corporation shall make dividends except from the sur- 
 plus 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 in- 
 vested in the business, the expenses incurred in its management 
 and the losses sustained by its operation." And the controll- 
 ing 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 state- 
 ments in great detail of their business. From these state- 
 ments 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 pro- 
 duced and were not considered. It was in evidence that malt 
 was always oversold, that contracts for future deliveries, run- 
 ning over many months, were entered into, and the claim is 
 that such contracts were required to be taken into considera- 
 
392 AUDITING. 
 
 tion when it came to be determined whether any particular 
 dividend was warranted or not. Such claim, in my opinion, 
 is unfounded. 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 transactions, and on 
 such calculations to declare dividends, was to base such divi- 
 dends 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 divi- 
 dend of a hope based on an expectation of a future delivery 
 at a favorable price of what is not yet in existence, 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 differ- 
 ent 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 act, was eliminated by the 
 company itself some months after its entry. There was entered 
 on the books on the 31st of December, 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 reasons stated in regard to the contracts 
 for future deliveries, was unjustifiable. The company sub- 
 sequently removed this entry. The actual transactions, that 
 is, the deliveries of the malt called for by the contracts and 
 the receipts in payment therefor being reported from time to 
 
AMERICAN MALTING CASE. 393 
 
 time as they occurred, resulting in double credits, the cancel- 
 lation 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 manu- 
 factories month by month as increase. Of course, this inr 
 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 inventory 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 pro- 
 fits, but all were paid out of capital. But it appears that de- 
 fendant, Curtiss, was not present at the meeting on February 
 28, 1899, when the dividend paid April 15, 1899, was author- 
 ized. Under the New York statute — under which we are pro- 
 ceedings — 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 
 
394 AUDITING. 
 
 that dividend. He is liable, in my judgment, as follows: For 
 dividends paid July 15, 1898, to the extent of $142,774.59; 
 October 15, 1898, $219,450; January 15, 1899, $219,450; July 
 15, 1899, $252,700; October 15, 1899, $252,7ock-$i,o87,074.59, 
 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" {Applet on v. Am. Malting Co.), I find 
 against the defendant upon his claim that the accrued profits 
 of the company, made under a changed management, can be 
 credited in his favor 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 com- 
 binations 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 incorporation, and not bring their com- 
 panies 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 " wilful, fraudulent and 
 illegal conspiracy," 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 alle- 
 gations have been where directors have diverted to themselves 
 for their own benefit the property of the company. The dam- 
 age 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 commissions, discounts and interest thereon 
 amount to $650,000, which, as a waste of its funds, the plain- 
 tiff seeks to recover. But as I find that this flowed as a 
 damage only from the declaration and payment of the divi- 
 dends 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: 
 *' In point of fact that statute of the State of New Jersey upon 
 
AMERICAN MALTING CASE. 395 
 
 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 extent of the recovery would depend 
 upon the damage sustained by the corporation and be the sub- 
 ject of proof. The statute measures the loss sustained, which 
 is usually the correct amount, and authorizes a recovery there- 
 from 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 im- 
 posed by the statute is not penal in its character. Its sole 
 purpose is not to punish, but to provide for the making of 
 compensation 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. 
 
APPENDIX D. 
 
 Forms of Accounts. 
 
 In Chapter VII mention was made of the fact that various 
 governmental bodies had prescribed classifications of accounts 
 and forms of report for corporations coming within their juris- 
 diction, and that the American Association of Public Account- 
 ants and other bodies had also been active in devising improved 
 forms for uniform use by various undertakings. Nearly all of 
 the forms now submitted are of recent compilation, and will 
 no doubt be improved from time to time. Nevertheless the 
 practitioner and student may find suggestions of value in these 
 pages. Criticisms for future use will be welcomed by the 
 editor. 
 
 The source from which each of the forms has been drawn 
 is given. As the forms of reports to governmental bodies are 
 usually quite voluminous, including many schedules for histor- 
 ical use and much statistical data which are not of sufficient 
 importance to warrant their reproduction in full, a selection 
 has been made of those parts which are of general interest to 
 accountants. 
 
 STEAM RAILROAD COMPANIES. 
 The fiield in which governmental regulation first took the 
 form of actually prescribing the manner in which the accounts 
 themselves should be kept, as distinguished from the require- 
 ment that reports should be made on a prescribed form, was 
 that of interstate common carriers, chief among which are 
 steam railroads. Except as noted, the following forms are 
 those prescribed by the Interstate Commerce Commission. 
 
 *Form 1. Balance Sheet. 
 The Interstate Commerce Commission has not yet prescribed 
 a standard form of balance sheet. The form here submitted is 
 
 * For convenience the forms follow the entire descriptive matter. See pages 411 et sej. 
 
APPENDIX D. 397 
 
 a modification of the form of report required to be made by 
 steam railroads to the Commission for the year ended 30th 
 June, 1908. 
 
 This form does not show all the details which it might be 
 desirable in the case of some companies to show. There will 
 frequently be special items which ought to be stated separately, 
 but they will usually fall under one of the general heads shown 
 on this form. 
 
 Form 2. Statement of Capital Expenditures. 
 
 A separate tentative classification of "Additions and Better- 
 ments " has also been issued by the Commission, but this is 
 not yet final nor is its use compulsory. 
 
 The totals of this statement appear in the Balance Sheet 
 (Form i) under the caption " Road and Equipment." 
 
 Form 3. Income Account. 
 
 In describing the balances shown at the various rests in the 
 account the terms " Revenue " and " Income '' would neces- 
 sarily become " Deficit " and " Lx)ss " if expenditure exceeded 
 income. 
 
 Form 4. Profit and Loss Account. 
 
 This is the form prescribed by the Interstate Commerce 
 Commission, slightly modified. 
 
 If the Income Account (Form 3) for the year shows a loss 
 instead of a profit, the balance thereof would naturally appear 
 on the debit instead of the credit side of the Profit and Loss 
 Account. Similarly, if instead of having a surplus at the date 
 of the balance sheet, the company has a deficit, the balance of 
 the Profit and Loss Account would be stated as a debit balance, 
 instead of a credit balance, as shown in this form. 
 
39^ AUDITING. 
 
 Form 5. Detailed Statement of Operating Revenues. 
 Form 6. Detailed Statement of Operating Expenses. 
 
 The totals of these statements are entered in the Income 
 Account (Form 3). 
 
 For independent companies operating 250 miles or less and 
 having annual operating revenues not exceeding $1,000,000, 
 and for terminal and switching companies, the Commission has 
 promulgated a condensed classification of operating expenses. 
 The five general accounts are the same for both classes of 
 roads, but the 116 primary accounts of the extended classifica- 
 tion are reduced to 44 accounts in the condensed classifica- 
 tion. 
 
 Form 7. Summary of Revenues and Expenses of Outside 
 Operations and other Properties. 
 
 This form shows the diflferent operations carried on by rail- 
 road companies which the Commission has officially designated 
 as " outside operations," and the revenues and expenses of 
 which are now stated separately from those which are directly 
 incidental to transportation by rail. 
 
 The totals of section "A" of this summary are entered in 
 the Income Account (Form 3), while the net profit or loss 
 shown by section " B " is entered in the Profit and Loss Ac- 
 count (Form 4). 
 
 Detailed classifications of operating accounts have also been 
 prescribed by the Commission for each class of operations in- 
 cluded in this form. 
 
 PUBLIC SERVICE CORPORATIONS AND MUNICIPAL 
 INDUSTRIES. 
 
 Attention has already been directed to the importance of the 
 subject of accounts pertaining to public service corporations. 
 
APPENDIX D. 399 
 
 Form 8. Standard Schedule of Revenue and Expense for 
 Municipal Industries and Public Service Companies. 
 
 This is the form as amended by a committee appointed by 
 the American Association of Public Accountants and sub- 
 mitted at the 1907 convention of the Association. 
 
 This is a condensed form which is applicable to any form of 
 public utility — transportation, electric or gas lighting, water 
 supply, telephone, etc. — and would be supported by detailed 
 schedules containing the details pertinent to each particular 
 utility. 
 
 It should be of especial value in comparing the operations 
 of different enterprises, as it is designed to bring out very 
 clearly ho\Y the items, the treatment of which is more or less 
 a matter of judgment (e. g., depreciation), or which for other 
 reasons may be considered as " variables," have been handled. 
 
 ELECTRIC RAILWAY COMPANIES. 
 
 These forms are based on the classification prescribed by the 
 Interstate Commerce Commission for use from ist January, 
 1909, by electric railways subject to its jurisdiction. In a pre- 
 liminary letter the Commission stated that it was working in 
 conjunction with the various state bodies having jurisdiction 
 over electric railways. This being so, the probability is that 
 the classification of accounts promulgated by the Commission 
 will eventually be adopted by the various state commissions and 
 become the uniform system of accounts for electric railways. 
 As noted in Chapter IV, the New York Public Service Com- 
 missions have already prescribed classifications very similar in 
 their general outline to the Interstate Commerce Commission 
 classification, though somewhat more elaborate. 
 
 The form of balance sheet, income account and profit and 
 loss account for electric railway companies would differ only 
 in minor details from those for steam railroad companies (see 
 Forms i, 3 and 4), and hence are not submitted. The classi- 
 
400 AUDITING. 
 
 fications of construction, earnings and operating expense ac- 
 counts, however, are given in the following forms: 
 
 Form 9. Classification of Expenditures for 
 Road and Equipment. 
 
 Form 10. Statement of Operating Revenues. 
 
 Form 11. Statement of Operating Expenses. 
 
 Two condensed classifications of operating expenses have 
 been promulgated for small companies, one of 58 accounts, 
 instead of the full number of 88, for companies having annual 
 operating revenues of $250,000 to $1,000,000, and another of 
 36 accounts for companies with annual operating revenues of 
 less than $250,000. The classifications of construction expen- 
 ditures and operating revenues are the same, however, for all 
 companies. 
 
 ELECTRIC LIGHT, HEAT AND POWER COMPANIES 
 AND GAS COMPANIES. 
 
 The systems of accounts prescribed by the Public Service 
 Commissions of New York for the corporations subject to 
 their jurisdiction are the basis of the forms shown herewith. 
 
 i 
 
 Form 12. Balance Sheet. 
 
 is for a company engaged in producing and supplying both 
 electricity and gas. For a company supplying only one or the 
 other of these commodities, the details under the heading of 
 Plant pertaining to that used in either electric or gas operations 
 would be eliminated and one of the items of Material and Sup- 
 plies under Current Assets would fall out; otherwise the bal- 
 ance sheet would be unchanged. 
 
 As the Commissions have not yet prescribed a definite form 
 of balance sheet, since promulgating the classifications of ac- 
 counts which became effective ist January, 1909, the form 
 herewith is a modification of the form in use by the Commis- 
 
APPENDIX D. 401 
 
 sion for the Second District up to this time. It will be noticed 
 that the capital stock is shown after the actual liabilities and 
 in juxtaposition to the surplus. 
 
 Form 13. Income Account 
 
 is also for company engaged in supplying both electricity and 
 gas. For a company supplying only one or the other, one of 
 the groups of Operating Revenues and Expenses would fall out, 
 and if no " outside operations " are carried on the group bear- 
 ing that designation would likewise be eliminated. In other 
 respects the form would be the same. 
 
 Form 14. Statement 01 Corporate Surplus Account. 
 (Profit and Loss.) 
 
 Form 15. Classification of Accounts for Electric Light, Heat 
 and Power Companies (" Electrical Corporations"). 
 
 Form 16. Classification of Accounts for Gas Companies. 
 
 Three condensed classifications of both electric and gas oper- 
 ating expense accounts have been issued for small companies, 
 the companies being divided into the following classes : 
 
 Gross Operating Revenues. . .$ioo,ocxD to $500,000 per annum 
 " " " ... 25,000 to 100,000 " 
 
 "... less than 25,000 
 
 WATER SUPPLY SYSTEMS. 
 
 In the autumn of 1908 the Bureau of the Census published in 
 connection with its report for the year 1906 on the "Statistics 
 of Cities Having a Population of Over 30,000," an appendix 
 dealing with the subject of " Uniform Accounts and Reports 
 of Water-supply Systems." In addition to presenting the re- 
 sults of an exhaustive study of the subject by Dr. L. G. 
 Powers, Chief Statistician of the Bureau (in which he had the 
 co-operation of Mr. Moses N. Baker, Associate Editor of the 
 Engineering Nezvs, and conferred with a committee of the 
 
402 AUDITING. 
 
 American Association of Public Accountants, as well as with 
 other organizations) a comprehensive scheme of uniform ac- 
 counts for water-supply systems is submitted. 
 
 Emphasis is laid on the fact that " uniform accounts (are) 
 the only basis for comparable statistics " and that " questions 
 of municipal ownership and of municipal control over water 
 and other public utility enterprises are demanding more per- 
 fect, as well as uniform, accounting for these enterprises." 
 
 Any one having occasion to deal with the accounts of water- 
 supply systems should procure the publication referred to, from 
 which the annexed forms are reproduced. The statement is 
 made that " the water supply schedules which the Bureau of 
 the Census presents herewith for constructive criticism result 
 from an attempt to set forth in logical and functional order all 
 the more pertinent facts relating to the construction and opera- 
 tion of municipal water-supply systems. If the schedules are 
 too extensive and too detailed, it is because the aim has been 
 to make them ideally inclusive with the idea that they may be 
 shortened, if necessary, to make them practicable for actual 
 use. . . . 
 
 "... five orders of accounts are suggested, viz. : 
 
 1. Summary or controlling accounts. 
 
 2. General accounts, indicated by Roman numerals. 
 
 3. Sub-general accounts, indicated by capital letters. 
 
 4. Primary accounts, indicated by Arabic numerals. 
 
 5. Sub-primary accounts, indicated by small letters. 
 
 The summary, general and subgeneral accounts are arranged 
 for the purpose of grouping the different items of income and 
 expenditure, and of property and equipment under certain 
 general heads, so as to admit of their presentation in a con- 
 densed form in publishing reports and statistical summaries. 
 The subgeneral accounts may also be used as the only, or at 
 least the principal, accounts of small water-supply enterprises, 
 with a gross annual income not exceeding $25,000, whose 
 operations do not warrant greater detail in accounting. The 
 
APPENDIX D. 403 
 
 primary accounts are provided for the use of the larger sys- 
 tems — those having a gross annual income of $25,000 or over. 
 Cities and corporations operating such systems may also use 
 subprimary accounts in whatever detail they may desire. No 
 suggestion is here made for such accounts other than that they 
 should be so arranged as to be subordinate to the primary ac- 
 counts mentioned in the tentative scheme of accounts." 
 
 Form 17. Tentative Classification of Operation Accounts. 
 
 Form 18. Allocation Accounts. 
 
 Form 19. Property Accounts. 
 
 Attention is also called to the value of combining the infor- 
 mation obtained from the financial accounts with that presented 
 by the physical statistics, or, in other words, cost accounting. 
 
 Form 20. Is a Suggestion for a Condensed Analytical Cost 
 Accounting Summary. 
 
 The following forms comprise the Proposed Census Sched- 
 ule for Securing Uniform Reports of the Transactions and 
 Condition of Water-Supply Enterprises: 
 
 Form 21. Part I, Financial Transactions for the Year. 
 
 Form 22. Part II, Summary of the Cost of W^ater-Supply 
 System and of Its Extensions, Additions, and Renewals. 
 
 Form 23. Part III, Condensed Balance Sheet. 
 
 It will be seen that Part I is a statement of earnings and 
 operating expenses and a profit and loss account. Exception 
 may be taken to including in gross income from, and expenses 
 of, operation such items as earnings and expenses of invested 
 funds and interest on cash balances in bank. These should be 
 shown under a separate heading, say, Other Income, in the 
 profit and loss account. It would also be well to segregate 
 the earnings and expenses of accessory enterprises, the opera- 
 tion of which by a water-supply company is optional. In other 
 
404 AUDITING. 
 
 words, in stating the profit and loss or income account the 
 gross earnings and the operating expenses directly incident 
 thereto, and the gross profit or net earnings resulting from, the 
 supplying of water, should be shown separate from accessory 
 enterprises (similar to the " outside operations '* of railroads) 
 and miscellaneous income, otherwise the basis of comparison 
 between different systems is lost. 
 
 It should be noted that the system of accounts proposed 
 by the Census Bureau is for use by both municipalities and 
 private corporations. The principal points of divergence would 
 be in the " allocation " section of the income or profit and loss 
 accounts and the " proprietary interests " section of the balance 
 sheet. 
 
 BANKS. 
 
 Form 24. Form of Report Required to Be Made by National 
 Banks to the Comptroller of the Currency 
 
 on the occasion of a call by him for the condition of national 
 banks throughout the country. Section 521 1 of the Revised 
 Statutes of the United States provides that the Comptroller 
 must make at least five such calls, as a day already past, dur- 
 ing each year. 
 
 Unlike the procedure in the regulation of railroads, the gov- 
 ernment, in its supervision of national banks, does not prescribe 
 a certain classification of accounts. Common sense, however, 
 would suggest the keeping of the accounts in such a way as to 
 facilitate the ready preparation of the reports called for. 
 
 The forms of report for state banks, trust companies and 
 savings banks vary with the states in which the institutions 
 are located and sometimes contain special features ; e. g., the 
 law of the State of New York requires state banks and trust 
 companies to state their deposit liabilities in two classes, " pre- 
 ferred deposits," the payment of which, in case of insolvency, 
 is preferred by law or otherwise over other deposits, and 
 " other deposits." 
 
APPENDIX D. 405 
 
 BUILDING AND LOAN ASSOCIATIONS. 
 
 Aside from the apportionment of profits among the various 
 series of stock, the stating of building association accounts in- 
 volves no unusual features. The accounts usually published 
 are in one respect subject to the same criticism as those of life 
 insurance companies, in that they seldom contain a profit and 
 loss account but only a statement of receipts and disbursements. 
 The latter is, however, a valuable statement and should not 
 be omitted even when a profit and loss account is submitted, as 
 it shows, among other things, the volume of transactions which 
 could otherwise be ascertained only by a laborious analysis 
 and comparison of the current balance sheet and the one pre- 
 ceding. 
 
 Building and loan associations are chartered by the states, 
 and are usually subject to the supervision of the state banking 
 department. The form of report required to be made varies 
 in the different states. The annexed forms are a combination 
 of the best ones in use. 
 
 Form 25. Balance Sheet. 
 
 Form 26. Profit and Loss Account. 
 
 Form 27. Receipts and Disbursements. 
 
 Form 28. Statement of Share Capital. 
 
 Some associations, though not many, accompany the last 
 statement by a tabulated exhibit of the dues paid in and 
 profits per share for each unmatured series in each year of its 
 existence, and the percentage of the profit earned each year. 
 Combined with the statements above enumerated, this makes 
 a very complete exhibit of the condition and earnings of an 
 association. 
 
 INSURANCE COMPANIES. 
 
 Why insurance companies have continued to transact busi- 
 ness with such primitive accounting systems as most of them 
 have, or have had until recently, is difficult to understand. It 
 
406 AUDITING. 
 
 may be due in part to the fact that the forms of reports re- 
 quired by the state departments having supervision over insur- 
 ance companies have encouraged, if not actually approved, un- 
 scientific methods of accounting. The distinction between 
 " ledger " and " non-ledger " assets is an instance in point ; the 
 incomplete cash account which is published in lieu of a proper 
 income and expenditure account is another. 
 
 At the time of the New York life insurance investigation 
 several years ago, the matter of requiring better accounting 
 methods on the part of the companies and the submission of 
 reports prepared along proper lines received the attention of 
 the American Association of Public Accountants, a committee 
 of which, acting jointly with a committee of the New York 
 Society of Certified Public Accountants, appeared before the 
 Armstrong Committee of the New York State Legislature and 
 presented the necessity for reform in accounting methods in a 
 very forcible manner. 
 
 A report of the Committee's criticisms and suggestions ap- 
 peared in the April, 1906, Journal of Accountancy. 
 
 The following forms of account, copies of which are an- 
 nexed, were suggested: 
 
 Form 29. Balance Sheet. 
 
 Form 30. Assurance Account and Surplus Account. 
 
 Form 31. Analysis of Agency Expenses. 
 
 Form 32. Analysis of Administration and General Expenses. 
 
 It is to be regretted that the forms suggested were not 
 adopted, as they are far superior to the forms ordinarily used, 
 and give in a concise way the information which is of vital 
 interest to the policy or stock holder. By means of supplemen- 
 tal schedules they can be amplified to any extent desired. 
 
 To show the contrast between these forms and those in use 
 by the state departments, the principal schedules in the volu- 
 minous report called for by the Insurance Department of New 
 
APPENDIX D. 407 
 
 York (which is the form in use by most, if not all, of the other 
 states) are shown herewith as Form 33. It will be noticed that 
 an analysis of the increase or decrease in the surplus is now 
 called for, though this form is very cumbersome; this may 
 be ascribed in part at least to the incomplete accounts from 
 which it must be prepared. The editor does not recollect hav- 
 ing ever seen this exhibit included in any of the statements 
 published by the companies for the information of their policy- 
 holders. 
 
 While these model forms are primarily for life companies, 
 the balance sheet, and assurance and surplus accounts can, by 
 proper modification, be adapted for use by fire and other com- 
 panies. 
 
 MANUFACTURING AND MERCANTILE 
 ENTERPRISES. 
 
 Here is where the greatest diversity of form is naturally 
 to be expected. While detailed forms suitable for any and 
 every business of this character cannot be prepared, yet the 
 essentials of a balance sheet and income account can be pointed 
 out. The annexed forms are submitted more for this purpose 
 than with any thought that they can be used without modifica- 
 tion. 
 
 Form 34. Form of Balance Sheet 
 
 prescribed by the English Companies Act, 1862 (Table "A"). 
 (The asset and liability sides have been transposed to accord 
 with the general American practice.) 
 
 There is much to be said in favor of this form, and despite 
 the fact that it had been in use for forty-six years, and hence 
 might be thought to require reconsideration, no change was 
 made therein at the time of passing the 1908 Companies Act. 
 
 Form 35. Form of Balance Sheet 
 submitted by Mr. G. S. Pitt in a paper on "Forms of Pub- 
 lished Accounts of Trading Concerns and Some Observations 
 
408 AUDITING. 
 
 on Their Audit," read at the 1908 Autumnal Conference of the 
 Society of Incorporated Accountants and Auditors. In the 
 words of Mr. Pitt : "It is not suggested that this form is suit- 
 able for general adoption. It has been prepared with a view 
 to illustrate the manner in which particular items should be 
 stated." Mr. Pitt laid special emphasis on the importance of 
 showing " the liquid assets added up in total on the one side, 
 and cash liabilities added up in total on the other side." 
 
 Mr. Pitt's paper and a report of the discussion which fol- 
 lowed its presentation will be found in The Accountant of 3rd 
 October, 1908. 
 
 As with the preceding forms, the asset and liability sides are 
 transposed on the form herein. 
 
 Form 36. Form 01 Balance Sheet 
 
 recommended to the Company Law Committee by the Society 
 of Incorporated Accountants and Auditors in 1906. 
 
 In the form herewith the asset and liability sides have been 
 transposed and some other slight modifications made for the 
 convenience of American practitioners and students. 
 
 Form 37. Balance Sheet for Manufacturing Companies. 
 
 This is a form combining the best features of published 
 American reports. This form can also be used for a consoli- 
 dated balance sheet by entering in the Capital Stock section 
 an item of Stock of Subsidiary Companies Not Owned by 
 Holding Company, if any, and including the proportion of sur- 
 plus of subsidiary companies accruing to the holders of such 
 stock, among the liabilities. 
 
 Form 38. Balance Sheet for Trading Firm. 
 
 A very simple form which can readily be amplified, as to 
 detail, to any extent desired. 
 
APPENDIX D. 409 
 
 Form 39. Profit and Loss Account. 
 
 Submitted by Mr. A. Lowes Dickinson, C.P.A., F.C.A., in 
 his paper on " The Profits of a Corporation,'* which was read 
 at the Congress of Accountants in 1904. This form "already 
 in fairly general use, is submitted as the most complete short 
 form and by means of exhibits it is capable of amplification 
 to any extent desirable." 
 
 Form 40. Profit and Loss Account for Trading Firm. 
 A simple form also capable of amplification to any extent. 
 
 Form 41. Standard Form of Borrowers' Statement. 
 
 This form has been officially adopted by the New York 
 State Bankers' Association and is believed to be the most com- 
 plete " short " form in use. 
 
 The question " Have the books been audited by a Certified 
 Public Accountant ? " was suggested some years ago by Mr. 
 James G. Cannon, Vice-President of the Fourth National Bank 
 of New York, one of the foremost bankers of the country. 
 
 Mr. Cannon's influence has resulted in a more general ap- 
 preciation by bankers of the services of public accountants. 
 
 If bankers would uniformly insist on the certification of bor- 
 rowers' statements by professional accountants they would save 
 millions of dollars through the elimination of doubtful loans. 
 
 MUNICIPAL REPORTS. 
 
 The movement for uniform municipal reports, which has 
 received the attention of such organizations as the National 
 Municipal League, as well as of accountants, economists and 
 others, for a considerable number of years past, has made 
 especial progress during the past few years. 
 
 Whereas it was at one time seriously questioned whether 
 there could be uniformity in either the accounts or reports 
 of municipalities, it is now recognized that there can be uni- 
 formity in reports, and that the keynote " is the classification 
 of the receipts and payments (or revenue and expenses) of 
 
4IO AUDITING. 
 
 cities upon a common basis along functional lines, so that the 
 relative cost of government and of any governmental function 
 of one city can be compared within reasonable limits with the 
 corresponding costs for other cities." (L. G. Powers, U. S. 
 Census Bureau.) 
 
 Form. 42. Classification of Receipts and Payments Used by 
 the United States Bureau of the Census 
 
 in preparing its reports on the statistics of cities ; this classifica- 
 tion has been unanimously recommended by the National 
 Municipal League and League of American Municipalities, the 
 latter organization including many Canadian cities. 
 
 The movement for municipal balance sheets has not yet re- 
 sulted in any considerable number of cities publishing such 
 statements, and it will doubtless require an extensive educa- 
 tional campaign before it will be the general custom for 
 American municipalities to issue balance sheets prepared on 
 scientific lines. It is, however, sure to come. 
 
THE-. RAILROAD COMPANY 
 
 BALANCE SHEET 19 
 
 ASSETS: 
 
 Road and Equipment: 
 
 Cost of Road 
 
 Cost of Equipment 
 
 General Expenditures . 
 
 Lands Owned 
 
 Other Permanent Investments (Specify) , 
 
 Securitiis Owned: 
 
 Stocks 
 
 Bonds 
 
 Advances to Controlled or Affiliated 
 
 Companies 
 
 Current Assets: 
 
 Materials and Supplies 
 
 Bills Receivable 
 
 Traffic Balances due from other Companies. 
 
 Due from Agents 
 
 Miscellaneous Accounts Receivable 
 
 Cash 
 
 Sinking and Special Fund Assets: 
 
 (Specify) 
 
 LIABILITIES: 
 
 Capital Stock 
 
 (If more than one class, specify) 
 
 Funded Debt: 
 
 (Specify, stating nature, rate of interest, 
 
 and due date) 
 
 Due Controlled or Affiliated Companies . 
 Current Liabilities: 
 
 Bills Payable 
 
 Audited Vouchers 
 
 Pay Rolls 
 
 Traffic Balances due other Companies — 
 
 Accrued Taxes 
 
 Accrued Interest on Funded Debts 
 
 Accrued Rentals 
 
 Miscellaneous 
 
 Sinking and Special Funds : 
 (Specify) 
 
 Profit and Loss (undivided profits) . 
 
 (Form 1) 
 411 
 
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 413 
 
(STEAM RAILROAD) 
 
 INCOME ACCOUNT 
 
 Year ended 19. . . 
 
 Operating Income: 
 Rail Operations : 
 
 Operating Revenues $ . 
 
 Operating Expenses 
 
 Net Operating Revenue. . $. . . . 
 Outside Operations: 
 
 Revenues $ . . . . 
 
 Expenses .... 
 
 Net Revenue. 
 
 Total Net Revenue. . $. 
 Taxes Accrued 
 
 Operating Income. . $. 
 
 Other Income: 
 *Other Rents — Credits: 
 
 (a) Hire of Equipment — Balance $. . . . 
 
 (b) Joint Facilities .... 
 
 (c) Miscellaneous Rents ....$.... 
 
 *Separately Operated Properties — Profit 
 
 Dividends Declared on Stocks Owned or Controlled. . . 
 Interest Accrued on Funded Debt Owned or Controlled . 
 Interest on Other Securities, Loans, and Accounts .... 
 Miscellaneous Income , 
 
 Total Other Income. 
 
 Gross Corporate Income $. 
 
 Deductions From Gross Corporate Income: 
 
 fRents Accrued for Lease of Other roads $ . 
 
 Interest Accrued on Funded Debt 
 
 Other Interest 
 
 Sinking Funds Chargeable to Income 
 
 Other Deductions 
 
 Total Deductions From Gross Corporate Income .... $ . 
 
 Net Corporate Income $. 
 
 Disposition of Net Corporate Income: 
 Dividends Declared: 
 
 (a) On Preferred Stock $ 
 
 (b) On Common Stock .... 
 
 (c) On Other Securities .... 
 
 . $.... 
 
 Additions and Betterments Charged to Income .... 
 
 Appropriations to Reserves .... 
 
 Miscellaneous : 
 
 (specify) 
 
 Balance for Year Carried Forward 
 To Credit of Profit and Loss 
 
 *If " Other Rents" shows a debit balance or "Separately Operated Properties' 
 loss, they are entered under "Deductions from Gross Corporate Income." 
 
 t" Rents Accrued from Lease of Roads" are entered under " Other Income." 
 
 (Form 3) 
 414 
 
(STEAM RAILROAD) 
 
 PROFIT AND LOSS ACCOUNT 
 Year ended 19. . . 
 
 / CREDIT : 
 
 Balance, (beginning date) $. 
 
 Balance for Year Brought Forward from Income Accoimt 
 
 ♦Other Properties — Profit 
 
 Additions for year: 
 
 (specify) $ 
 
 DEBIT: 
 
 Deductions for Year: 
 (specify) 
 
 Dividends Declared out of Surplus: 
 
 (a) On Preferred Stock $. 
 
 (b) On Common Stock 
 
 (c) On Other Securities 
 
 Balance Credit — (ending date) $. 
 
 ♦If " other Properties" show a loss it is, of course, entered under "Debit. 
 
 (FOEM 4) 
 
 415 
 
(STEAM RAILROAD) 
 
 OPERATING REVENUES 
 
 Year ended 19 . . . 
 
 Revenue From Transportation: 
 
 Freight Revenue $ . 
 
 Passenger Revenue $ 
 
 Excess Baggage Revenue 
 
 Parlor and Chair Car Revenue 
 
 Mail Revenue 
 
 Express Revenue 
 
 Milk Revenue (on Passenger Trains) 
 
 Other Passenger Train Revenue 
 
 Total Passenger Service Train Revenue 
 
 Switching Revenue 
 
 Special Service Train Revenue 
 
 Miscellaneous Transportation Revenue 
 
 Total Revenue from Transportation $ . 
 
 Revenue from Operations Other Than 
 Transportation : 
 
 Station and Train Privileges $ 
 
 Parcel-Room Receipts 
 
 Storage — Freight 
 
 Storage — Baggage 
 
 Car Service 
 
 Telegraph Service 
 
 Rents of Buildings and Other Property 
 
 Miscellaneous 
 
 Total Revenue from Operations Other 
 Than Transportation 
 
 Total Operating Revenues $ . 
 
 (FOEM 5) 
 416 
 
(STEAM RAILROAD) 
 
 r OPERATING EXPENSES 
 
 Year ended 19. . 
 
 Ratio to 
 
 Ratio to Total 
 
 Gen'l Acc't Operating 
 
 (Per cent) Expenses 
 
 (Per cent) 
 
 Maintenance of Wat and Structures: 
 
 I, Superintendence $ 
 
 Ballast 
 
 Ties 
 
 Rails 
 
 Other Track Material 
 
 Roadway and Track 
 
 Removal of Snow, Sand and Ice 
 
 Tunnels 
 
 Bridges, Trestles, and Culverts 
 
 Over and Under Grade Crossings 
 
 Grade Cross 'gs, Fences, Ct 'le G 'ds, and Signs ; 
 
 Snow and Sand Fences and Snow Sheds 
 
 Signals and Interlocking Plants 
 
 Telegraph and Telephone Lines 
 
 Electric Power Transmission 
 
 Buildings, Fixtures, and Grounds 
 
 Docks and Wharves 
 
 Roadway Tools and Supplies 
 
 Injuries to Persons 
 
 Stationery and Printing 
 
 Other Expenses 
 
 Total of Foregoing Accounts $ 
 
 Maintaining Joint Tracks, Yards, and 
 Other Facilities — Dr. , 
 
 Maintaining Joint Tracks, Yards, and 
 Other Facilities — Cr., 
 
 Total — Maintenance of Way and 
 Structures, 
 
 Maintenance of Equipment: 
 Superintendence 
 Steam Locomotives — Repairs 
 Steam Locomotives — Renewals 
 Steam Locomotives — Depreciation 
 Electric Locomotives — Repairs 
 Electric Locomotives — Renewals 
 Electric Locomotives — Depreciation 
 Passenger-Train Cars — Repairs 
 Passenger-Train Cars — Renewals 
 Pat5senger-Train Cars — Depreciation 
 Freight-Train Cars — Repairs 
 Freight-Train Cars — Renewals 
 Freight-Train Cars — Depreciation 
 Electric Equipment of Cars — Repairs 
 Electric Equipment of Cars — Renewals 
 Elec. Equipm't of Cars — Depreciation 
 Floating Eq\iipment — Repairs 
 Floating Equipment — Renewals 
 Floating Equipment — Depreciation 
 Work Equipment — Repairs 
 Work Equipment — Renewals 
 Work Equipment — Depreciation 
 Shop Machinery and Tools 
 Power Plant Equipment 
 
 M. E, Expenses carried forward 
 
 (Form 6) 
 417 
 
(STEAM RAILROAD) 
 
 OPERATING EXPENSES— Continued 
 
 Maintenance of Equipment — Continued : 
 
 Brought]_forward J 
 Injuries to Persons 
 Stationery and Printing 
 Other Expenses 
 
 Total of Foregoing Accounts, ! 
 
 Maintaining Joint Equipment at Termi- 
 nals — Dr. 
 Maintaining Joint Equipment at Termi- 
 nals — Cr. 
 
 Total — ^Maintenance of Equipment i 
 
 Traffic Expenses: I 
 
 Superintendence 
 Outside Agencies 
 Advertising 
 Traffic Associations 
 Fast Freight Lines 
 
 Industrial and Immigration Bureaus 
 Stationery and Printing 
 Other Expenses 
 
 Total — Traffic Expenses 
 
 Transportation Expenses: i 
 
 Superintendence 
 Dispatching Trains 
 Station Employees 
 
 Weighing and Car-Service Associations 
 Coal and Ore Docks 
 Station Supplies and Expenses 
 Yardmasters and their Clerks 
 Yard Conductors and Brakemen 
 Yard Switch and Signal Tenders 
 Yard Supplies and Expenses 
 Yard Enginemen 
 Enginehouse Expenses — Yard 
 Fuel for Yard Locomotives 
 Water for Yard Locomotives 
 Lubricants for Yard Locomotives 
 Other Supplies for Yard Locomotives 
 
 Total of Last Fifteen Accounts : 
 
 Operating Joint Yards and Terminals — Dr. 
 Operating Joint Yards and Terminals — Cr. 
 
 Total — Station and Yard Expenses I 
 Motormen 
 
 Road Enginemen I 
 
 Enginehouse Expenses — Road 
 Fuel for Road Locomotives 
 Water for Road Locomotives 
 Lubricants for Road Locomotives 
 Other Supplies for Road Locomotives 
 
 Transportation Expenses carried 
 
 forward I 
 
 Form 6 — Continued 
 
 418 
 
 Ratio to 
 IRatioto m Total 
 {General |Operating 
 ^Account Expenses \ 
 (Percent.) (Per Cent.) 
 
(STEAM RAILROAD.) 
 OPERATING EXPENSES— Continued. 
 
 Ratio to Ratio to 
 General T'talOper- 
 
 Expenses atingE*p. 
 
 (Percent) (Percent) 
 Transportation Expenses — Continued:! 
 
 Brought forward $ 
 Operating Power Plants 
 Purchased Power 
 Road Trainmen 
 Train Supplies and Expenses 
 Interlockers, Block and Other Signals — 
 
 Operation 
 Crossing Flagmen and Gatemen 
 Drawbridge Operation 
 Clearing Wrecks 
 
 Telegraph and Telephone — Operation 
 Operating Floating Equipment 
 Express Service 
 Stationery and Printing 
 Other Expenses 
 Loss and Damage — Freight 
 Loss and Damage — Baggage 
 Damage to Property 
 Damage to Stock on Right of Way 
 
 Injuries to Persons 
 
 Total of Last Twenty-five Accounts $ 
 Oper't'g Joint Tracks and Facilities — Dr. 
 Oper't'g Joint Tracks and Facilities — Cr. 
 
 Total — ^Movement Expenses, $ 
 
 Total — ^Transportation Expenses, $ 
 
 General Expenses 
 
 Salaries and Expenses of General Officers 
 Salaries and Expenses of Clerks and 
 
 Attendants 
 General Office Supplies and Expenses 
 Law Expenses 
 Insurance 
 
 Rehef Department Expenses 
 Pensions 
 
 Stationery and Printing 
 Other Expenses 
 
 Total of Foregoing Accounts, 
 General Administration Joint Tracks, 
 
 Yards, and Terminals — Dr., 
 General Administration Joint Tracks, 
 
 Yards, and Terminals — Cr. , 
 
 Total — General Expenses 
 
 Recapitulation of Expenses : 
 
 Maintenance of Way and Structures 
 Maintenance of Equipment 
 Traffic Expenses 
 Transportation Expenses 
 General Expenses 
 
 Total — Operating Expenses, 
 
 Ratio of Operating Expenses to Operating 
 Revenues, per cent. 
 
 (Form 6 — Concluded) 
 419 
 
(STEAM RAILROAD) 
 
 SUMMARY OF REVENUES AND EXPENSES OF OUTSIDE 
 OPERATIONS AND OTHER PROPERTIES 
 
 Year ended 19 
 
 A. OUTSIDE OPERATIONS. 
 
 Net 
 Revenue 
 or 
 Designation. Revenues Expenses Deficit 
 
 Boat Lines $ $ $ 
 
 Ferry Lines 
 
 Harbor Terminal Transfers 
 
 Electric Railways 
 
 Express Lines 
 
 Cab and Omnibus Service 
 
 Sleeping-Car Service 
 
 Parlor and Chair-Car Service 
 
 Dining and Special Car Service 
 
 Electric Light and Power Plants 
 
 Gas-Producing Plants 
 
 Canals 
 
 Grain Elevators 
 
 Stock Yards 
 
 Conmiercial Telegraph and Telephone Lines 
 
 Hotels and Restaurants 
 
 Amusement Parks and Resorts 
 
 Coal Storage Plants 
 
 Cold Storage Plants 
 
 Commercial Ice Supply Plants 
 
 Public Toll-Bridge Service 
 
 Miscellaneous: 
 
 Total 
 
 B. OTHER PROPERTIES. 
 
 Income 
 or 
 Designation. Revenues Expenses Taxes Loss 
 
 Total, $ 
 
 (Form 7) 
 
 420 
 
STANDARD SCHEDULE OF REVENUE AND EXPENSE 
 
 (Income and Expenditure) 
 
 For Municipal Industries and Public Service Corporations 
 
 revenue from operating. 
 
 Gross Earnings from Public Services $ 
 
 Gross Earnings from Private Consumers $ 
 
 Gross Earnings from By-Products, etc $ 
 
 Total $ 
 
 Deduct Rebates, Refunds, Discounts, etc $- 
 
 Total Revenue from Operating $ 
 
 Expense of Operating 
 
 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 Taxes (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 Re- 
 
 serve for Doubtful Accounts) $ 
 
 10. Depreciation (Deterioration Written Off and 
 
 Reserve for Estimated Depreciation) . . $ 
 
 Total Expense of Operating $ 
 
 a. Net Revenue from Operating (or Deficiency) $ 
 
 b. Other Revenue, or Income, net (from Sources Other Than 
 
 Operating) $ 
 
 c. Appropriations for Operating, Provided by the Munici- 
 
 pality from General Funds $ 
 
 Total Available Income $ 
 
 Disposition of Available Income 
 
 11. Interest on Funded and Floating Debts $ 
 
 Remainder of Available Income $ ' 
 
 12. Reserved for Sinking Funds $ 
 
 13. Reserved for Amortization Funds $ 
 
 14. Reserved for Other Funds $ 
 
 Total Reserves $ 
 
 15. Dividends (Private Plants) $ 
 
 16. Appropriation to General City Funds (Pub- 
 
 lic Plants) $ 
 
 Total disposition of Available Income $ 
 
 Credit (or Debit) balance transferable to "Surplus" $~ 
 
 Note: The various items in this condensed statement (particularly expense items 
 1 2 and 3) should be supported by detailed schedules. 
 
 (FOKM 8) 
 421 
 
CLASSIFICATION OF EXPENDITURES FOR ROAD AND EQUIP- 
 MENT OF ELECTRIC RAILWAYS 
 
 I. Road — 
 
 1. Engineering and Superintendence 
 
 2. Right of Way 
 
 3. Other Land Used in Electric Railway Operations 
 
 4. Grading 
 6. Ballast 
 
 6. Ties 
 
 7. Rails, Rail Fastenings, and Joints 
 
 8. Special Work 
 
 9. Underground Construction 
 
 10. Paving 
 
 11. Track Laying and Surfacing 
 
 12. Roadway Tools 
 
 13. Tunnels 
 
 14. Elevated Structures and Foundations 
 16. Bridges, Trestles, and Culverts 
 
 16. Crossings, Fences, Cattle Guards, and Signs 
 
 17. Interlocking and other Signal Apparatus 
 
 18. Telegraph and Telephone Lines 
 
 19. Poles and Fixtures 
 
 20. Underground Conduits 
 
 21. Transmission System 
 
 22. Distribution System 
 
 23. Dams, Canals, and Pipe Lines 
 
 24. Power-Plant Buildings 
 
 25. Substation Buildings 
 
 26. General Office Buildings 
 
 27. Shops and Carhouses 
 
 28. Stations, Waiting Rooms, and Miscellaneous Buildings 
 
 29. Docks and Wharves 
 
 30. Power-Plant Equipment 
 
 31. Substation Equipment 
 
 32. Shop Equipment 
 
 33. Park and Resort Property 
 
 34. Cost of Road Purchased 
 
 II. Equipment — 
 
 35. Cars 
 
 36. Locomotives 
 
 37. Electric Equipment of Cars 
 
 38. Other Rail Equipment 
 
 39. Miscellaneous Equipment 
 
 III. General Expenditures — 
 
 40. Law Expenses 
 
 41. Interest 
 
 42. Injuries and Damages 
 
 43. Taxes 
 
 44. Miscellaneous 
 
 (Form 9) 
 
 422] 
 
(ELECTRIC RAILWAY) 
 
 OPERATING REVENUES. 
 Year ended 19 . . 
 
 Revenue from Transportation: 
 
 Passenger Revenue $ 
 
 Baggage Revenue 
 
 Parlor, Chair and Special Car Revenue 
 
 Mail Revenue 
 
 Express Revenue 
 
 Milk Revenue 
 
 Freight Revenue 
 
 Switching Revenue 
 
 Miscellaneous Transportation Revenue 
 
 Total, $. 
 
 Revenue from Operations Other than Transportation: 
 
 Station and Car Privileges $ 
 
 Parcel-Room Receipts 
 
 Storage 
 
 Car Service 
 
 Telegraph and Telephone Service 
 
 Rents of Tracks and Terminals 
 
 Rents of Equipment 
 
 Rents of Buildings and Other Property 
 
 Power 
 
 Miscellaneous 
 
 Total, 
 
 Total Operating Revenues $. 
 
 (Form 10) 
 423 
 
OPERATING EXPENSES 
 
 Year ended 19 . . . Ratio to 
 
 Ratio to ^ Total 
 Gen'l Acc't Operating 
 
 Way and Structures : (Per cent) f^^^^^f^ 
 
 Sup'tendence of Way and Structures $ 
 
 Ballast 
 
 Ties 
 
 Rails 
 
 Rail Fastenings and Joints 
 
 Special Work 
 
 Underground Construction 
 
 Roadway and Track Labor 
 
 Paving 
 
 Misc. R'dway and Track Expenses 
 
 Cleaning and Sanding Track 
 
 Removal of Snow, Ice and Sand 
 
 Tunnels 
 
 Elevated Structures and Foundations 
 
 Bridges, Trestles, and Culverts 
 
 Cross 'gs, Fences, Cattle G'ds, and Signs 
 
 Signal and Interlocking Systems 
 
 Telephone and Telegraph Systems 
 
 Other Miscellaneous Way Expenses 
 
 Poles and Fixtures 
 
 Underground Conduits 
 
 Transmission System 
 
 Distribution System 
 
 Miscellaneous Electric Line Expenses 
 
 Buildings and Structures 
 
 Depreciation of Way and Structures 
 
 Foreg'g Way and Structure Exp. $ 
 
 Other Operations — Dr., 
 
 Other Operations — Cr., 
 
 Total — ^Way and Structures, $ 
 
 Equipment: 
 
 Superintendence of Equipment 
 
 Power-Plant Equipment 
 
 Substation Equipment 
 
 Passenger and Combination Cars 
 
 Freight, Express, and Mail Cars 
 
 Locomotives 
 
 Service Cars 
 
 Electric Equipment of Cars 
 
 Electric Equipment of Locomotives 
 
 Shop Machinery and Tools 
 
 Shop Expenses 
 
 Horses and Vehicles 
 
 Other Misc. Equipment Expenses 
 
 Depreciation of Equipment 
 
 Foregoing Equipment Expenses 
 Others Operations — Dr., 
 Other Operations — Cr., 
 
 Total — ^Equipment 
 
 Traffic: 
 
 Superintendence and Solicitation 
 Advertising 
 
 Miscellaneous Traffic Expenses 
 Total Traffic, 
 
 (Form 11) 
 424 
 
(ELECTRIC RAILWAY) 
 
 OPERATING EXPENSES— Continued 
 
 Ratio to 
 
 Ratio to Total | 
 
 General Operating 
 
 Account Expenses 
 
 (Percent) (PerCent) 
 
 Conducting Transportation: 
 
 Superintendence of Transportation ... $ 
 
 Group I — Power 
 Power-Plant Employees 
 Substation Employees 
 Fuel for Power 
 Water for Power 
 Lubricants for Power 
 Miscellaneous Power-Plant Supplies 
 
 and Expenses 
 Substation Supplies and Expenses 
 Power Purchased 
 Power Exchanged — Balance, 
 
 Foregoing Conducting Transporta- 
 tion Expenses 
 Other Operations — Dr., 
 Other Operations — Cr., 
 
 Group II Operation of Cars 
 Passenger Conductors, Motormen, 
 
 and Trainmen 
 Freight and Express Conductors, 
 
 Motormen and Trainmen 
 Miscellaneous Car-Service Employees 
 Miscellaneous Car-Service Expenses 
 Station Employees 
 Station Expenses 
 Carhouse Employees 
 Carhouse Expenses 
 Operation of Signal and Interlocking 
 
 Systems 
 Operation of Telephone and Telegraph 
 
 Systems 
 Express and Freight Collections and 
 
 DeUvery 
 Loss and Damage 
 Other Transportation Expenses 
 
 Total— Conducting Transportation 
 
 General and Miscellaneous: 
 Salaries and Expenses of General 
 
 Officers 
 Salaries and Expenses of General 
 
 Office Clerks 
 General Office SuppHes and Expenses 
 Law Expenses 
 
 Rehef Department Expenses 
 Pensions 
 Miscellaneous General Expenses 
 
 Foregoing General and Miscellaneous 
 Expenses, forward 
 
 (Form 11 — Continued) 
 426 
 
(ELECTRIC RAILWAY) 
 
 OPERATING EXPENSES— €oncluded 
 
 Ratio to 
 Ratio to Total 
 
 General Operating 
 Account Expenses 
 (Per Cent) (Per Cent) 
 General and Misc. Exp., forward 
 Other Operations — ^Dr., 
 Other Operations — Cr., 
 
 Total — General and Miscellaneous 
 Undistributed Accounts: 
 
 Note: Carriers are at liberty to distribute 
 items covered by the following accounts, but 
 all reports to the Commission must agree with 
 accounts which are prescribed. 
 
 Injuries and Damages 
 
 Insurance 
 
 Stationery and Printing 
 
 Store Expenses 
 
 Stable Expenses 
 
 Rent of Tracks and Terminals 
 
 Rent of Equipment 
 
 Total 
 
 Recapitulation of Expenses: 
 Way and Structures 
 Equipment 
 Traffic 
 
 Conducting Transportation 
 General and Miscellaneous 
 
 Total Operating Expenses 
 Ratio of Operating Expenses to Operating Revenues^per cent). 
 
 (Form 11 — Concluded) 
 
 426 
 
THE GAS AND ELECTRIC COMPANY 
 
 BALANCE SHEET 19 
 
 ASSETS: 
 Franchises and Plant: 
 
 Organization $ . 
 
 Electric: Franchises $ 
 
 Land Devoted to Operations 
 
 Plant and Equipment 
 
 Gas: Franchises 
 
 Land Devoted to Operations. 
 Plant and Equipment 
 
 Outside Operations. 
 
 Investments: 
 
 Funded Debt of Other Corporations $. 
 
 Stocks of Other Corporations 
 
 Advances to *Subsidiaiy and AflaUated Cor- 
 porations 
 
 Other Investments 
 
 Special Deposits 
 
 Prepayments 
 
 Suspense 
 
 Current Assets: 
 
 Materials and Supplies, Electric. 
 
 Materials and Supplies, Gas 
 
 Bills Receivable 
 
 Accounts Receivable 
 
 Cash 
 
 Other Current Assets 
 
 LIABILITIES: 
 Funded Debt: 
 
 (Specify, stating nature, rate of interest and due date) 
 
 Due *Subsidiary and Affiliated Companies 
 
 Current Liabilities: 
 
 Bills Payable S. 
 
 Accounts Payable 
 
 Interest on Funded Debt 
 
 Interest on Floating Debt 
 
 Taxes 
 
 Consumers' Deposits, Electric 
 
 Consumers' Deposits, Gas 
 
 Miscellaneous 
 
 Reserves : 
 
 (Specify) $. 
 
 Capital Stock: 
 (If more than one class specify) . 
 Corporate Surplus 
 
 *0r "Controlling" 
 
 (FOBM 12) 
 
 427 
 
(GAS AND ELECTRIC COMPANY) 
 
 INCOME ACCOUNT 
 
 YEAR ENDED 19 
 
 Operating Income: 
 Electric Operations: 
 
 Gross Operating Revenues $ 
 
 Operating Expenses $ 
 
 Taxes 
 
 Uncollectible Bills 
 
 Income from Electric Operations $ , 
 
 Gas Operations: 
 
 Gross Operating Revenues $ 
 
 Operating Expenses $ 
 
 Taxes 
 
 Uncollectible Bills 
 
 Income from Gas Operations 
 
 Outside Operations: 
 
 Gross Revenues from Outside 
 
 Operations $ 
 
 Operating Expenses $ 
 
 Taxes 
 
 Uncollectible Bills 
 
 Income from Outside Operations 
 
 Total Operating Income $ 
 
 Non-Operating Income: 
 
 Other Rents — Credits $ 
 
 Interest Accrued on Bonds Owned 
 
 or Controlled 
 
 Interest on Other Securities, Loans 
 
 and Accounts 
 
 Dividends on Stocks Owned or Con- 
 trolled 
 
 ♦Separately Operated Properties — 
 
 Profit 
 
 Miscellaneous Income 
 
 Total Non-Operating Income. . $ 
 
 Gross Income Applicable to 
 
 Corporate and Leased Pro- 
 perties I 
 
 Deductions from Gross Income: 
 Interest accrued on Funded Debt 
 
 and Debenture Stocks $ 
 
 Other Interest Deductions 
 
 fRents Accrued for Lease of Other 
 
 Electric Plant or Equipment 
 
 fRents Accrued for Lease of Other 
 
 Gas Plant or Equipment 
 
 Other Rents Accrued — Debits 
 
 Sinking Funds Chargeable to In- 
 come 
 
 Guaranties of Periodic Payments. . 
 
 Other Contractual Deductions * 
 
 Amortization Chargeable to Income 
 
 Total Deductions from Gross 
 
 Income 
 
 Net Corporate Income Trans- 
 ferred to Credit of Corpo- 
 rate Surplus $ 
 
 ♦Loss on separately operated properties would be entered under "Deductions from 
 Gross Income." 
 
 fRents accrued from plant or equipment leased would be entered tmder "Non-operat- 
 ing Income." 
 
 (Form 13) 
 
 428 
 
(GAS AND ELECTRIC COMPANY) 
 
 CORPORATE SURPLUS ACCOUNT 
 CREDITS: 
 
 Balance (beginning date) S. 
 
 Balance transferred from Income Account : 
 
 Bad Debts Collected 
 
 Other Additions to Surplus: 
 
 (Specify) 
 
 DEBITS: 
 
 Dividends Declared: 
 On Preferred Stock . 
 On CJommon Stock. . 
 On Other Securities. 
 
 Expenses elsewhere unprovided for 
 
 Amortization elsewhere unprovided for 
 
 Appropriations to Reserves 
 
 Gifts to Controlled Corporations 
 
 Other Appropriations 
 
 Bad Debts written off 
 
 Other Deductions from Surplus: 
 
 (Specify) 
 
 Balance (closing date). 
 
 (Form 14) 
 
 429 
 
LIST OF ACCOUNTS 
 
 Prescribed by New York Public Service-^Commission 
 (2nd District) 
 
 FOR 
 
 Electric Light, Heat and Power Companies 
 (Effective 1st January, 1909) 
 
 SCHEDULE A: BALANCE SHEET OR INDICANT ACCOUNTS. 
 
 Fixed Capital: 
 
 Fixed Capital, December 31, 1908 
 
 Land Devoted to Electric Operations 
 
 Organization 
 
 Franchises (Electric) 
 
 Patent-rights (Electric) 
 
 Other Intangible Electric Capital 
 
 General Structures 
 
 General Equipment 
 
 Dams, Canals, and Pipe Lines 
 
 Power Plant Buildings 
 
 Furnaces, Boilers, and Accessories 
 
 Steam Engines 
 
 Turbines and Water-wheels 
 
 Gas Producers and Accessories 
 
 Gas Engines 
 
 Electric Generators 
 
 Accessory Electric Power Equipment 
 
 Miscellaneous Power Plant Equipment 
 
 Substation Buildings 
 
 Substation Equipment 
 
 Poles and Fixtures 
 
 Underground Conduits 
 
 Transmission System 
 
 Distribution System 
 
 Line Transformers and Devices 
 
 Electric Services 
 
 Electric Meters 
 
 Electric Meter Installation 
 
 Municipal Street Lighting System (Electric) 
 
 Commercial Arc Lamps 
 
 Glower Lamps 
 
 Electric Motors and Heaters 
 
 Electric Tools and Implements 
 
 Electric Laboratory Equipment 
 
 Other Tangible Electric Capital 
 
 Engineering and Superintendence 
 
 Law Expenditures During Construction 
 
 Injuries During Construction 
 
 Taxes During Construction 
 
 Miscellaneous Construction Expenditures 
 
 Interest During Construction 
 
 l»and in other Departments 
 
 Franchises in Other Departments 
 
 Patent-rights in Other Departments 
 
 Other Intangible Capital in Other Departments 
 
 Tangible Capital in Other Departments 
 
 (Form 15) 
 
 430 
 
ACCOUNTS FOR ELECTRIC COMPANIES— Continued 
 
 Floating Capital: 
 Materials and Supplies 
 Cash 
 
 Bills Receivable 
 Accounts Receivable 
 Interest and Dividends Receivable 
 Other Current Assets 
 
 Investments: 
 ♦Investments 
 
 Special Deposits : 
 
 Coupon Special Deposits 
 Dividend Special Deposits 
 Other Special Deposits 
 
 Prepayment Accounts: 
 Prepaid Taxes 
 Prepaid Insurance 
 Prepaid Rents 
 Other Prepayments 
 
 Suspense Accounts: 
 
 Unamortized Debt|Discount and Expense 
 Other Suspense 
 
 Re-Acquired Securities: 
 Re-acquired Securities 
 
 Debt: 
 Funded (Separate sub-account for each class) 
 Unfunded: 
 
 Taxes Accrued 
 
 Receiver's Certificates 
 
 Judgments Unpaid 
 
 Interest Accrued 
 
 Dividends Declared 
 
 Bills Payable 
 
 Consumers' Deposits — Electric 
 
 Other Accounts Payable 
 
 Other Unfunded Debt 
 
 Permanent 
 
 Premiums on Stock 
 Other Permanent Reserves 
 
 ♦Defined as "all properties acquired not for use in present operations, but as a means 
 of obtaining or exercising control over other corporations, or for income to be derived 
 therefronri, or for a rise in value, or for devotion to future operations at a time when it seems 
 probable that they cannot be so advantageously acquired as at the time of actual acqui- 
 eition." 
 
 (Form 15 — Continued) 
 
 431 
 
(ELECTRIC RAILWAY) 
 ACCOUNTS FOR ELECTRIC COMPANIES.— Continued 
 
 Reserves — Continued: 
 Temporary: 
 
 Contractual 
 
 Non-contractual 
 Required: 
 
 Accrued Amortization of Capital 
 
 Unamortized Premium on Debt 
 
 Other Required Reserves 
 Optional: 
 
 Casualties and Insurance Reserve 
 
 Other Optional Reserves 
 
 Stocks: 
 
 Stocks (separate sub-account for each class) 
 
 SCHEDULE B: INCOME ACCOUNT. 
 
 Operating Revenues: 
 
 Municipal Street Lighting — ^Arc 
 
 Municipal Street Lighting — Incandescent 
 
 Lighting Municipal Buildings — Electric 
 
 Municipal Heat and Power — Electric 
 
 Miscellaneous Electric Revenue — Municipal 
 
 Commercial Flat Rate Lighting 
 
 Commercial Flat Rate Power 
 
 Commercial Metered Lighting 
 
 Commercial Metered Power 
 
 Railroad Corporations 
 
 Other Electrical Corporations 
 
 Rent of Electric Meters 
 
 Rent of Electric Appliances 
 
 Electric Merchandise and Jobbing Revenue 
 
 Sale of By-Products 
 
 Joint Electric Rent Revenue 
 
 Break-down Service 
 
 Other Miscellaneous Electric Revenue 
 
 OPERATING EXPENSES. 
 
 I. Production Expenses: 
 
 Station Superintendence and Care 
 
 Boiler Labor 
 
 Producer Labor 
 
 Engine Labor 
 
 Electric Labor 
 
 Fuel for Steam 
 
 Fuel for Producer Gas 
 
 Water for Steam Power and Gas 
 
 Water for Hydraulic Power 
 
 Lubricants for Power 
 
 Production Supplies 
 
 Station Expense 
 
 Repairs of Power Plant Buildings 
 
 Repairs of Furnaces and Boilers 
 
 Repairs of Boiler Apparatus 
 
 (Form 15 — Continued) 
 432 
 
ACCOUNTS FOR ELECTRIC COMPANIES— Continued 
 
 Repairs of Steam Accessories 
 
 Repairs of Reciprocating Engines 
 
 Repairs of Steam Turbines 
 
 Repairs of Other Steam Engine Equipment 
 
 Repairs of Dams, Canals, and Pipe Lines 
 
 Repairs of Turbines and Water-wheels 
 
 Repairs of Gas Producers and Accessories 
 
 Repairs of Gas Engines 
 
 Repairs of Electric Generators 
 
 Repairs of Accessory Electric Equipment 
 
 Repairs of Station Tools and Implements 
 
 Repairs of Miscellaneous Station Equipment 
 
 Steam from Other Sources 
 
 Power Gas from Other Sources 
 
 Electric Energy from Other Sources 
 
 II. Transmission Expenses: 
 Transmission Subway Rent 
 Transmission Pole and Fixture Repairs 
 Transmission Underground Conduit Repairs 
 Overhead Transmission System Repairs 
 Underground Transmission System Repairs 
 Substation Labor 
 
 Substation Supplies and Expenses 
 Repairs of Substation Buildings 
 Repairs of Substation Equipment 
 
 III. Electric Storage Expenses: 
 Storage Battery Labor 
 
 Storage Battery Supplies 
 
 Storage Battery Renewals 
 
 Repairs of Storage Battery Accessories 
 
 IV. Distribution Expenses: 
 Electric Distribution Superintendence 
 Electric Distribution Maps and Records 
 Electric Distribution Office Expense 
 
 Setting and Removing Meters and Transformers 
 
 Distribution Subway Rent 
 
 Distribution Pole and Fixture Repairs 
 
 Distribution Underground Conduit Repairs 
 
 Overhead Distribution System Repairs 
 
 Edison Tube System Repairs 
 
 Other Underground Distribution System Repairs 
 
 Repairs of Electric Services 
 
 Repairs of Transformers 
 
 Electric Meter Operation 
 
 Electric Meter Repairs 
 
 (Form 15 — Continued) 
 433 
 
ACCOUNTS FOR ELECTRIC COMPANIES -Continued 
 
 V. Utilization Expenses: 
 Commercial Arc Labor 
 Commercial Arc Supplies 
 Commercial Arc Repairs 
 Commercial Incandescent Installation 
 Commercial Incandescent Renewals 
 Inspection of Consumers' Premises 
 Repairs of Consumers' Installations 
 Municipal Street Arc Labor 
 Municipal Street Arc Supplies 
 Municipal Street Arc Repairs 
 Municipal Street Incandescent Installation 
 Municipal Street Incandescent Renewals 
 Municipal Street Incandescent Repairs 
 
 VI. Commercial Expenses: 
 Commercial Administration — Electric 
 Promotion Office Expense — Electric 
 Advertising — ^Electric 
 Canvassing and Soliciting — Electric 
 Promotion Wiring and Devices 
 
 VII. General and Miscellaneous Expenses: 
 Salaries and Expenses of General Officers 
 Salaries and Expenses of General Office^Clerks 
 General Office Supplies and Expenses 
 General Law Expenses 
 Miscellaneous General Expenses 
 Insurance 
 
 Relief Department Expenses 
 Pensions 
 
 Electric Franchise Requirements 
 General Amortization — Electric 
 Electric Expenses Transferred — Cr. 
 Joint Operating Expense — Cr. 
 Accidents and Damages 
 Law Expenses Connected withT)amages 
 General Stationery and Printing 
 Store Expenses 
 Stable Expenses 
 
 Undistributed Adjustments — Balance 
 Duplicate Electric Charges — Cr. 
 
 Taxes: 
 Taxes 
 Uncollectible Electric Bills 
 
 (Form 15 — Continued) 
 434 
 
ACCOUNTS FOR ELECTRIC COMPANIES— Continued 
 
 Non-Operating Revenues: 
 
 Rent Accrued from Lease of Electric^Plant 
 
 Miscellaneous Rent Revenues 
 
 Interest Revenues 
 
 Dividend Revenues 
 
 Profits from Operations'of Others 
 
 Miscellaneous Non-operating Revenues 
 
 Non-Operating Revenue Deductions: 
 
 a. Rent Expense 
 
 b. Interest Expense 
 
 c. Dividend Expense 
 
 d. Others' Operations Expense 
 
 e. Miscellaneous Non-Operating Expense 
 
 f. Non-Operating Taxes 
 
 g. Uncollectible Non-operating Revenues 
 
 Income Deductions: 
 Interest Deductions 
 Rent for Lease of Other Electric Plant 
 Joint Facility Rents 
 Miscellaneous Rent Deductions 
 Sinking Fund Accruals 
 Guaranties of Periodic Payments 
 Loss on Operations of Others 
 Other Contractual Deductions from Income 
 Amortization of Landed Capital 
 Amortization of Debt, Discount and Expense 
 Amortization of Premium on Debt — Cr. 
 
 Appropriation Accounts: 
 Bad Debts Collected 
 Other Additions to Surplus 
 Expenses Elsewhere Unprovided for 
 Dividends on Outstanding Stocks 
 Amortization Elsewhere Unprovided^for 
 Appropriations to Reserves 
 Gifts to Controlled Corporations 
 Other Appropriations 
 Bad Debts Written Off 
 Other Deductions from Surplus 
 
 (Form 15 — Concluded) 
 
 435 
 
List of A(X0UNTS 
 Prescribed by New York Public Service Commission (2nd District) 
 
 FOR 
 
 Gas Companies 
 (Effective 1st January, 1909) 
 
 SCHEDULE A: BALANCE SHEET OR INDICANT ACCOUNTS 
 
 Fixed Capital: 
 Fixed Capital, December 31, 1908 
 Land Devoted to Gas Operations 
 Organization 
 Franchises (Gas) 
 Patent-rights (Gas) 
 Other Intangible Gas Capital 
 General Structures 
 General Equipment 
 Works and Station Structures 
 Holders 
 
 Furnaces, Boilers, and Accessories 
 Steam Engines 
 Gas Engines 
 
 Miscellaneous Power Plant Equipment 
 Benches and Retorts 
 Water Gas Sets and Accessories 
 Purification Apparatus 
 Accessory Equipment at Works 
 Trunk Lines and Mains 
 Gas Services 
 Gas Meters 
 
 Gas Meter Installation 
 Municipal Street Lighting Fixtures^(Gas) 
 Gas Engines and Appliances 
 Gas Tools and Implements 
 Gas Laboratory Equipment 
 Other Tangible Gas Capital 
 Engineering and Supenntendence] 
 Law Expenditures During Construction 
 Injuries During Construction 
 Taxes During Construction 
 Miscellaneous Construction Expenditures 
 Interest During Construction 
 Land in Other Departments 
 Franchises in Other Departments 
 Patent-rights in Other Departments 
 Other Intan^ble Capital in Other Departmentsi 
 Tangible Capital in Other Departments 
 
 Floating^Capital : 
 Materials and Supplies 
 Cash 
 
 Bills Receivable 
 Accounts Receivable 
 Interest and Dividends Receivable 
 Other Current Assets 
 
 (Form 16) 
 4S6 
 
ACCOUNTS FOR GAS COMPANIES— Continued 
 
 Investments: 
 Investments 
 
 Special Deposits: 
 
 Coupon Special Deposits 
 Dividend Special Deposits 
 Other Special Deposits] 
 
 Prepayments: 
 Prepaid Taxes 
 Prepaid Insurance 
 Prepaid Rents 
 Other Prepayments 
 
 Suspense Accounts: 
 Unamortized Debt Discount'and^Expense 
 Other Suspense 
 
 Re-acquired Securities: 
 Re-acquired Securities 
 
 Debt: 
 
 Fimded (separate sub-account^for]eacb class) 
 Unfunded: 
 
 Taxes Accrued 
 
 Receiver's Certificates 
 
 Judgments Unpaid 
 
 Interest Accrued 
 
 Dividends Declared 
 
 Bills Payable 
 
 Consumers' Deposits — Gas 
 
 Other Accoimts Payable 
 
 Other Unfunded Debt 
 
 Reserves: 
 Permanent : 
 
 Premiums on Stocks 
 
 Other Permanent Reserves 
 Temporary: 
 
 Contractual 
 
 Non-contractual 
 Required: 
 
 Accrued Amortization of Capital 
 
 Unamortized Premium on Debt 
 
 Other Required Reserves 
 Optional: 
 
 Casualties and Insurance Reserve 
 
 Other Optional Reserves 
 
 Stocks: 
 Stocks (separate sub-account for each class) 
 
 (Form 16 — Continued) 
 
 437 
 
ACCOUNTS FOR GAS COMPANIES--Continued 
 SCHEDXJLE B: INCOME ACCOUNT 
 
 Operating Revenues: 
 
 Municipal Street Lighting — Gas 
 
 Lighting Municipal Buildings — Gas 
 
 Municipal Heat and Power— Gas 
 
 Miscellaneous Gas Revenue — Municipal 
 
 Prepaid Gas 
 
 Commercial Metered Lighting — Gas 
 
 Commercial Heat and Power — Gas 
 
 Other Gas Corporations 
 
 Commissions on Others' Gas 
 
 Rent of Gas Appliances 
 
 Gas, Merchandise, and Jobbing Revenue 
 
 Sale of Residuals and By-Products 
 
 Joint Gas Rent Revenue 
 
 Other Miscellaneous Gas Revenue 
 
 Operating Expenses: 
 
 T. Production Expenses: 
 
 Works Superintendence 
 
 Boiler House Labor 
 
 Retort House Labor 
 
 Generator House Labor 
 
 Purifier House Labor 
 
 Miscellaneous Labor at Works 
 
 Boiler Fuel 
 
 Water 
 
 Fuel Under Retorts 
 
 Coal Carbonized 
 
 Coal Gas Enric.er 
 
 Generator Fuel 
 
 Water Gas Oil 
 
 Purification Supplies 
 
 Miscellaneous Works Expense 
 
 Repairs of Works and Station Structures 
 
 Repairs of Furnaces, Boilers, and Accessories 
 
 Repairs of Steam Engines 
 
 Repairs of Gas Engines 
 
 Repairs of Miscellaneous Power Plant Equipment 
 
 Repairs of Benches and Retorts 
 
 Repairs of Water Gas Sets and Accessories 
 
 Repairs of Purification Apparatus 
 
 Repairs of Holders 
 
 Repairs of Miscellaneous Equipment 
 
 Repairs of Works Tools 
 
 Gas Storage 
 
 Gas from Other Sources 
 
 II. Transmission and Distribution Expenses: 
 
 Transmission Pumping 
 Distribution Superintendence 
 Distribution Supplies and Expenses 
 Gas Meter and Installation Work 
 
 (Form 16 — Continued) 
 438 
 
ACCOUNTS FOR GAS COMPANIES— Continued 
 
 Work on Consumers' Premises 
 Repairs of Gas Mains 
 Repairs of Gas Services 
 Repairs of Gas Meters 
 Repairs of Distribution Tools 
 Repairs of Gas Appliances 
 
 III. Municipal Street Lighting Expenses: 
 Street Lamp Operating 
 
 Street Lamp Repairs 
 
 IV. Commercial Expenses: 
 Commercial Administration — Gas 
 Promotion Office Expenses — Gas 
 Advertising — Gas 
 Canvassing and Soliciting — Gas 
 
 V. General and Miscellaneous Expenses: 
 Salaries of General Officers 
 
 Salaries of General Office Clerks 
 
 General Office Supplies and Incidental Expenses 
 
 General Law Expenses 
 
 Miscellaneous General Expenses 
 
 Insurance 
 
 Relief Department Expenses 
 
 Pensions 
 
 Gas Franchise Requirements 
 
 Residuals Expense 
 
 General Amortization — Gas 
 
 Gas Expenses Transferred — Cr. 
 
 Joint Operating Expense 
 
 Accidents and Damages 
 
 Law Expenses Connected with Damages 
 
 General Stationery and Printing 
 
 Store Expenses 
 
 Stable Expenses 
 
 Undistributed Adjustments — Balance 
 
 Duplicate Gas Charges — Cr. 
 
 Taxes: 
 Taxes 
 Uncollectible Gas Bills 
 
 Non-Operating Revenues: 
 
 Rent Accrued from Lease of Gas Plant 
 
 Miscellaneous Rent Revenues 
 
 Interest Revenues 
 
 Dividend Revenues 
 
 Profits from Operations of Others 
 
 Miscellaneous Non-Operating Revenues 
 
 (Form 16 — Continued) 
 439 
 
ACCOUNTS FOR GAS COMPANIES— Continued 
 
 Non-Operating Revenue Deductions : 
 
 a. Rent Expense 
 
 b. Interest Expense 
 
 c. Dividend Expense 
 
 d. Others' Operations Expense 
 
 e. Miscellaneous Non-Operating Expense 
 
 f. Non-Operating Taxes 
 
 g. Uncollectible Non-operating Revenues 
 
 Income Deductions: 
 Interest Deductions 
 Rent for Lease of Other Gas Plant 
 Other Rent Deductions 
 
 f. Joint Facihty Rents 
 
 g. Miscellaneous Rent Deductions 
 Sinking Fund Accruals 
 Guaranties of Periodic Payments 
 Loss on Operations of Others 
 
 Other Contractual Deductions from Income 
 Amortization of Landed Capital 
 Amortization of Debt Discount and Expense 
 Amortization of Premium on Debt — Cr. 
 
 Appropriation Accounts : 
 Bad Debts Collected 
 Other Additions to Surplus 
 Expenses Elsewhere Unprovided for 
 Dividends on Outstanding Stocks 
 Amortization Elsewhere Unprovided for 
 Appropriations to Reserves 
 Gifts to Controlled Corporations 
 Other Appropriations 
 Bad Debts Written Off 
 Other Deductions from Surplus 
 
 I (Form 16 — Concluded) 
 
 440 
 
TENTATIVE CLASSIFICATION OF THE OPERATION ACCOUNTS OF 
 WATER SUPPLY ENTERPRISES. 
 
 INCOME ACCOUNTS. 
 
 GROSS INCOME FROM OPERATION. 
 
 I. Income From Water'^Service. 
 
 A~Pay Rates for Private Consumers Within City 
 
 1. Metered Domestic Rates 
 
 2. Metered Manufacturing and Commercial Rates 
 
 3. Unmetered Domestic Rates 
 
 4. Unmetered Manufacturing and ConamerciarRates 
 
 B. Pay Rates for Private Consumers Outside City 
 
 5. Metered Domestic Rates 
 
 6. Metered Manufacturing and CommerciaPRates 
 
 7. Unmetered Domestic Rates 
 
 8. Unmetered Manufacturing and Commercial Rates 
 
 C Pay Rates for Other Waterworks 
 
 9. Rates for Other City and Private Water Enterprises 
 
 D. Fees for Shutting off and Turning on Water 
 
 10. Fees for Shutting off and Tuming'on]Water 
 
 E. Pay Rates for City 
 
 11. Fire Department 
 
 12. Sewer Flushing 
 
 13. Street Sprinkling and Washing 
 
 14. Public Schools 
 
 15. All Other PubUc Buildings 
 
 16. Public Parks, Fountains, and Troughs 
 
 17. All Other Municipal Purposes 
 
 F. Free Rates for City 
 
 18. Fire Department 
 
 19. Sewer Flushing 
 
 20. Street Sprinklmg and Washing 
 
 21. Public Schools 
 
 22. All Other Pubhc Buildings 
 
 23. Public Parks, Fountains and Troughs 
 
 24. All Other Municipal Purposes 
 
 (j. Free Rates for Private Consumers 
 
 25. Water for Churches, Private Charities, etc. 
 
 H. Value of Water Used by Water-Supply]^ystem 
 
 26. For Purification Purposes 
 
 27. For Pumping Purposes 
 
 28. For Plant and Other Private Fire Protection 
 
 29. For all Other Uses and Purposes 
 
 II. Income Other Than From Water Service 
 
 /. Income from Accessory Enterprises 
 
 30. Income from Plumbing Work for Compensation 
 
 31. Rents from Rental Property 
 
 32. Rents from Meters, Meter Boxes, and Vaults 
 
 33. Income from Stables, Teams, and Teamsters 
 
 34. Income from Forest Lands 
 
 35. Income from Other Accessory Enterprises 
 
 J. Earnings of Invested Funds 
 
 36. Earnings of Sinking Funds 
 
 37. Earnings of Depreciation Funds 
 
 38. Earnings of Other Reserve Funds 
 
 (Form 17) 
 441 
 
(WATER SUPPLY ENTERPRISES) 
 INCOME ACCOUNTS— Continued 
 
 K. Irderest on Cash Balances in Bank: 
 
 39. Interest to Credit of Enterprise 
 
 40. Interest to Credit of City 
 
 L. Income from Miscellaneous Sources: 
 
 41. Sundry Rents 
 
 42. Sundry Services 
 
 43. Sundry Objects 
 
 44. Permits 
 
 45. Gains ^rom Bond Transactions 
 
 46. Other Gains 
 
 Income Clearing Accounts: 
 
 Income from Water Service 
 Income from Accessory Enterprises 
 Earnings from Invested Funds 
 Income from Miscellaneous Sources 
 
 EXPENSE ACCOUNTS 
 
 TOTAL EXPENSES OF OPERATIONS 
 
 GROUP 1. EXPENSES OF WATER SERVICE 
 
 III. Expenses of General Management 
 
 M. General Administrative Expenses 
 
 Division 1. — Expenses Payable to Public 
 
 100. Salaries and Expenses of General Administrative Officers and 
 Employees 
 
 101. Rent of Offices, etc. 
 
 102. Other General Administrative Office Expenses 
 
 103. Stationery, Printing, and Advertising 
 
 104. Law Expenses 
 
 105. Sundry General Administrative Expenses 
 Division 2. — Expenses Payable to City 
 
 106. Rent of City Offices for Administrative Purposes 
 
 N, Accounting Expenses: 
 
 Division 1. — Expenses Payable to Public 
 
 107. Salaries and Expenses of Accounting Officers and Employees 
 
 108. Rent of Offices, etc 
 
 109. Other Accounting Office Expenses 
 
 110. Stationeiy, Printing and Advertising 
 
 111. Sundry Accounting Expenses 
 Division 2. — Expenses Payable to City 
 
 112. Proportion of Salaries and Expenses of Accounting Officers and 
 Employees of City 
 
 113. Rent of City Offices for Accounting Purposes 
 
 O. Operating Management Expenses: 
 
 Division 1. — Expenses Payable to Public 
 
 114. Salaries and Expenses of Operating Management Officers 
 
 115. Laboratory Salaries and Expenses 
 
 116. Salaries and Expenses of Other Operating Management 
 Employees 
 
 117. Rent of Offices 
 
 118. Other Office Expenses of Operating Management 
 
 (Form 17 — Continued) 
 442 
 
(WATER SUPPLY ENTERPRISES) 
 EXPENSE ACCOUNTS— Continued 
 
 0. Operating Management Expenses, — Continued 
 Division 1. — Expenses Payable to Public 
 
 119. Rents and Expenses of Shops, Storerooms, etc. 
 
 120. Stationery and Printing 
 
 121. Advertising and Soliciting 
 
 122. Law Expenses 
 
 Division 2. — Expenses Payable to City 
 
 123. Proportion of Salaries and Expenses of Operating Management 
 Officers and Employees of City 
 
 124. Rent of City Offices for Operating Management 
 
 125. Rent of City Buildings for Shops, Storerooms, etc. 
 
 126. Proportion of Law Expenses of City 
 
 IV. Expenses for Collecting and Supplying Water 
 
 P. Expenses for Care of Sources of Supply 
 Division 1. — Surface supply 
 
 127. Drainage area and reservations 
 
 128. Impounding Dams and Reservoirs 
 
 129. Lake and River Cribs 
 Division 2. — Ground Supply 
 
 130. Springs and Wells 
 
 131. Infiltration Galleries and Tunnels 
 
 132. Collecting Conduits and Reservoirs 
 
 Q. Expenses for Care of Intakes and Aqueducts: 
 
 133. Gravity Intakes and Suction Maios 
 
 134. Aqueducts and Supply Mains 
 
 R. Expenses for Purification of Water: 
 
 135. By Sedimentation 
 
 136. By Coagulation 
 
 137. By Softening 
 
 138. By Slow Sand Filtration 
 
 139. By Mechanical Filtration 
 
 140. By Other Methods 
 
 S. Expenses for Pumpipg Water: 
 
 141. Salaries and Wages 
 
 142. Fuel (Coal, Wood, Gas, Oil, etc.) 
 
 143. Oils and Waste 
 
 144. Supplies 
 
 145. Waterpower 
 
 146. Electric Power 
 
 147. Other Power 
 
 148. All Other Pumping Expenses 
 
 149. Proportion of Steam or Other Power Plant Expenses 
 
 T. Expenses for Transmission and Distribution Storage of Water: 
 
 150. Force Mains 
 
 151. Reservoirs and Fire Cisterns 
 
 152. Tanks and Standpipes 
 
 U. Expenses for Distribution of Water: 
 
 153. Main Pipes and Specials 
 
 154. Main Valves and Valve Boxes 
 
 155. Fire Hydrants 
 
 156. Other Main Pipe Appliances 
 
 157. Service Pipes and Stops Owned by Enterprises 
 
 158. Meters and Meter Boxes and Vaults Furnished Rent Free 
 
 159. Fountains and Troughs 
 
 160. All Other 
 
 (Form 17 — Continued) 
 
 443 
 
(WATER SUPPLY ENTERPRISES) 
 EXPENSE ACXOUNTS— Continued 
 
 V. Expenses for Water Service Repairs 
 MM. General Administrative Repairs: 
 
 161. Repairs of General Administrative Buildings and Equipment 
 
 NN. Accounting Repairs 
 
 162. Repairs of Accounting Equipment 
 
 163. Repairs of Operating Management Buildings and Equipment 
 
 00. Operating Management Repairs: 
 
 PP. Repairs at Sources of Supply: 
 Division 1. — Surface Supply 
 
 164. Drainage area and reservations 
 
 165. Impounding Dams and Reservoirs 
 
 166. Lake and River Cribs 
 Division 2. — Ground Supply 
 
 167. Springs and Wells 
 
 168. Infiltration Galleries and Tunnels 
 
 169. Aqueducts and Supply Mains 
 
 QQ. Repairs of Intakes and Aqueducts: 
 
 170. Gravity Intakes and Suction Mains 
 
 171. Aqueducts and Supply Mains 
 
 RR, Repairs of Purification System: 
 
 172. Buildings 
 
 173. Settling Basins 
 
 174. Coagulating Basins 
 
 175. Softening Equipment 
 
 176. Slow Sand Filters 
 
 177. Mechanical Filters 
 
 178. Other Purification Equipment 
 
 SS, Repairs of Pumping System: 
 
 179. Buildings 
 
 180. Boilers 
 
 181. Steam Piping and Equipment 
 
 182. Steam and Power Pumping Machinery 
 
 183. Waterpower Equipment 
 
 184. Electric Power Equipment 
 
 185. Other Power Equipment 
 
 186. Other Station Equipment 
 
 187. Proportion of Repairs of Steam and Other Power Plant and 
 Equipment 
 
 TT. Repairs of Transmission and Distribution Storage System: 
 
 188. Force Mains 
 
 189. Reservoirs and Fire Cisterns 
 
 190. Tanks and Standpipes 
 
 UU. Repairs of Distribution System: 
 
 191. Main Pipes and Specials 
 
 192. Main Valves and Valve Boxes 
 
 193. Fire Hydrants 
 
 194. Other Main Pipe Appliances 
 
 195. Services Pipes and Stops Owned by Enterprise 
 
 196. Meters and Meter Boxes and Vaults Furnished Rent Free 
 
 197. Fountains and Troughs 
 
 198. All Other 
 
 (Form 17 — Continued) 
 
 444 
 
(WATER SUPPLY ENTERPRISES) 
 
 EXPENSE ACCOUNTS- Continued 
 
 VI. Expenses for Water Service Insurance 
 
 199. On General Administration Buildings and Equipment. 
 
 200. On Accounting Equipment. 
 
 201. On Operating Management Buildings and Equipment 
 
 202. On source of supply buildings and equipment 
 
 203. On Intake and Aqueduct Buildings and Equipment 
 
 204. On Purification System Buildings and Equipment 
 
 205. On Pumping System Buildings and Equipment. 
 
 206. On Transmission and Distribution Storage System Buildings 
 and Equipment 
 
 207. On Distribution System Buildings and Equipment. 
 
 VII. Expenses for Water Service Depreciation 
 
 208. On General Administration Buildings and Equipment 
 
 209. On Accounting Equipment 
 
 210. On operating management buildings and equipment. 
 
 211. On Sources of Supply 
 
 212. On Intakes and aqueducts 
 
 213. On Purification System. 
 
 214. On Pumping System 
 
 215. On Transmission and Distribution Storage System 
 
 216. On Distribution System 
 
 GROUP 2. EXPENSES OTHER THAN FOR WATER SERVICE 
 VIII. Miscellaneous Expenses 
 
 y. Expenses of Accessory Enterprises: 
 
 217. Plumbing Work for Compensation 
 
 (a) General (b) Repairs (c) Insurance (d) Depreciation 
 
 218. Rental Property 
 
 (a) General (b) Repairs (c) Insurance (d) Depreciation 
 
 219. Meters and Meter Boxes and Vaults Rented to Consumers 
 (a) General (b) Repairs (c) Insurance (d) Depreciation 
 
 220. Stables, Teams and Teamsters. 
 
 (a) General (b) Repairs (c) Insurance (d) Depreciation 
 
 221. Forest Lands 
 
 (a) General (b) Repairs (c) Insurance (d) Depreciation 
 
 222. Other Accessory Enterprises 
 
 (a) General (b) Repairs (c) Insurance (d) Depreciation 
 
 TT. Expenses of Invested Funds: 
 
 223. Expenses of Sinking Funds 
 
 224. Expenses of Depreciation Funds 
 
 225. Expenses of Other Reserve Funds 
 
 X, Sundry Expenses: 
 
 226. Sundry Services and Objects 
 
 227. Gratuitous Work 
 
 228. Losses on Bond Transactions 
 
 229. Other Losses 
 
 IX. First Charges for Water and Taxes 
 
 Y. Cost of Water: 
 
 230. Annual Payments for Water Rights 
 
 231. Annual Dues to Other Water-Supply Systems 
 
 232. Amortization of expiring Term Water Rights 
 
 (Form 17 — Continued) 
 445 
 
(WATER SUPPLY ENTERPRISES) 
 EXPENSE ACCOUNTS— Continued 
 
 Z. Taxes and Franchise Diies: 
 
 Division 1. Taxes and Dues Actually Paid or Payable by Enterprise 
 
 233. Real and Personal Taxes 
 
 234. Taxes on Capital Stock 
 
 235. Taxes on Earnings or Receipts 
 
 236. Other Taxes 
 
 237. Franchise dues 
 
 238. Amortization of Expiring Term Franchises 
 
 Division 2. Taxes and Dues Chargeable against Municipally Operated 
 Enterprises by Operating City, other than those actually paid or 
 payable 
 
 239. Real and Personal Taxes 
 
 240. Taxes on Beamings or Receipts 
 
 241. Other Taxes 
 
 242. Franchise Dues 
 
 243. Amortization of Expiring Term Franchises 
 
 Expense Clearing Accounts: 
 Franchise Dues 
 Fuel 
 
 Injuries to Persons 
 Law Expenses 
 Oil 
 
 Stables, Teams, and Teamsters 
 SuppUes 
 Taxes 
 Waste 
 Work Equipment 
 
 (Form 17 — Concluded) 
 
 TENTATIVE CLASSIFICATION OF THE ALLOCATION ACCOUNTS 
 OF WATER-SUPPLY ENTERPRISES 
 
 X. Interest Paid and Payable 
 
 300. Interest on Funded and Fixed Debts 
 
 301. Interest on Real Estate Mortgages 
 
 302. Interest on Current Liabilities 
 
 XI. Dividends and Assessments 
 
 303. Dividends on Preferred Stock 
 
 304. Dividends on Common Stock 
 
 305. Apportionment to individuals and Firm Members. 
 
 306. Profit and Loss Assessments 
 
 307. City Profit and Loss Allocation 
 
 XII. Sundry Allocation 
 
 308. Sinking Fund Appropriation 
 
 309. Depreciation Fund Allocation 
 
 310. Other Reserve Fund Allocation 
 
 311. Capital Account Transfers 
 
 Supplemental Allocation Account: 
 Current Transactions with City 
 
 (Form IS) 
 446 
 
TENTATIVE CLASSIFICATION OF THE PROPERTY ACCOUNTS 
 
 OR ACCOUNTS WITH COST AND PRESENT VALUE OF 
 
 WATER-SUPPLY ENTERPRISES 
 
 DIVISION 1. COST AND VALUE OF OPERATING W^ORKS 
 
 AND PROPERTY 
 
 XX. Value as a Going Concern 
 
 A . Preliminary Expenditures: 
 
 400. Engineering Expenses 
 
 401. Law Expenses 
 
 402. Injuries to Persons and Property 
 
 403. Insurance 
 
 404. Interest and Commissions 
 
 405. Taxes 
 
 406. Other Expenditures 
 
 407. Cost of Charter 
 
 B. Franchise 
 
 408. Operating Franchises and Easements 
 
 XXI. Value of Land, Buildings, and Equipments 
 
 C. Land and Equipment for Administrative Offices: 
 
 409. Land and Equipment for Administrative Ofl&ces. 
 
 D. Equipment for Accounting Offices: 
 
 410. Equipment for Accounting Offices 
 
 E. Land, Buildings, and Equipment for Operating Management: 
 
 411. Operating Management Offices 
 
 (a) Land (b) Buildings (c) Fixtures and Equipment 
 
 412. Laboratory 
 
 (a) Land (b) Buildings (c) Fixtures and Equipment 
 
 413. Shops of Operating Management 
 
 (a) Land (b) Buildings (c) Fixtures and Equipment 
 
 414. Other General Equipment 
 
 (a) Land (b) Buildings (c) Fixtures and Equipment 
 
 XXII. Value of Land, Buildings, and Equipment for Water Service 
 
 F. Land, Buildings, and Equipment at Sources of Supply: 
 
 415. Reservations 
 
 (a) Land (b) Buildings (c) Equipment 
 
 416. Impounding Dams and Reservoirs 
 
 (a) Land (b) Dams (c) Reser\^oirs (d) Buildings 
 (e) Equipment 
 
 417. Lake and River Cribs 
 
 (a) Land (b) Cribs (c) Buildings (d) Equipment 
 
 418. Springs and Wells 
 
 (a) Land (b) Springs (c) Wells (d) Buildings (e) Equipment 
 
 419. Infiltration Galleries and Tunnels 
 
 (a) Land and Right of Way (b) Galleries (c) Tunnels 
 (d) Buildings (e) Equipment 
 
 420. Collecting Conduits and Reservoirs 
 
 (a) Land and Right of Way (b) Conduits (c) Reservoirs 
 (d) Buildings (e) Equipment 
 
 G. Land, Buildings, and Equipment for Intakes and Aqueducts: 
 
 421 . Gravity Intakes and Suction Mains 
 
 (a) Land and Right of Way (b) Gravity Intakes (c) Suction 
 mains (d) Suction Wells (e) Buildings (f) Equipment 
 
 (Form 19) 
 447 
 
 ^ OF THE 
 
 I i».ii\#coeiTV 
 
(WATER SUPPLY ENTERPRISES) 
 
 G. Land, Buildings, and Equipment for Intakes and Aqueducts, — Continued 
 422. Aqueducts and Supply Mains 
 
 (a) Land and right of way (b) Aqueducts (c) Supply Mains 
 
 (d) Wet Wells (e) Buildings (f) Equipment 
 H. Land, Buildings and Equipment for Purification Works: 
 
 423. Settling Basins 
 
 ^g (a) Land (b) Basins (c) Buildings (d) Equipment 
 
 424. Coagulating Basins 
 
 (a) Land (b) Basins (c) Buildings (d) Equipment 
 
 425. Softening Plant 
 
 (a) Land (b) Buildings (c) General Plant (d) Minor Equip- 
 ment 
 
 426. Slow Sand Filters 
 
 (a) Land (b) Filters (c) Buildings (d) Equipment 
 
 427. Mechanical Filters 
 
 (a) Land (b) Buildings (c) Filters (d) Equipment 
 
 428. Other Purification Equipment 
 
 (a) Land (b) Buildings (c) General Plant (d) Minor Equip- 
 ment 
 /. Land, Buildings, and Equipment for Pumping: 
 
 429. Pumping Stations 
 
 (a) Land (b) Buildings 
 
 430. Pumping Plant 
 
 (a) Steam and Power Pumps (b) Other Pumping Equipment 
 
 431. Steam Plant 
 
 (a) Boilers with Settings, Stacks, etc. 
 
 (b) Engines (c) Steam Pip>ing, Condensers, etc. 
 
 (d) Other Steam Plant Equipment 
 
 432. Waterpower Plant 
 
 (a) Land (b) Dams (c) Canals (d) Buildings 
 
 (e) Other Structures (f ) Water Wheels and Connections 
 (g) Other Equipment 
 
 433. Electric Power Equipment 
 
 (a) Motors and Dynamos 
 
 (b) Switchboards and Apparatus (c) Minor Equipment 
 
 434. Gas and Other Power Equipment 
 
 (a) Producers and Engines (b) Gas and Oil Engine Equipment 
 
 (c) Other Equipment 
 
 435. Other Station Equipment 
 
 (a) Oil and waste Apparatus (b) Station Repair Shop Equip- 
 ment (c) Other Equipment 
 
 436. Proportion of Value of Steam and Other Power Plant and 
 
 Equipment 
 J. Land, Buildings, and Equipment for Transmission and Distribution 
 Storage System 
 
 437. Force Mains 
 
 (a) Land and Right of Way (b) Mains and Specials 
 
 (c) Valves and Valve Boxes (d) Other AppUances 
 (e) Buildings and Other Structures 
 
 438. Reservoirs and Fire Cisterns 
 
 (a) Land (b) Reservoirs (c) Cisterns 
 
 (d) Buildings (e) Equipment 
 
 439. Tanks and Standpipes 
 
 (a) Land (b) Tanks (c) Standpipes (d) Buildings 
 
 (e) Equipment 
 
 K.^ Land, Buildings, and Equipment for Distribution System 
 
 440. Land and Right of Way 
 
 441. Main Pipes and Specials 
 
 442. Main Valves and Valve Boxes 
 (a) Valves (b) Boxes 
 
 443. Fire Hydrants 
 
 (Form 19 — Continued) 
 
 448 
 
(WATER SUPPLY ENTERPRISES) 
 
 K, Land, Buildings, and Equipment for Distribution System. — Continued 
 
 444. Other Main Pipe Appliances 
 
 (a) Regulators, Air Chambers, Relief Valves, etc. 
 
 (b) Blow-off Cocks, etc. 
 
 445. Service Pipes and Stops Owned by Enterprise 
 
 446. Meters and meter Boxes and Vaults Furnished Rent Free 
 (a) Meters and Connections (b) Meter Boxes and Vaults 
 
 447. Fountains and Troughs 
 
 448. All Other 
 
 XXIII. Value of General Tools and Accessories Other than for 
 General Shop Use, etc. 
 
 L. Tools and Accessories: 
 
 449. AU General Tools 
 
 450. All General Apparatus and Equipment 
 
 451. All general Accessories 
 
 XXIV. Value of Water Rights 
 
 M. [Water Rights: 
 
 452. Water Rights Owned in Perpetuity 
 
 453. Terminable Water Rights 
 
 DIVISION II.— VALUE OF ACCESSORY PROPERTY 
 XXV. Value of Accessory Property 
 
 N. Land, Buildings and Equipment for Miscellaneous Purposes 
 
 454. Of&ces, Shops, Storerooms, etc. 
 (a) Land (b) Buildings 
 
 455. Rental Property 
 
 (a) Land (b) Buildings 
 
 456. Meters and Meter Boxes and Vaults, Rented to Consumers 
 (a) Meters and Connections (b) Meter Boxes and vaults 
 
 457. Stables and teams 
 
 (a) Land (b) Buildings (c) Equipment for Stables 
 (d) Live Stock (e) Wagons (f) Harness and Team Equipment 
 Grand Total Value of All Physical and Intangible Property of Enterprise 
 
 (Form 19 — Concluded) 
 
 449 
 
(WATER SUPPLY ENTERPRISES) 
 CONDENSED ANALYTICAL COST ACCOUNTING SUMMARY 
 
 
 AMOUNTS 
 
 TRANSACTIONS 
 
 Total 
 
 per capita 
 supplied 
 
 Per 
 1,000,000 
 
 gallons 
 supplied 
 
 to pipes 
 
 Per mile of 
 equivalent 
 4-inch dis- 
 tribution 
 pipej ^ 
 
 1. Income from Domestic 
 rates 
 
 $ 
 
 $ 
 
 $ 
 
 $ 
 
 2. Income from Mfg. and 
 
 Commercial Rates 
 
 3. Income from Water Ser- 
 
 vice for City . . . 
 
 
 4. Value of Water Con- 
 
 sumed by Enterprise 
 
 5. Other Income from 
 
 Water Service 
 
 
 6. Gross Income from 
 
 Water Service 
 
 7. Income other than from 
 
 Water Service 
 
 
 
 
 
 8. Gross Income from Op. 
 
 9. Expenses of General 
 
 Management 
 
 10. Expenses for Collecting 
 
 and Supplying Water 
 
 11. Expenses for Repairs. . . 
 
 12. Expenses for Insurance 
 
 13. Exp. for Depreciation. 
 
 14. Miscellaneous Expenses 
 
 15. First Charges 
 
 
 
 
 
 
 
 
 
 
 16. Total Operating Ex- 
 
 penses 
 
 17. All General Expenses 
 
 18. All Expenses at Sources 
 
 of Supply 
 
 
 
 
 
 
 
 19. All Expenses of Intakes 
 
 and Aqueducts 
 
 20. AU Expenses of Purifi- 
 
 cation system 
 
 21. All Expenses of Pump- 
 
 ing System 
 
 22. All Expenses of Trans- 
 
 mission and Distribu- 
 tion Storage System.. 
 
 
 23. All Expenses of Distribu- 
 
 tion System 
 
 24. Total Exp.ofWtr.Service 
 
 25. Six % of Value of Assets 
 
 26. Net Anticipated Income 
 
 from Operation 
 
 27. Net Income from Oper- 
 
 ation Realized 
 
 28. Interest Expenses 
 
 29. Anticipated Profit or loss 
 
 30. Profit or Loss Realized 
 
 
 
 
 
 
 
 (Form 20) 
 460 
 
PROPOSED CENStJS SCHEDULE FOR SECURING UNIFORM RE- 
 PORTS OF THE TRANSACTIONS AND CONDITIONiOF 
 WATER-SUPPLY ENTERPRISES 
 Part I. Financial Transactions for Year Ending 
 
 Income 
 
 I. Income from Water Service: 
 
 A. (1 and 3) Domestic Pay Rates Within 
 
 City $ 
 
 A. (2 and 4) Manufacturing and Commer- 
 cial Pay Rates Within City 
 
 B. (5 and 7) Domestic Pay Rates Outside 
 
 of City 
 
 B. (6 and 8) Manufacturing and Commer- 
 cial Pay Rates Outside of City 
 
 C. Pay Rates for Other Water Companies 
 
 D. Fees for Shutting off and Turning on 
 ■^a^^gj. 
 
 E. Pay Rates for City. ...'.'. .'....' 
 
 F. Free Rates for City 
 
 G. Free Rates for Private Consumers. ... 
 
 H. Water Used by Water-Supply System 
 
 //. Income Other Than From Water Service : 
 
 I. Income from Accessory Enterprises. ... $. 
 
 J. Earnings of Invested Funds 
 
 K. Interest on Cash Balances in Bank 
 
 L. Income from Miscellaneous Sources 
 
 $ 
 
 Gross Income from Operation $ . 
 
 Expenses 
 Group 1. Expenses op Water Services 
 
 ///. Expenses for General ManoLgement % 
 
 IV Expenses for Collecting and Supplying Water: 
 
 P. Expenses for Care of Source of Supply 
 
 Q. Expenses for Care of Intakes and Aque- 
 ducts 
 
 R. Expenses for Purification of Water 
 
 S. Expenses for Pumping Water 
 
 T. Expenses for Transmission and Distri- 
 bution Storage of Water 
 
 U, Expenses for Distribution of Water. ... 
 
 $. 
 
 V. Expenses for Water Service Repairs: 
 
 MM. Repairs of General Management Build- 
 ings and Equipment $ 
 
 PP. Repairs at Sources of Supply 
 
 QQ. Repairs of Intakes and Aqueducts ... 
 
 RR. Repairs to Purification System 
 
 SS. Repairs of Pumping System , . 
 
 TT. Repairs of Transmission and Distri- 
 bution Storage System 
 
 (Form 21) 
 451 
 
(WATER SUPPLY ENTERPRISES) 
 
 EXPENSES OF WATER SERVICES— Continued 
 
 VI. Expenses for General and Water Service Insurance $ , 
 
 VII. Expenses for General and Water Service Depreciation 
 
 Total Expenses for Water Service $. 
 
 Group 2. Expenses Other Than for Water Service 
 
 VIII. Miscellaneous Expenses: 
 
 V. Expenses of Accessory Enterprises $ 
 
 W. Expenses of Invested Funds 
 
 X. Sundry Expenses 
 
 IX. First Charges for Water and Taxes: 
 
 Y. Cost of Water 
 
 Z. Division 1. — Taxes and Franchise Dues 
 
 Other Than Those Paid to Operating City 
 Z. Division 2. — ^Taxes Paid by Municipally 
 
 Operated Enterprise to City 
 
 Total Expenses]of Operation 
 
 Profit and Loss Account 
 
 Gross Income from Operation $ . 
 
 Total Expenses of Operation 
 
 Gross Profit or Net Income from Operation* 
 Interest 
 
 Net Profit or Net Income Surplusf 
 
 Dividends and Assessments 
 
 Net Investment Transfers 
 
 Current Appropriation Surplus^ 
 
 ♦The excess of expense is here called "total loss from operation." 
 fThe excess of interest and other expenses is here called "net loss." 
 JThe excess of all expenses, charges, and payments is here called "deficit." 
 
 (FoBM 21— Concluded) 
 
 452 
 
B 
 
 2 e8 
 
 03 ©^ © 
 
 
 
 IS ■! 
 
 |3 ^ 
 
 2 s g ® 
 
 I 
 
 o 
 O 
 
 
 ^B 
 
 o^ 
 
 
 4s2i.i 
 
 •■«° 
 
 C 3 3 
 
 III !•-=■= 
 
 .2.S 
 
 =" " «-, 
 ^ a 
 
 O +3 o o o o o 
 
 s . . . 
 
 I 
 
 ><1 
 
 
 1^ 
 
 458 
 
PROPOSED CENSUS^ SCHEDULE FOR SECURING UNIFORM 
 REPORTS OF THE TRANSACTIONS OF WATER-SUPPLY 
 ENTERPRISES.— Continued 
 
 Part III. — Condensed Balance Sheet 
 
 Total Assets : 
 
 Miscellaneous Cash $ . 
 
 Income Arrears (Recoverable) 
 
 Accrued and Unassessed Income of Current Year 
 
 Sundry Debtors 
 
 Materials and Supplies 
 
 Investments 
 
 Sinking and Other Reserve Funds 
 
 Present Value of Physical Property 
 
 Operating Works or Property 
 
 Accessory Property 
 
 Deficit (In the case of Municipally Owned Water-Supply Sys- 
 tem this is a liabihty of the city to the enterprise) .... 
 
 Liabilities and Proprietary Interests: 
 Debt Liabilities: 
 
 Deposits by Customers $. 
 
 Income for future Period Levied in Advance 
 
 Audited Bills and Warrants Outstanding 
 
 Notes Payable, Revenue Loans, etc 
 
 Interest and dividends 
 
 Sundry creditors 
 
 Bonds, Debentures, etc 
 
 Proprietary Interests: 
 
 City $. 
 
 Corporation 
 
 Capital Stock 
 
 Surplus 
 
 (Form 23) 
 454 
 
(NATIONAL BANK REPORT) 
 
 Enter charter No. 
 of Bank here. 
 
 No. 
 
 (use the blank lines if necessary, but do not 
 erase or change ant op the printed items.) 
 
 Report of the Condition of "The " 
 
 At , IN the State of , at the Close of Business 
 
 on the Day of , 190 
 
 De. 
 
 RESOURCES 
 
 Loans and Discounts (see schedule) 
 
 Overdrafts, secured, $ ; unsecured, $ 
 
 (see schedule 
 
 U. S. Bonds to secure Circulation (par value) ... 
 
 per cents, per cents 
 
 U. S. Bonds to secure U.S. Deposits (par value). 
 
 per cents 
 
 Other Bonds to secure U. S. Deposits 
 
 U.S. Bonds on hand (par value) per cents 
 
 Premium on Bonds for Circulation, $ ; Premiiun 
 
 on other U.S. Bonds, $ 
 
 Bonds, Securities, etc., including premium on same (a 
 
 schedule) 
 
 Banking House, $ ; Furniture and Fixtures $ 
 
 Other Real Estate owned (see schedule) 
 
 Due from National Banks (not approved reserve 
 agents) 
 
 Due from State and Private Banks and Bankers, 
 Trust Companies, and Savings Banks 
 
 Due from approved Reserve Agents (see schedule) 
 
 14. Checks and other Cash Items (see schedule) 
 
 15. Exchanges for Clearing House 
 
 16. Notes of other National Banks , 
 
 17. Fractional Paper Currency, Nickels, and Cents. 
 
 ^1 
 
 Clearing-H'se.C'tfic't's (Sec. 5192) 
 
 Gold Coin 
 
 Gold Certificates.. 
 
 Gold Certificates payable to order 
 
 Silver Dollars 
 
 Silver Certificates 
 
 Fractional Silver Coin 
 
 Total Coin and Certificates.. 
 (. Legal-Tender Notes 
 
 19. Redemption Fund with U. S. Treasurer (not more than 
 
 5 per cent on Circulation) 
 
 20. Due from U. S. Treasurer 
 
 DOLLARS 
 
 CTS, 
 
 Total (to avoid discrepancies the total should be footed) 
 
 Place for official 
 seal to he affixed by 
 officer before whom 
 acknowledged. See 
 Act Feb. 26. 1881. 
 Notary must not be 
 an officer or director 
 of the bank. 
 
 State of County of. 
 
 SvDorn to and subscribed before me this 
 
 day of 190 ; and I 
 
 hereby certify that I am not an officer or a director of this bank. 
 
 Notary Public. 
 
 (Form 24) 
 455 
 
(NATIONAL BANK REPORT— Continued) 
 
 Report of the Condition of "The : " 
 
 At , IN the State of , at the Close of Bvsimsss 
 
 ON THE Day of. 
 
 190 
 
 Cr. 
 
 LIABILITIES 
 
 DOLLARS 
 
 CTS. 
 
 1 Canital Stock Daid in 
 
 
 
 
 
 
 
 
 
 
 
 
 3. Undivided Profits (including amounts, if 
 any, set aside for special purposes, 
 
 except Item 22) $.. 
 
 Less Current Expenses, Interest, and 
 Taxes paid 
 
 
 
 
 
 
 
 
 4. Circulating Notes secured by U.S. Bonds.. ..$.. 
 Less amount on hand and in Treasury for 
 
 redemption or in transit 
 
 5 State Bank Circulation outstanding 
 
 
 
 .... 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 6 Due to National Banks (not approved Reserve AorentR') 
 
 
 7.' Due to State and Private Banks and Bankers. 
 
 8. Due to Trust Companies and Savings Banks... 
 
 9. Due to approved Reserve Agents (see schedu] 
 
 ° 
 
 
 
 
 
 
 
 
 
 
 e) 
 
 
 
 
 
 
 
 
 
 
 10. Dividends unpaid 
 
 
 11 Individual Deposits subject to Check $ .... 
 
 — 
 
 — 
 
 — 
 
 — 
 
 
 
 
 
 12 Savings Deposits 
 
 
 
 
 
 
 13* Demand Certificates of Deposit 
 
 
 
 
 
 
 14. Time Certificate of Deposit 
 
 
 
 
 
 
 15 Certified Checks 
 
 
 
 
 
 
 16. Cashier's Checks outstanding 
 
 
 
 
 
 
 17. United States Deposits 
 
 
 
 
 
 18. Deposits of U. S. Disbursing Officers 
 
 
 
 
 
 19. Bonds Borrowed , 
 
 
 
 
 
 
 
 
 
 
 20 Notes and Bills rediscounted . 
 
 
 21 . Bills payable, including Certificates of Deposit represent- 
 
 
 
 
 
 22. Reserved for Taxes 
 
 
 
 
 
 23. Liabilities other than those above stated 
 
 
 
 
 
 
 
 
 
 .... ... 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 i 
 
 /, , of the above-named bank, do solemnly swear that the above state 
 
 (Cashier or President) 
 ment is true, and that the SCHEDULES on back of the report fully and correctly represent 
 the true state of the several matters therein contained, to the best of my knowledge and belief. 
 
 Correct. — A ttest: 
 
 NOTE. — This report must be sworn to 
 by the President or Cashier, NOT by 
 any other officer; attested by not less 
 than three Directors, and forwarded to 
 the Comptroller of the Currency with the 
 least possible delay, as it is desired to 
 complete the summary of reports as soon 
 as possible after a call has been issued. 
 
 To be attested 
 by three Direc- 
 t'yrs other than 
 the officer verv- 
 fying the report. 
 
 Cashier. 
 
 Directors. 
 
 (Form 24 — Continued) 
 456 
 
(NATIONAL BANK REPORT— Continued) 
 CERTIFICATES OF DEPOSIT REPRESENTING MONEY BORROWED. 
 
 To whom issued 
 
 Address 
 
 Amotmt on demand 
 
 Amount on time 
 
 Rate of 
 interest 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 1 
 
 
 
 
 
 
 
 
 
 
 Total (include in 
 Liabilities) 
 
 Item 21, 
 
 
 
 
 
 
 
 
 
 
 LOANS Exceeding the Limit Prescribed by Section 5200 of the Revised Statutes, including 
 
 Amoimts which Exceed this Limit due from State, Private Banks and Bankers, Trust 
 
 Companies, and Savings Banks. Overdrafts, if any, to be classed with Loans. 
 
 Name of borrower 
 
 Enter full 
 
 amount of 
 
 loan 
 
 1 
 
 Name of borrower 
 
 Enter fuU 
 
 amount of 
 
 loan 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 From- 
 
 BALANCES DUE FROM OR TO APPROVED RESERVE AGENTS To- 
 
 Enter name and location of 
 bank 
 
 Amount 
 
 Enter name and location of 
 bank 
 
 Amount 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Total (Item 13, Resources) 
 
 
 
 
 
 ToTALdtem 9. Liabilities) 
 
 
 
 
 LIABILITIES OF OFFICERS AND DIRECTORS 
 
 Names of 
 
 officers and 
 
 directors 
 
 Official 
 title 
 
 Liability 
 
 (individual 
 
 or firm) as 
 
 payers 
 
 Liability 
 (individual 
 or firm) as 
 indorsers 
 
 or 
 guarantors 
 
 Checks and 
 cash items ' 
 
 1 ^ 
 
 Overdrafts 
 
 No. of 
 
 shares 
 stock 
 owned 
 
 
 President 
 Cashier .... 
 Vice-Pres.. 
 Asst. Cash. 
 Directors... 
 ...do 
 
 
 
 
 •••"••• 
 
 ••••• 
 
 "Z" 
 
 
 
 
 1 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 do 
 
 
 
 ...do 
 
 
 
 . do 
 
 
 
 
 
 Total 
 
 
 
 
 
 
 1 
 
 
 
 
 
 (Form 24— Continued) 
 457 
 
(NATIONAL BANK REPORT— Continued) 
 
 LOANS AND DISCOUNTS. 
 
 (Including Loans and Discounts on which Officers and 
 Directors are Liable.) 
 
 A. On demand, paper with one or more individual or tirm names.... $ 
 
 
 
 
 B. On demand, secured by stocks, bonds, and other personal securities 
 
 
 
 
 C On time paper with two or more individual or firm names . 
 
 
 
 
 D. On time.single name paper(l person or firm) without other security 
 
 E. On time, secured by stocks, bonds, and other personal securities. 
 
 
 
 
 
 
 
 F. Secured by real estate mtgs. or other liens on realty (see schedule) 
 
 
 
 
 
 
 
 Total (Item 1, Resources) 
 
 
 
 
 Enter the amount Included in the above ake — 
 in each of these items, G. Bad debts, as defined in Section 5204, 
 
 
 
 
 "none" if there is no H. Other suspended or overdue 
 amount to enter. paper 
 
 
 
 
 X. Loans for accovmt of correspondents made from their fimds $ | | | 
 
 Secured: 
 
 OVERDRAFTS 
 
 Unsecured: 
 
 Stand'g 6 mos. or over 
 
 Temporary 
 
 Officers and Directors 
 Total (Item 2, 
 Resources) 
 
 Stand'g 6 mos. or over 
 
 Temporary 
 
 Officers and Directors 
 Total (Item 2, 
 Resources) 
 
 BONDS, SECURITIES, KlU. (Bonds, Clahns, Judgments, and simUar items should be 
 included under this head.) 
 
 Enter face 
 
 value of 
 
 bonds 
 
 Name of corporation 
 issuing bonds, etc. 
 
 Amoimt at 
 which carried 
 on books 
 
 Estimated 
 actual market 
 value 
 
 State whether taken 
 for "debts pre- 
 viously contracted 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 ToTAX, (Item 8, 
 Resources) 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 OTHER REAL ESTATE OWNED 
 
 Describe property, 
 state form of con- 
 veyance, and from 
 whom obtained 
 
 Amount at 
 
 which carried 
 
 on books 
 
 Amount of 
 
 prior lien on 
 
 property, if 
 
 any 
 
 Estimated 
 actual value 
 of property 
 
 Date when 
 title was 
 acquired 
 
 St'tewh'ther 
 taken for 
 'debts pre- 
 viously con- 
 tracted." 
 
 Total (Item 10, 
 Resources) 
 
 LOANS AND DISCOUNTS Secured by Real Estate Mortgages or 
 
 other Liens on Realty 
 
 Give name of 
 borrower, form of 
 
 collateral, and 
 describe property 
 
 Amount at 
 
 which carried 
 
 on books 
 
 Amount of 
 
 prior lien ou 
 
 property, if 
 
 any 
 
 Estimated 
 actual value 
 of property 
 
 Date when 
 
 security was 
 
 taken 
 
 St'tewh'ther 
 taken for 
 "debts pre- 
 viously con- 
 tracted." 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 * 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 ""' " ■ 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Total (Item "F. 
 Loans and Disc , 
 
 
 
 
 
 
 
 
 ; j 
 
 
 
 
 
 
 
 
 
 
 
 1 i 
 
 
 
 
 
 CHECKS AND CASH ITEMS OTHER 
 THAN EXCHANGES FOR C. H. 
 
 AVERAGE RESERVE AND INTEREST 
 
 Average reser\'-e for last 
 
 Checks and drafts on banks, etc., 
 in this city, not members of clear- 
 
 
 
 
 thirty days on deposits 
 bank balances in bank 
 With Reserve Aorents 
 
 and 
 
 was per cent. 
 
 
 Checks and drafts on othe 
 not members of clearing h 
 
 r banks 
 ouse 
 
 
 
 
 Aggregate w 
 The highest 
 
 IS per cent. 
 
 
 
 
 
 rate of inte- 
 V the bank on 
 
 
 
 
 
 deposits is percent. 
 
 Total (Item 14, Resources) 
 
 
 
 — 
 
 At 
 
 count 
 id on 
 
 edis. 
 bills r 
 
 laya 
 
 bieis 
 
 
 
 per cent. 
 
 percent. 
 
 (Form 24 — Concluded) 
 458 
 
BUILDING AND LOAN ASSOCIATION 
 
 BALANCE SHEET 19... 
 
 ASSETS: 
 Loans: 
 
 Real Estate Loans with Stock Collateral %. 
 
 Real Estate Loans without Stock Collateral 
 
 Stock Loans 
 
 Real Estate 
 
 Other Investments (if any; state nature). 
 
 Dues, Fines, etc., Delinquent 
 
 Prepaid Insurance and Taxes 
 
 Accrued Income 
 
 Cash... 
 
 LIABILITIES: 
 
 Loans Payable (if any) $. 
 
 Unearned Premiums 
 
 Dues, etc., Paid in Advance 
 
 Accrued Taxes (if any) 
 
 Share Capital:. 
 
 Dues Paid in and Accrued Profits Thereon, Per Schedule of 
 Series and Values, Annexed 
 
 (Form 25) 
 
 459 
 
(BUILDING AND LOAN ASSOCIATION) 
 
 PROFIT AND LOSS ACCOUNT 
 Year Ended 19... 
 
 Interest. . . 
 Premiums. 
 
 Fines. 
 
 EARNINGS: 
 
 Admission and Transfer Fees. 
 
 Rents of Real Estate 
 
 Less, Insurance, Taxes, etc . . . 
 Profit on Stock Withdrawals. 
 
 Interest on Stock Withdrawn. 
 Interest on Borrowed Money. 
 Administration Expenses. . . . 
 
 EXPENSES: 
 
 Net Profit for Apportionment Among Stock Series 
 
 (Form 26) 
 
 460 
 
(BUILDING AND LOAN ASSOCIATION) 
 
 RECEIPTS AND DISBURSEMENTS 
 
 Year Ended 19 
 
 Balance (Beginning of Year) $. 
 
 Receipts: 
 
 Dues $ 
 
 Interest, Premiums and Fines 
 
 Admission and Other Fees 
 
 Rents 
 
 Loans Repaid 
 
 Sales of Real Estate 
 
 Money Borrowed 
 
 $. 
 
 Disbursements : 
 
 Loans $ . 
 
 Matured Stock 
 
 Stock Withdrawals 
 
 Salaries 
 
 Rent, Printing, Stationeiy and Sundry Expenses . 
 
 Real Estate Expenses 
 
 Borrowed Money 
 
 Interest 
 
 Balance (End of Year) $. 
 
 (Form 27) 
 
 461 
 
(BUILDING AND LOAN ASSOCIATION) 
 
 STATEMENT OF SHARE CAPITAL 
 19 
 
 Shares Value Per Share With- 
 
 Value drawal 
 
 Series Date of Borrow- of Value 
 
 No. Issue ed on Free Total Dues Prof- Total Series per 
 
 its Share 
 
 *Thie amount shoiild agree with the item of "Share Capital" shown in the balance 
 sheet. 
 
 (Form 28) 
 
 462 
 
THE IDEAL LIFE INSURANCE COMPANY 
 BALANCE SHEET, DECEMBER 31,19.. 
 ASSETS 
 Real Estate — (Appraised Value): 
 Office Buildings: 
 
 Home Office $ 
 
 Domestic Branches ........ 
 
 Foreign Branches 
 
 Other Real Estate 
 
 Secured Loans: 
 
 On Mortgage 
 
 On Policies 
 
 On Other Collateral 
 
 Bonds, Stocks and Other Market- 
 able Securities — (Market Value)' 
 Bonds: 
 
 Govemm't, State and Municipal of 
 
 the United States and Canada $ 
 
 Railroad and Traction Companies 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 Companies 
 in the United States and Canada 
 Miscellaneous 
 
 Syndicate Subscriptions 
 
 Cash: . 
 
 In Banks and Trust Companies : 
 
 Home Office Subject to Check $ , 
 
 Branches and Agencies, Subject to 
 
 Check 
 
 On Deposit on Special Terms., 
 
 Deposits with Foreign Governments. 
 
 In Transit 
 
 On Hand — At Home Office, Branches 
 and Agencies 
 
 Premiums in Course of Collection 
 OR Collected and not Reported : 
 
 Fiist Year P emiums 
 
 Renewal Premiums 
 
 Annuities 
 
 Agents' Balances and Miscellaneous 
 
 Advances 
 
 Interest and Rentals Due or 
 Accrued: 
 Interest : 
 
 On Bonds and Dividends on Stocks. $ . 
 
 On Secured lioans 
 
 On Agents' Advances and Balances. 
 Miscellaneous 
 
 Rentals. 
 
 (FoKM 29) 
 463 
 
THE IDEAL INSURANCE COMPANY 
 BALANCE SHEET, DECEMBER 31, 19. . 
 LIABILITIES: 
 
 General Insurance Reserve: 
 
 (Describing Basis) 
 
 Current Liabilities : 
 
 Under Policies and Policy Contracts : 
 Death Claims — Due and Unpaid. . . 
 
 Matured Endownments 
 
 Annuities — Due and Unpaid 
 
 Dividends — Due and Unpaid 
 
 Commissions and Current Expenses: 
 Commissions on Premiums in Course 
 
 of Collections 
 
 Current Expenses 
 
 Premiums, Interest and Rents Pre- 
 paid, and Sundry Deposits. . . . 
 
 Capital Stock: 
 
 Surplus and Reserves: 
 
 Contingency Fund 
 
 Investment Fluctuation Reserve Fund 
 
 Deferred Dividend Funds 
 
 Annual Dividend Funds 
 
 Unappropriated Surplus 
 
 (Form 29 — Concluded) 
 464 
 
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 19 
 
 Jan. 1. Surplus as per Previous Account 
 
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FORM PRESCRIBED BY THE ENGLISH COMPANIES ACT 
 
 BALANCE SHEET OF THE CO., MADE UP TO 19 
 
 PROPERTY AND ASSETS: 
 
 Property held by Company: 
 Showing: 
 Immovable Property, distinguishing: 
 
 (a) Freehold Land $ 
 
 (b) Freehold Buildings 
 
 (c) Leasehold Buildings 
 
 Movable Property, distinguishing: 
 
 (d) Stock-in-Trade 
 
 (e) Plant 
 
 The cost to be stated with deductions for 
 
 deterioration in value as charged to the 
 Reserve Fund or Profit and Loss 
 
 Debts Owing to the Company: 
 Showing: 
 
 Debts considered good for which the Company 
 
 holds Bills or other Securities 
 
 Debts considered good for which the Company 
 
 holds no Security 
 
 Debts considered doubtful and bad 
 
 Any Debt Due from a Director or Other OflBicer 
 of the Company to be separately stated. 
 
 Cash and Investments: 
 Showing: 
 
 The nature of Investment and Rate of In- 
 terest 
 
 The Amount of Cash, where Lodged, and if 
 Bearing Interest 
 
 (Form 34) 
 484 
 
FORM PRESCRIBED BY TEE ENGLISH COMPANIES ACT 
 BALANCE SHEET OF THE CO., MADE UP TO 19 
 
 CAPITAL AND LIABILITIES: 
 Capital: 
 
 The Number of Shares $ 
 
 The Amount Paid per Share 
 
 If any Arrears of Calls, the nature of the 
 
 Arrears, and the Names of the Defaulters 
 
 The Particulars of any Forfeited Shares 
 
 Debts and Liabilities op the Company: 
 Showing: 
 
 The Amount of Loans on Mortgages or Deben- 
 ture Bonds 
 
 The Amount of Debts Owing by the Company 
 distinguishing: 
 
 (a) Debts for which Acceptances have been 
 given 
 
 (b) Debts to Tradesmen for Supplies of 
 Stock-in-Trade or Other Articles 
 
 (c) Debts for Law Expenses 
 
 (d) Debts for Interest on Debentures or 
 Other Loans 
 
 (e) Unclaimed Dividends 
 
 (f) Debts not enumerated above 
 
 Reserve Fund: 
 Showing: 
 The Amount set aside from Profits to meet 
 Contingencies 
 
 Profit and Loss: 
 Showing: 
 
 The Disposable Balance for Payment of 
 
 Dividends, etc. 
 
 Contingent Liabilities: 
 
 Claims Against the Company not Acknowl- 
 edged as Debts 
 
 Moneys for which the Company is Contin- 
 gently Liable 
 
 (Form 34— Conclutjed) 
 485 
 
FORM SUGGESTED BY G. S. PITT TO SOCIETY OF INCORPORATED 
 ACCOUNTANTS AND AUDITORS* 
 
 BALANCE SHEET (date) 
 
 PROPERTIES AND ASSETS: 
 Cash and Bills: 
 
 Bank $ 
 
 Bills Receivable I 
 
 Investments : 
 At Middle Market Price, viz.: 
 
 British Government $ . 
 
 Colonies 
 
 Sundry Debtors: 
 
 Secured 
 
 Unsecured $ . 
 
 Less: Reserve for Discount and Bad 
 Debts 
 
 Stock: 
 At Managers' Valuation 
 
 Total Liquid Assets 
 
 Plant at Cost $ . 
 
 Additions to 31st December, 1906 
 
 Additions During Year 
 
 $ 
 
 Less: Amount Written Off to 
 
 31st December, 1906 $ 
 
 Amount Written Off Dur- 
 ing the Year 
 
 Property : 
 
 Freehold at Cost $. 
 
 Leasehold at Cost $ 
 
 Less: Written Off 
 
 Goodwill as at 
 
 Accounts in Course of Extinction 
 
 Preliminary Expenses $ . 
 
 Less: Written Off 
 
 Rates and Taxes Paid in Advance. 
 
 (FOBM 35) 
 
FORM SUGGESTED BY G. S. PITT TO SOCIETY OF INCORPORATED 
 ACCOUNTANTS AND AUDITORS 
 
 BALANCE SHEET (date) 
 
 CAPITAL AND LIABILITIES: 
 
 Sundry Creditors: 
 
 Trade Creditors $ . 
 
 Sundry Creditors 
 
 Bills Payable 
 
 Unclaimed Dividends 
 
 Debentures (Due Date) 
 
 Total Cash Liabilities 
 
 Capital: 
 Authorized S . 
 
 Contingent Liabilities, viz.: 
 
 Subscribed in Cash $ . 
 
 Less: Calls in Arrears 
 
 Issued as Fully Paid 
 
 Forfeited Shares Account 
 
 Investment Reserve 
 
 Ordinary Reserve 
 
 Profit and Loss 
 
 (Form 35— Concluded) 
 487 
 
FORM RECOMMENDED BY SOCIETY OF INCORPORATED^ACCOUN- 
 TANTS AND AUDITORS TO COMMITTEE OF PARLIAMENT 
 
 A. B. COMPANY LIMITED 
 
 BALANCE SHEET, (date) 
 
 ASSETS: 
 
 Fixed Assets. Showing: — 
 
 Freehold Property $ 
 
 Leasehold Property $ 
 
 Less Depreciation 
 
 Plant and Machinery. 
 Less Depreciation. . 
 
 Fixtures and Fittings. 
 Less Depreciation. . 
 
 Goodwill 
 
 Other Fixed Assets (if any). 
 
 Floating Assets. Showing: — 
 
 Cash in Bank and in Hand 
 
 Investment of Sinking Fund (if any) 
 
 Other Investments 
 
 Debts Due to the Company, Distinguish- 
 ing— 
 
 (a) Debts on Bills Receivable $. 
 
 (b) Trade Debts on Open Accounts. ... 
 
 (c) Other Debts 
 
 (Any Debt Due by an Officer of the 
 
 Company to be Separately Stated) 
 
 Deduct Reserve for Bad and Doubtful 
 Debts 
 
 Stock-in Trade 
 
 Other Floating Assets (if any). 
 
 Nominal Accounts . Showing : — 
 
 Preliminary Expenses $ . 
 
 Less amount written off 
 
 Insurance, etc. Unexpired 
 
 Rents, Rates and Taxes, etc., Paid in 
 
 Advance 
 
 Items in Suspense 
 
 Other Nominal Items (if any) 
 
 (Form 36) 
 488 
 
FORM RECOMMENDED BY SOCIETY OF INCORPORATED ACCOUN- 
 TANTS AND AUDITORS TO COMMITTEE OF PARLIAMENT 
 
 A. B. COMPANY LIMITED 
 
 BALANCE SHEET, (date) 
 
 LIABILITIES: 
 
 Capital Stock. Showing: — 
 Preferred, 
 Authorized, Shares at $ each. ... $ 
 
 Outstanding Shares at $ each $ 
 
 Common, 
 
 Authorized, Shares at $ each 
 
 Outstanding Shares at $ each 
 
 Liabilities to the Public. Showing: — 
 Specific Mortgages (if not Deducted per 
 
 Contra) 
 
 Bonds 
 
 Debts owing by the Company, Distinguish- 
 ing— 
 (a) Bills Payable $. 
 
 (b) Accounts Payable. 
 
 (c) Interest on Bonds and Loans. 
 
 (d) Unclaimed Dividends 
 
 (e) Other Debts 
 
 Balance. Consisting of: — 
 General Reserve, Including Bond Re- 
 demption, if any (Specific Reserves being 
 deducted per Contra) 
 
 Sinking Fund (if any) 
 
 Forfeited Shares Account (if any) 
 
 Undivided Profits 
 
 Contingent Liabilities 
 
 Claims against the Company not Acknowl- 
 edged as Debts, Moneys for which the 
 Company is contingently liable. 
 
 (Form 36 — Concluded) 
 489 
 
AMERICAN FORM IN GENERAL USE AMONG LARGE 
 CORPORATIONS 
 
 MODEL MANUFACTURING COMPANY 
 BALANCE SHEET 19. . . 
 
 ASSETS: 
 Property Account: 
 
 Balance at 19 $ 
 
 Construction and Purchases of Additional Property 
 During Year 
 
 $. 
 
 Less Charged off to Following Accounts : 
 
 $. 
 Reserve for Depreciation $ 
 
 Goodwill. 
 
 Deferred Charges to Operations: 
 
 (Prepaid insurance Taxes, etc.; Advanced Mining 
 Royalities and Similar Expanses Chargeable to 
 Future Operations) 
 
 Investments: 
 
 Outside Real Estate and Other Property $. 
 
 Stocks of Other Companies 
 
 Bonds of Other Companies 
 
 Current Assets : 
 
 Inventories 
 
 Bills Receivable 
 
 Accounts Receivable. 
 Cash. . . . : 
 
 Sinking and Special Fund Assets: 
 
 (State Nature of Assets and Funds for which held $ . 
 
 (FoBM 37) 
 490 
 
AMERICAN FORM IN GENERAL USE AMONG LARGE 
 CORPORATIONS 
 
 MODEL MANUFACTURING COMPANY 
 BALANCE SHEET 19 
 
 LIABILITIES: 
 
 Bonded Debt: 
 
 (State Nature, Rate of Interest and Due Date of 
 Various Issues and Show Deduction of any Unsold 
 Bonds) $ 
 
 $. 
 
 Current Liabilities : 
 
 Bills Payable $ 
 
 Accounts Payable 
 
 Accrued Taxes 
 
 Accrued Interest W 
 
 Miscellaneous 
 
 Reserves and Special Funds : 
 
 (State Purpose and Amount of Each Reserve or Fund . 
 
 Capital Stock : 
 
 (If more than One Class State Accordingly $ . 
 
 ♦Bond Sinking Fund 
 
 Surplus, as Annexed 
 
 ♦This is the proper place for the bond sinking fund only in the event of it having 
 been set up by charges to profit and loss in addition to adequate provision for deprec iation 
 of all wasting assets. If the sinking fund is permitted to take the place of a depreciation 
 reserve it should be shown under "Reserves and Special Funds." 
 
 (Form 37— Concluded) 
 491 
 
AMERICAN FORM USED BY FIRMS AND INDIVIDUALS 
 
 BIRD & GUNN 
 
 BALANCE SHEET 19 
 
 (for trading firm) 
 
 ASSETS: 
 
 Cash in Bank and on Hand $ . 
 
 Bills Receivable 
 
 Accounts Receivable 
 
 Inventory of Merchandise (at cost) 
 
 Unexpired Insurance 
 
 Furniture and Fixtures 
 
 LIABILITIES: 
 
 Bills Payable $. 
 
 Accounts Payable 
 
 Accrued Accounts (Wages, Interest, Etc.) 
 
 CAPITAL: 
 
 R. A. Bird, as annexed. . 
 A. B. Gunn, as annexed. 
 
 (Form 38) 
 
 402 
 
PROFIT AND LOSS ACCOUNT 
 
 (approved AMERICAN FORm) 
 
 Gross Earnings, (whether sales of products, transportation 
 
 earnings, professional earnings, etc.) $, 
 
 DedtLct : Cost of Manufacture or Operation : 
 
 (a) Manufacture (for a Manufacturing Concern) : 
 
 Labor $ 
 
 Material 
 
 General Manufacturing Expenses 
 
 (b) Cost of Operation" (for Conceiiis not Manu- 
 facturing) : 
 
 (Under suitable headings according to the 
 nature of the business) 
 
 Gross Profits $ . 
 
 Other Earnings 
 
 $. 
 
 Dedtui^t: 
 
 Expenses of sale (manufacturing business only) $ 
 
 Expenses of management (if distinct from opera- 
 
 ation) 
 
 Net Profits from Operations %. 
 
 Dediict: 
 
 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 opera- 
 tions of the year $ 
 
 Interest and Dividends on Stocks 
 
 Surplus carried forward $ . 
 
 (Form 39) 
 
 493 
 
PROFIT AND LOSS ACCOUNT 
 (fob trading firm) 
 
 Gross Sales $ . 
 
 Less: Returns and Allowances $ 
 
 Discounts 
 
 Net Sales $. 
 
 Inventory (beginning of year) $ 
 
 Purchases 
 
 $ 
 
 Less: Inventory (end of year) 
 
 Cost of Sales 
 
 Gross Profit $ . 
 
 Selling and General Expenses (probably stated in some detail) ... 
 
 Trading Profit $. 
 
 Interest (and other fixed charges not chargeable among selling 
 expenses) 
 
 Net Profit .$. 
 
 Apportioned between Partners: 
 
 R. A. Bird, % $ 
 
 A. B. Gunn, H 
 
 <K 
 
 (Form 40) 
 
 494 
 
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 19 , 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 trans- 
 ferred) 
 
 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 
 business 
 
 Machinery owned by corporation, used for this 
 business 
 
 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 Liabiuties 
 
 Capital 
 
 Surplus including Undivided Profits 
 
 TOTAL 
 
 (Form 41) 
 
 495 
 
STANDARD FORM OF BORROWERS' STATEMENT 
 
 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 Receiv- 
 able; 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 190.... 
 
 or from 190. ..to 190... 
 
 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 190... to 190.$ 
 
 BAD DEBTS for the period 190.. ..to 190. ..$ 
 
 CAPITAL: Authorized $ Issued $ 
 
 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 OF YEAR when NOTES and ACCOUNTS RECEIVABLE of CUS- 
 TOMERS, Uncollected, are generally maximum 
 
 minimum 
 
 TIME OF 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 190 ... 
 
 (Form 41 — Concluded) 
 496 
 
(MUNICIPAL REPORTS) 
 
 RECEIPTS CLASSIFIED BY CHARACTER AND SOURCE, AND 
 
 BY DEPARTMENT, OFFICE, ENTERPRISE' OR ACCOUNT 
 
 A. Receipts from Revenues and Accompanying TemporaryIReceipts 
 
 I. From General Revenues 
 (a) From Taxes 
 
 General Property Taxes for Government of City 
 
 1. For City Corporation 
 
 2. For Other Independent Divisions 
 
 For Other Civil Divisions 
 
 3. For State 
 
 4. For County 
 
 5. For Minor Civil Divisions 
 
 Special Property and Business Taxes 
 
 6. 
 
 7. 
 
 8. 
 
 9. 
 10. 
 11. 
 12. 
 
 Poll Taxes 
 
 13. For City Corporation 
 
 14. For Other Independent^divisions of the^Govemment'of the City 
 
 15. For State 
 
 16. For minor Civil Divisions 
 
 17. Total Taxes 
 
 B. From Taxes, Licenses, Permits, Fines, and Forfeits 
 
 18. Total Taxes 
 
 19. Liquor Licenses and^Other Imposts 
 
 20. Other Business Licenses 
 
 21. Dog Licenses 
 
 22. General Licenses 
 
 23. Departmental Permits 
 
 24. Fines and Forfeits: 
 o. Penal 
 
 h. Commercial 
 
 25. Total Taxes, Licenses, Permits, Fines, and Forfeits 
 
 (Form 42) 
 497 
 
(MUNICIPAL REPORTS) 
 
 A. Receipts from Revenues and Accompanying Temporary Receipts — 
 
 Continued 
 
 I. From General Revenues — Continued 
 
 (c) From Gifts, Subventions, Grants, and Miscellaneous General Revenues 
 
 26. Subventions and Grants from Other Civil Divisions: 
 
 a. From State, for Education 
 
 h. From State, for Other Purposes 
 
 c. From County, for Education 
 
 d. From County, for Other Purposes 
 
 e. Other Governmental Grants 
 
 27. Gifts from Individuals and Corporations: 
 
 a. For Expenses 
 6. For Outlays 
 
 28. Miscellaneous General Revenues: 
 
 a 
 
 h 
 
 29. Total General Revenue Receipts 
 
 II. From Commercial Revenues 
 id) From Special Assessments and Privileges 
 
 30. Special Assessments: 
 
 o. For Expense 
 6. For Outlays 
 c. For Other Civil Divisions 
 
 31. Public Service Privileges 
 
 32. Minor Privileges 
 
 33. Total Special Assessments and Privileges 
 
 (e). From Interest 
 
 34. Interest : 
 
 a. Sinking Funds 
 
 6. Investment Funds 
 
 c. Public Trust Funds 
 
 d. Original Loans 
 
 e. Current Deposits 
 /. Deferred Taxes 
 
 g . Deferred Special Assessments 
 
 h. Other Sources 
 
 i. Total Interest Receipts 
 
 (Form 42 — Continued) 
 498 
 
(MUNICIPAL REPORTS) 
 A. Receipts from Revenues and Accompanying Temporary Receipts- 
 
 Continued 
 
 II. From Commercial Revenues — Continued 
 (/) From Municipal Services by Departments, Offices, or Accounts 
 
 /. General Government 
 
 35. Council and Legislative Offices 
 
 36. Chief Executive Offices 
 
 37. Assessment and Collection of Revenues 
 
 38. Other Finance Offices and Accounts 
 
 39. Law Offices 
 
 40. Miscellaneous Executive Offices 
 
 41. Elections 
 
 42. Municipal Buildings 
 
 43. Courts 
 
 44. Total General Government 
 
 //. Protection of Life and Property 
 
 45. Police Department 
 
 46. Fire Department 
 
 47. MisceUaneous Inspection 
 
 48. Pounds 
 
 49. Other Protection of Life and Property 
 
 50. Total Protection of Life and Property . . . . 
 
 ///. Health Conservation and Sanitation 
 
 51. Health Department, Quarantine, and Morgue 
 
 52. Sewers and Sewage Disposal 
 
 53. Street Cleaning 
 
 54. Refuse Disposal and Other Sanitation 
 
 55. Total Health Conservation and Sanitation 
 
 IV. Highways 
 
 56. General Supervision 
 
 57. General Street Services 
 
 58. Sidewalks 
 
 59. Bridges, Other Than Toll 
 
 60. Abolition of Grade Crossings 
 
 61. Snow and Ice Removal 
 
 62. Street Lighting 
 
 63. Street Sprinkling 
 
 64. Miscellaneous 
 
 65. Total Highways 
 
 (Form 42 — Continued) 
 499 
 
(MUNICIPAL REPORTS) 
 A. Receipts from Revenues and Accompanying Temporary Rbceipts- 
 
 Continued 
 
 II. From Commercial Revenues — Continued 
 
 (/) From Municipal Services by Departments, Offices,'^or 
 Accounts — Continued 
 
 V. Charities and Corrections 
 
 66. General Supervision 
 
 67. Poor in Institutions 
 
 68. Outdoor poor Relief 
 
 69. Care of Children 
 
 70. Miscellaneous Charities 
 
 71. Hospitals 
 
 72. Insane in Institutions 
 
 73. Prisons and Reformatories 
 
 74. Total Charities and Corrections . 
 
 VI. Education 
 
 75. Schools 
 
 76. Libraries 
 
 77. Art Galleries and Museums 
 
 78. Total Education . 
 
 VII. Recreation 
 
 79. Parks, gardens, etc 
 
 80. Baths, Bathing Beaches, etc. 
 
 81. Celebrations and Entertainments 
 
 82. Total Recreation . 
 
 VIII. Miscellaneous Services 
 
 83. Miscellaneous Services 
 
 84. Total from Municipal Services . . . 
 
 ig) From Municipal Service Enterprises 
 
 85. Electric hght svstems 
 
 86 
 
 87 
 
 88 
 
 89 
 
 90. Total Municipal Service Enterprises. . . 
 
 (Form 42 — Continued) 
 500 
 
(MUNICIPAL REPORTS) 
 
 A. Receipts from Revenues and Accompanying Temporary Receipts- 
 
 Continued 
 
 II From Commercial Revenues — Continued 
 
 (h) From Public Service Enterprises 
 
 91. Water Supply Systems 
 
 92. Electric Light Systems 
 
 93. Gas Supply Systems 
 
 94. Markets and Public Scales 
 
 95. Docks, Wharves and Landings 
 
 96. Subways for Pipes and Wires 
 
 97. Ferries 
 
 98. Toll Bridges 
 
 99. Cemetaries and Crematories 
 100. Institutional Industries 
 
 101 
 
 102 
 
 103 
 
 104. Total Public Service Enterprises 
 
 Total Receipts from Revenue and Accom- 
 panying Temporary Receipts 
 
 B. Receipts from Municipal Debt Obligations Issued 
 
 105. a. General bonds 
 
 b. Special Debt ObUgations to PubUc Trust Funds 
 
 c. Debt Obligations to Other Civil Divisions 
 
 d. Special Assessment Bonds 
 
 e. Revenue Loans 
 
 /. Outstanding Warrants and Orders 
 
 g. Outstanding judgments 
 
 h. Miscellaneous Debt Obligations 
 
 i. Total Receipts from Dept Obligations Issued. 
 
 C. Miscellaneous Temporary Receipts 
 
 106. Objects of Public Trust Funds for Non-municipal usee 
 
 107. Objects of Private Trust Funds 
 
 108. Objects of Private Trust Accounts 
 
 109. From Investments Disposed of: 
 
 a. By Sinking Funds 
 6. By Investment Funds 
 
 c. By Public Trust Funds for Municipal Uses 
 
 d. By Public Trust Funds for Non-municipal Uses 
 
 e. By Private Trust Funds 
 
 110. Sales of Real Property 
 
 111. Damages to City Property 
 
 (Form 42 — Continued) 
 601 
 
(MUNICIPAL REPORTS) 
 C. Miscellaneous Temporary Receipts — Continued 
 
 112. Refund Receipts in Correction of Erroneous Payments: 
 
 a. In Expenses, P. 1 to P. 72 
 
 h. In Outlays, P. 1 to P. 72 
 
 c . In Expenses of Public Service Enterprises 
 
 d. In Outlays of Public Service Enterprises 
 
 e. In Conscience Money 
 
 /. In Losses by Defalcation, etc. 
 
 113. Total Temporary Receipts 
 
 D. Miscellaneous Accounting Credits 
 
 114. Cash Transfer Receipts of Independent Divisions and Funds: 
 
 a. By City Corporation from Sinking Funds 
 
 h. By from 
 
 c. By from 
 
 d. By from .^ 
 
 e. By from 
 
 /. By from 
 
 115. Depreciation Service Transfers 
 
 116. Minor Transfer Receipts 
 
 117. Other Accounting Credits 
 
 118. Total Receipts and Accounting Credits 
 
 (Form 42 — Continued) 
 
 5U2 
 
(MUNICIPAL REPORTS) 
 
 PAYMENTS CLASSIFIED BY DEPARTMENT, OFFICE, ENTER- 
 PRISE, OR ACCOUNT, AND BY OBJECT 
 FOR WHICH MADE 
 
 A. Payments for Expenses and Outlays 
 I. General Government 
 
 1. Council and Legislative Offices: 
 
 a. Council, Board of Aldermen, etc. 
 h. City Clerk 
 
 2. Chief Executive Offices: 
 
 a. Mayor's Office 
 
 h. Executive Boards and Commissions 
 
 3. Finance Offices and Accounts: 
 
 a. Auditor, or Comptroller 
 h. Treasurer, or Chamberlain 
 
 c. Assessment of Revenue 
 
 d. Collection of Revenue 
 
 e. Other Finance Offices and Accounts 
 
 4. Law Offices 
 
 5. Miscellaneous Executive Offices: 
 
 a. Boards of Pubhc Service 
 6. City Engineer 
 
 c 
 
 d 
 
 e 
 
 6. Elections 
 
 7. Municipal Buildings 
 
 8. Courts and Court Officers : 
 
 a. General Municipal Courts 
 
 h. Special Municipal Courts 
 
 c. Superior Courts 
 
 d. Court Buildings 
 
 e. Prosecuting Officers 
 /. Marshals and Sheriffs 
 
 9. Total General Government 
 
 11. Protection of Life and Property 
 
 10. Police Department: 
 
 a. General Expenditures 
 h. Pensions and Gratuities 
 
 1 1 . Militia and Armories 
 
 12. Fire Department : 
 
 a. General Expenditures 
 h. Pensions and Gratuities 
 c. Water 
 
 (Form 42 — Continuetl) 
 503 
 
(MUNICIPAL REPORTS) 
 A. Payments for Expenses and Outlays — Continued 
 
 II. Protection of Life and Property — Continued 
 
 13. Miscellaneous Inspection 
 
 14. Pounds 
 
 15. Miscellaneous 
 
 a 
 
 h 
 
 c 
 
 d 
 
 16. Total Protection of Life and Property 
 
 III. Health Conservation and Sanitation 
 
 Health Conservation 
 
 17. Health Department : 
 
 a. General Expenditures 
 h. Pensions and Gratuities 
 
 18. Quarantine and Contageous Disease Hospitals 
 
 19. Morgues 
 
 Sanitation 
 
 20. Sewers and Sewage Disposal: 
 
 a. Supervision 
 
 h. General Expenditures 
 
 21. Street Cleaning 
 
 22. Refuse Disposal 
 
 23 . Miscellaneous : 
 
 
 a 
 
 h 
 
 24. 
 
 Total Health Conservation 
 
 
 IV. Highways 
 
 25. 
 
 General Supervision 
 
 26. 
 
 General Street Expenditures 
 
 27. 
 
 Street Pavements: 
 
 
 a. General Expenditures 
 
 
 h. Renewals 
 
 28. 
 
 Street Curbing 
 
 29. 
 
 Sidewalks 
 
 30. 
 
 Bridges Other Than Toll 
 
 31. 
 
 Abolition of Grade Crossings 
 
 
 (Form 42— Continued) 
 
 
 504 
 
(MUNICIPAL REPORTS) 
 A, Payments for Expenses and Outlays — Contimi ; 
 IV. Highways — Continued. 
 
 32. Snow and Ice Removal 
 
 33. Street Lighting 
 
 34. Street Sprinkling 
 
 35. Miscellaneous 
 
 o 
 
 b 
 
 36. Total Highways 
 
 V. Charities and Corrections 
 
 37. General Supervision 
 
 38. Poor in Institutions: 
 
 a Of City 
 
 b. Of Other Civil Divisions 
 
 c. Of Private Associations 
 
 39. Outdoor Poor Relief: 
 
 a. In City (direct) 
 
 b. By Other Civil Divisions 
 
 c. By Private Associations 
 
 40. Care of Children: 
 
 a. In City Institutions 
 
 b. In Institutions of Other Civil Divisions 
 
 c. In Private Institutions 
 
 d. In Private Families 
 
 41. Miscellaneous Charities : 
 
 a. Employment Agencies 
 
 b. Soldiers' Relief 
 
 c 
 
 d 
 
 e 
 
 / 
 
 9 
 
 42. Hospitals: 
 
 a. Of City 
 
 b. Of Other Civil Divisions 
 
 c. Of Private Associations 
 
 43. Insane in Institutions : 
 
 a. Of City 
 
 b. Of Other Civil Divisions 
 
 c. Of Private Associations 
 
 44. Prisons and Reformatories: 
 
 a. Of City 
 
 b. Of Other Civil Divisions 
 
 c. Of Private Associations 
 
 45. Total Charities and Corrections 
 
 (Form 42 — CJontinued) 
 605 
 
(MUNICIPAL REPORTS) 
 
 A. Payments for Expenses and Outlays — Contiuusd 
 
 VI. Education 
 
 Schools 
 
 46. General Supervision 
 
 47. Elementary Day Schools: 
 
 a. General Expenditures 
 
 b. Teaching 
 
 48. Day Schools for Higher Education : 
 
 a. General Expenditures 
 
 b. Teaching 
 
 49. Night Schools: 
 
 a. General Expenditures 
 
 b. Teaching 
 
 50. Schools for Special Classes : 
 
 a. General Expenditures 
 
 b. Teaching 
 
 51. Pensions and Gratuities 
 
 52. Schools of Other Civil Divisions 
 
 53. Private Schools 
 
 54. Total Schools 
 
 55. Libraries 
 
 56. Art Galleries and Museums 
 
 57. Total Education 
 
 VII. Recreation 
 
 58. Parks, Gardens, etc. : 
 
 a. General Supervision 
 
 b. Buildings and Grounds 
 
 c. Park Police 
 
 d. Zoological Collections 
 
 e. Public Playgrounds 
 /. Music in Parks 
 
 g. Trees in Streets 
 
 59. Total Parks, Gardens, etc. . . . 
 
 60. Baths, Bathing Beaches, etc. 
 
 61. Celebrations and Entertainments 
 
 62. Miscellaneous : 
 
 a 
 
 b 
 
 c 
 
 63. Total Recreation 
 
 (Form 42 — Continued) 
 506 
 
(MUNICIPAL REPORTS) 
 A. Payments for Expenses and Outlays — Continued 
 
 VIII. Miscellaneous 
 
 64. Miscellaneous Offices : 
 
 a 
 
 h 
 
 c 
 
 65. Miscellaneous Objects: 
 
 a. Damage Settlements and Judgments 
 
 b. Losses by Defalcation, Banks, etc. 
 c 
 
 d 
 
 e 
 
 66. Total Miscellaneous 
 
 67. Total Divisions I to VIII 
 
 IX. Municipal Service Enterprises 
 68. Electric Light Systems 
 
 69 
 
 70 
 
 71 
 
 72 ; 
 
 73. Total Municipal Service Enterprises . 
 
 X. Public Service Enterprises 
 
 74. Water Supply Systems 
 
 75. Electric Light Systems 
 
 76. Gas Supply Systems 
 
 77. Markets and Public Scales 
 
 78. Docks, Wharves, and Landings 
 
 79. Subways for Pipes and Wires 
 
 80. Ferries 
 
 81. ToU Bridges 
 
 82. Cemeteries and Crematories 
 
 83. Institutional Industries 
 
 84 
 
 86 
 
 86. Total Public Service Enterprises . . . . 
 
 (Form 42 — Continued) 
 607 
 
(MUNICIPAL REPORTS) 
 A, Payments for Expenses and Outlays — Continued 
 
 XI. Expenses of Invested Funds 
 
 87. Expenses of Invested Funds 
 
 88. Total Divisions IX to XI . 
 
 XII. Interest 
 
 89. a. On Debts for General Purposes 
 
 h. On Debts for Public Service Enterprises 
 
 c. On Debts of Invested Funds 
 
 d. On Debts for Local Improvements (Special Assessments) 
 
 e. On Outlay Accounts 
 
 /. Total Interest Payments 
 
 90. Total Payments for Expenses and Outlays. . 
 
 B. Payments op Municipal Debt Obligations 
 
 91. a. General Bonds 
 
 h. Special Debt Obligations to Public Trust Funds 
 
 c. Debt Obligations to Other Civil Divisions 
 
 d. Special Assessment Bonds 
 
 e. Revenue Loans 
 
 /. Outstanding Warrants and Orders 
 
 g. Outstanding Judgments 
 
 h. Miscellaneous Debt Obligations 
 
 i. Total Payments of Debt Obligations 
 
 C. Miscellaneous Temporary Payments 
 
 92. Objects of Public Trust Funds for Non-municipal Uses 
 
 93. Objects of Private Trust Funds 
 
 94. Objects of Private Trust Accounts 
 
 95. For Investments purchased: 
 
 a. By Sinking Funds 
 
 6. By Investment Funds 
 
 c. By Public Trust Funds for Municipal Uses 
 
 d. By Public Trust Funds for Non-municipal Uses 
 
 e. By Private Trust Funds 
 
 (Form 42 — Continued) 
 508 
 
(MUNICIPAL REPORTS) 
 C. Miscellaneous Temporary Payments — Continued 
 
 96. Refund Payments in Correction of Erroneous Receipts: 
 
 a. In Subdivisions (a), (b), (c), (d) and (e) of Revenue Receipts 
 
 b. In Subdivision (f) and (g) of Revenue Receipts 
 
 c. In Subdivision Qi) of Revenue Receipts 
 
 d. In Unspecified Receipts 
 
 97. Payments to Other Civil Divisions: 
 
 a. To State, for Taxes .... $ On Other Accounts $. . 
 
 b. To Counties, for Taxes On Other Accounts . . 
 
 c. To Minor Civil Divisions 
 
 for Taxes On Other Accounts . . 
 
 98. Total Miscellaneous Temporary Payments $ . 
 
 D. Miscellaneous Accounting Debits 
 
 99. Cash Transfer Payments by Independent Divisions and Funds: 
 
 a. By City Corporation To Sinking Funds 
 
 b. By To 
 
 c. By To 
 
 d. By To 
 
 e. By To 
 
 /. By To 
 
 100. Minor Transfer Payments 
 
 101. Other Accounting Debits 
 
 102. Total Payments and Accounting Debits 
 
 (Form 42 — Concluded) 
 
APPENDIX E. 
 
 C. P. A. Examination Questions. 
 
 Since the first certified public accountant law — that of the 
 State of New York — was enacted in 1896, many states, partic- 
 ularly those in which the larger cities of the country are located, 
 have followed suit. 
 
 At this writing there are nineteen states which have passed 
 C. P. A. laws. These, with the year in which the law was 
 enacted, are: 
 
 1896 New York 1907 Utah 
 
 1899 Pennsylvania 1907 Colorado 
 
 1900 Maryland 1907 Connecticut 
 
 1 90 1 California 1908 Ohio 
 1903 Washington 1908 Louisiana 
 
 1903 Illinois 1908 Georgia 
 
 1904 New Jersey 1909 Massachusetts 
 
 1905 Michigan 1909 Minnesota 
 
 1905 Florida 1909 Montana 
 
 1906 Rhode Island 
 
 The laws in all the states excepting New York, Pennsyl- 
 vania, Maryland, New Jersey and Massachusetts specify theory 
 of accounts, practical accounting, auditing* and commercial law 
 as subjects on which candidates shall be examined, and the 
 model C. P. A. law submitted by the Committee on Legislation 
 at the 1907 annual meeting of the American Association of 
 Public Accountants likewise names these four topics as the 
 subject of examination of applicants for certificates. 
 
 There has been considerable discussion as to the desirability 
 of continuing examinations under these headings, and one 
 
 * The Colorado law specifies only theoretical and practical accounting and com- 
 mercial law, auditing not being specifically mentioned, though it would come within the 
 scope of the phrase "such other subjects as the Board may deem advisable." This 
 phrase also appears in the laws of some other states. 
 
APPENDIX E. 511 
 
 examining board — that of Pennsylvania — now groups the sub- 
 jects of examination under two general headings, viz., " Com- 
 mercial Law " and " General Accounting," the latter covering 
 the ground, formerly divided among Theory of Accounts, 
 Practical Accounting and Auditing. These subjects are inter- 
 related to such an extent that it is difficult to frame questions 
 on any one of them which do not overlap and the innovation 
 of the Pennsylvania board has met with general approval. It 
 has the further advantage of enabling the examining board to 
 designedly frame questions which combine all three of the 
 subjects in one question, which is more in accord with actual 
 facts and practical experience. The rules of the Pennsylvania 
 State Board of Examiners of Public Accountants which have 
 been in effect since January i, 1907, are probably the most 
 complete and set the highest standard of any yet promul- 
 gated. Those desirous of becoming certified public account- 
 ants, no matter in what state they expect to take their exam- 
 inations, will do well to study these rules (published in full in 
 the January, 1907, Journal of Accountancy) as they outline 
 in a comprehensive way the qualifications which the aspirant 
 to a C.P.A. certificate should strive to acquire. 
 
 To what extent the fact that the laws of those states, which 
 specify that candidates shall be examined in theory of accounts, 
 practical accounting and auditing would interfere with the ex- 
 aminers in those states following the example of the Pennsyl- 
 vania board, the editor, of course, does not pretend to say. 
 It is thought, however, that this part of the examination could 
 be stated as being on " General Accounting, Embracing the 
 Subjects of Theory of Accounts, Practical Accounting and 
 Auditing." 
 
 The necessity for a broader general education and more 
 scientific preparation for a professional career, as distinguished 
 from the narrow technical accomplishments which were at first, 
 when accompanied by a good moral character, considered suffi- 
 cient to entitle the applicant to practice as a certified public ac- 
 countant, is now recognized. It should be said to the credit of 
 
$12 AUDITING. 
 
 New York that it early recognized the importance of a good 
 general education and required the equivalent of a high school 
 education. Some of the later laws include such a requirement, 
 while in still other cases the examining boards are making it a 
 prerequisite to taking the technical examinations. 
 
 Future development along the line of testing the qualifica- 
 tions of applicants for C.P.A. certificates will doubtless result 
 in the division of the examination into two sections, a prelim- 
 inary and a final. This step has already been taken by the 
 Pennsylvania board, which subjects the candidates to a 
 
 Preliminary Examination " intended as a test of the 
 candidates' general fitness for the study of accountancy." 
 In the absence of having had a general education of high 
 school grade, the appHcant is examined on the subjects 
 found in a high school curriculum ; and all candidates are 
 examined in the " History of Accountancy " and " Ele- 
 mentary Principles of Accounts," 
 
 and a 
 
 Final Examination, . in " Commercial Law," and " Gen- 
 eral Accounting," to which reference has already been 
 made. 
 
 The question of an experience requirement for applicants 
 for certificates is also receiving much attention and considera- 
 tion. It is becoming recognized that it is essential that one 
 must have had some experience in the practical application of 
 the theory he has studied or been taught in schools before 
 he can really be qualified to hold himself out to the public as 
 one who on examination by the proper authorities has been 
 skilled in the practice of accountancy. Some of the examin- 
 ing boards have already prescribed an experience requirement 
 and, without doubt, it will in time become general. 
 
 Included in this appendix are the questions on " Auditing " 
 submitted at recent examinations in a number of different 
 states. These give a fair idea of the scope of the subject of 
 
APPENDIX E. 513 
 
 this work from the viewpoint of the examining Soards. The 
 Pennsylvania questions are on " General Accounting " and in- 
 clude questions which are not strictly on auditing, but they 
 are given in full that the superiority of this manner of treat- 
 ment may be seen by those studying the questions. 
 
 PENNSYLVANIA. 
 
 Examinations held November 23 and 24, 1908. 
 
 ( 1 ) State the more important points of the national banking 
 system relating to the formation of banks, responsibilities of 
 directors and the general requirements as to the scope and 
 conduct of the business. 
 
 (2) The Safe Trust Company has the following depart- 
 ments : 
 
 Banking, 
 Corporate Trust, 
 Individual Trust, 
 Registration and Transfer 
 Safe Deposit. 
 
 (i) Describe the various classes of business conducted 
 in (a) the Corporate Trust Department and (b) the Indi- 
 vidual Trust Department. 
 
 (2) Outline the accounting system you would recom- 
 mend for the business of these two departments (assum- 
 ing that the gross assets in each were $75,000,000 and 
 $30,000,000 respectively) and describe the principal books 
 you think should be used. 
 
 (3) Prepare a balance sheet as of September 30, 1908, 
 for these two departments, showing captions, but omitting 
 amounts. 
 
 (3) Describes the functions and method of operation of a 
 stock exchange clearing house, and points out the differences 
 
5 1 4 AUDITING. 
 
 between a stock exchange clearing house and a bank clearing 
 house. 
 
 (4) In auditing the accounts of a firm of stockbrokers how 
 would you verify the accounts relating to bonds, stocks or other 
 securities owned by the firm or carried for account of custom- 
 ers or others. 
 
 (5) You are asked to audit the accounts of the Universal 
 Fire Insurance Company at December 31, 1908, and furnish a 
 certificate to be published in connection with the balance sheet 
 of the company. To what matters more or less peculiar to a 
 fire insurance company should your attention be directed and 
 how would you deal with each one ? 
 
 (6) The Valley Manufacturing Company operates an ex- 
 tensive machine shop in the manufacture of sewing machines 
 of which they produce a number of types. From time to time 
 the company, through improvements designed in its experi- 
 mental department, is able to produce new types of sewing 
 machines or parts thereof. In bringing out a new type it is 
 first necessary to make or buy a quantity of new machine tools, 
 such as jigs, dies, etc., at a cost of say $5,000. These new 
 types of sewing machines are brought out at irregular inter- 
 vals averaging perhaps eighteen months apart. The machine 
 shop contains a large variety of machines ranging in cost from 
 $150 each to $2,500 each. In addition to its sales of completed 
 machines the company sells large quantities of parts for pur- 
 poses of repairs. 
 
 You are retained to devise and instal a system of cost ac- 
 counts that will show as accurately as possible the cost not 
 only of a complete sewing machine, but also of each one of its 
 component parts. 
 
 Omitting a description of the portions of your cost system 
 relative to materials and productive labor, explain how you 
 would deal with (a) the problem of ascertaining the costs of 
 individual parts, (b) the ascertainment and distribution of the 
 
APPENDIX E. 515 
 
 general expenses of the factory frequently known as the "shop 
 burden," and (c) the disposition to be made of the cost of 
 special jigs, dies and other machine tools acquired for the pro- 
 duction of improved types of sewing machines or parts thereof. 
 
 (7) Form a trial balance of a manufacturing concern, either 
 corporation, partnership, or individual, with which you are 
 acquainted, and prepare therefrom a statement giving the re- 
 sults of operation, and a final balance sheet. Write a report 
 dealing with the conditions of the business and commenting 
 on the managerial results, volume of expenses, etc. 
 
 (8) By the partnership deed of a manufacturing firm con- 
 sisting of four members, A., B., C, and D., it was provided 
 that in the event of the death of any partner before the expira- 
 tion of the partnership on December 31, 1909, there should be 
 paid to the legal representatives of the deceased partner the 
 amount appearing to his credit on December 31, next preceding 
 the death, together with interest thereon at 5 per cent, per 
 annum, to December 31 following the date of decease, and a 
 share of the profits of the year of his decease corresponding to 
 the number of days that he lived during it, calculated after the 
 rate of the average of his share for the last three completed 
 years. The four partners shared profits equally, and each took 
 interest on his capital at 5 per cent, per annum, but no interest 
 was charged on the drawings. The surviving partners were to 
 share the profits equally. C. died on June 30, 1907. The 
 profits of the three immediately preceding years had been re- 
 spectively $70,000, $78,000 and $65,000. From the following 
 trial balance of December 31, 1907, prepare manufacturing and 
 profit and loss accounts for 1907, allowing $2,500 for deprecia- 
 tion of plant, and $250 for depreciation of office fixtures and 
 furniture. Also construct a balance sheet showing the interest 
 of the remaining partners and treating the amount owing to 
 the estate of C. as a liability of the firm. In preparing this 
 balance sheet follow the form you prefer and group the items 
 in accordance with your best judgment. 
 
5 I'6 AUDITING. 
 
 Trial Balance — December 31, 1907. 
 
 A, Capital Account ] $120,000.00 
 
 B, " " 1 No change in partners' capital ac- 110,000.00 
 
 C, " " j counts during year 1907. 100,000.00 
 
 D, " " J 90,000.00 
 
 A, Drawing Account $12,000.00 
 
 B, " " 12,000.00 
 
 C, " " 5,000.00 
 
 D, " " 12,000.00 
 
 Stock December 31, 1906 $100,000.00 
 
 (Note: Stock at December 31, 1907 
 
 was $125,000.00) 
 
 Purchases during Year $1,775,000.00 
 
 Factory Wages and Salaries 250,000.00 
 
 Discount received and allowed, balance 
 
 of 20,000.00 
 
 Sales during the year 2,110,000.00 
 
 Cash in hand and at bank 29,500.00 
 
 Bad Debts 16,000.00 
 
 Bills Receivable in hand 15,000.00 
 
 Office Salaries 9,000.00 
 
 Office Expenses, General 2,500.00 
 
 Sundry Debtors 414,000.00 
 
 Traveling Expenses 10,000.00 
 
 Insurance 1,000.00 
 
 Office Rent, Taxes, etc 2,000.00 
 
 Real Estate— Factory 60,000.00 
 
 Factory Plant 15,000.00 
 
 Office Fixtures and Furniture 2,500.00 
 
 Bills Payable 50,000.00 
 
 Sundry Creditors on Open Accounts. . . . 150,000.00 
 
 Interest paid 7,500.00 
 
 $2,750,000.00 $2,750,000.00 
 
 (9) You are retained by an industrial company to make 
 such an examination of its accounts as will enable you to 
 certify to its balance sheet at December 31, 1908, the object ot 
 the company being to aid it in selling its notes through note 
 brokers. 
 
 Give an outline of your method of procedure, showing the 
 extent to which you would consider it necessary to carry your 
 examination in respect to the several classes of assets and 
 liabilities. 
 
 Assuming that you are satisfied to give a certificate to the 
 balance sheet, in what form would you express it? 
 
APEXDIX E. 517 
 
 (10) A coal mining company "A," desires to acquire an- 
 other smaller mining corporation **B,' the capital stock of 
 which is $ioo,cxx). It purchases the entire capital stock for 
 $300,000, and in order to obtain the funds, borrows that 
 amount, giving five notes due in one, two, three, four and five 
 years, for $60,000 each, and bearing interest at the rate of 6 
 per cent, per annum. 
 
 Company "B" owns no real estate, but operates under a lease 
 which will expire fifteen years after the date of the above 
 mentioned purchase. At the termination of the lease, all per- 
 manent improvements, buildings, etc., other than movable 
 equipment, becomes the property of the lessor. 
 
 At the time of the purchase it is found that the current or 
 liquid assets of company "B," other than the investment in 
 buildings and equipment, amount to $50,000. It is also neces- 
 sary to expend $10,000 per annum for the first two years in the 
 erection of permanent buildings in addition to the ordinary 
 charges for maintenance. 
 
 It is required that the stock of company "B" shall be worth 
 par at the termination of the lease. It is further desired that 
 interest on the notes given by "A" should be extinguished by 
 the income received from "B," and also that the investment of 
 "A," except as represented by the par value of the stock of 
 company "B" should be extinguished before the termination 
 of the lease. 
 
 Both companies are to be operated entirely independently of 
 each other and the only connection is through that of stock 
 ownership. 
 
 The reply to this question should be in the nature of a clear 
 and concise plan, stating how these transactions should be 
 treated on the books of both companies. Include with this a 
 set of ledger accounts illustrating the workings of the plan 
 you would recommend. 
 
Sl8 AUDITING. 
 
 (ii) A book publishing company has brought out its first 
 book. Plates capable of 100,000 impressions cost $20,000; 
 composition, proof reading, etc., cost $6,000; the author is to 
 receive a royalty of 25 cents per volume on the books sold. As 
 a first edition, 20,000 books are printed at a labor cost of 
 $2,000, and a further charge of $1,500 to cover the proportion 
 of general expenses. At the end of the year 10,000 copies had 
 been sold for $20,000. How would you prepare the accounts 
 under the following conditions? 
 
 (i) If it were ascertained that the demand for the 
 book had practically ceased. 
 
 (2) If a steady demand would continue until the plates 
 were worn out. 
 
 (12) The B. & E. Company is a wholesale trading concern, 
 having its headquarters in Lancaster, Pa., and maintaining 
 branch stores in a number of cities, Richmond, Va., among 
 others. These branch stores receive their goods upon consign- 
 ment from the head office; keep the accounts with their cus- 
 tomers; make collections thereon; keep local bank accounts; 
 pay current expense bills and remit their excess funds from 
 time to time to the head office. The manager of the Richmond 
 branch is employed on a small, fixed salary, and a commission 
 based on the sales, the latter compensation being forwarded 
 to him quarterly by check from the Lancaster office. Without 
 intending to steal he adopted the habit of anticipating the ar- 
 rival of his check and withheld collections received from cus- 
 tomers, making no entries therefor upon the books for the time 
 being, but being careful, however, not to hold out any one item 
 longer than a few days, thus constantly replacing out of the 
 current receipts items previously withheld. Upon receipt of 
 his quarterly check for commissions he would at once make 
 good the amount he had in the above manner advanced from 
 the company's funds to himself. 
 
APPENDIX E. 519 
 
 (a) If you were instructed to audit the accounts of 
 the B. & E. Company, including those of the branch offices, 
 would your audit disclose this condition, and, if so, con- 
 cisely and carefully describe the course you would pursue. 
 
 (b) What criticisms have you to offer relative to the 
 administrative plan of the B. & E. Company as outlined 
 above ? 
 
 (c) Describe clearly the form of accounts you think is 
 best adapted to this business if it were operated in accord- 
 ance with the methods best suited in your judgment for 
 the management of a business maintaining branch stores. 
 
 (13) A wool merchant has entered into an agreement to 
 take 1,000,000 pounds of wool, in the grease, on joint account 
 with the shipper, to have it washed, scoured, combed, etc., and 
 sell the product; the profit or loss to be shared equally. 
 
 The grease wool is sent to the scourer in lots as received 
 from the shipper and returned from day to day in smaller 
 quantities as grades A B, C, D and E; these lots (or some of 
 them) and combinations of said lots are sent to combers and 
 again returned in smaller quantities from day to day as grades 
 Nos. I, 2, 3, 4, and 5. 
 
 The wool may be sold in any form that is in the grease, as 
 grade, A, B, C, D, and E, or as grades Nos. i, 2, 3, 4 and 5. 
 
 It will be necessary for the merchant to report the results of 
 the transactions in each lot separately. 
 
 Submit a method for keeping a record of this stock and 
 accounts from which proper statements can be made to the 
 shipper showing the loss in the various processes, the quantities 
 sold, to whom, prices, etc., and the net loss or gain. 
 
 (14) What are the present requirements of the Interstate 
 Commerce Commission relative to the treatment of deprecia- 
 tion in the accounts and reports of railroad companies? 
 
520 AUDITING. 
 
 (15) Three railway lines, "A" Ry. Co., "B" Ry. Co., and 
 "C" Ry. Co., all of the stocks of which are owned by a holding 
 company, enter into an agreement of consolidation and merger 
 under the name of the C. Ry. Co. New stock is issued to the 
 holding company in exchange for the old stock, on a basis of 
 share for share. And it is further agreed that sufficient addi- 
 tional new stock shall be issued and sold at par to the holding 
 company for the purpose of redeeming the bonds of "A" and 
 "C* and paying the interest accrued. 
 
 Following are balance sheets of the three companies. Ac- 
 cept values as stated and prepare a balance sheet of the con- 
 solidated company after all transactions incident to the merger 
 are completed. In setting up the balance sheet do so with a 
 view to the fact that none of the companies have made very 
 liberal provision for the depreciation of their road and equip- 
 ment. 
 
 BALANCE SHEET —"A" RAILWAY CO. 
 
 Assets. 
 
 Road and Equipment $600,000.00 
 
 Material and Supplies 5,000.00 
 
 Accounts Receivable 2,000.00 
 
 Bills Receivable owing from " B" Rwy. Co . . . 15,000.00 
 
 Bills Receivable owing from "C" Rwy. Co. . 2,000.00 
 
 Cash 1,000.00 
 
 Cash and Bonds in hands of Trustee of Sink- 
 ing Fund for 1st Mortgage Bonds 30,000.00 
 
 Total Assets $655,000.00 
 
 Liabilities. 
 
 Capital Stock $300,000.00 
 
 First Mortgage Bonds 250,000.00 
 
 Accounts Payable 10,000.00 
 
 Sinking Fund— First Mortgage Bonds 30,000.00 
 
 Accrued Interest on Bonds 6,250.00 
 
 Profit and Loss 58,750.00 
 
 Total Liabilities $655,000.00 
 
APPENDIX E. 521 
 
 BALANCE SHEET— "B" RAILWAY CO. 
 
 Assets. 
 
 Road and Equipment $250,000.00 
 
 Material and Supplies 1,000.00 
 
 Accounts Receivable 1,000.00 
 
 Cash 1,000.00 
 
 Profit and Loss 62,000.00 
 
 Total Assets $315,000.00 
 
 Liabilities. 
 
 Capital Stock $300,000.00 
 
 Bills Payable 15,000.00 
 
 Total Liabilities $315,000.00 
 
 BALANCE SHEET— "C" RAILWAY CO. 
 
 Assets. 
 
 Road and Equipment $1,500,000.00 
 
 Material and Supplies 10,000.00 
 
 Accounts Receivable 10,000.00 
 
 Cash 15,000.00 
 
 Cash and Bonds in hands of Trustee of 
 
 Sinking Fund for 1st Mtge Bonds 100,000.00 
 
 Total Assets $1,635,000.00 
 
 Liabilities. 
 
 Capital Stock $1,000,000.00 
 
 First Mortgage Bonds 500,000.00 
 
 Bills Payable 2,000.00 
 
 Sinking Fund 1st Mortgage Bonds 100,000.00 
 
 Accrued Interest on Bonds 12,500.00 
 
 Profit and Loss 20,500.00 
 
 Total Liabilities $1,635,000.00 
 
 (16) In municipal affairs what is the purpose of a budget? 
 What relation does it bear to the accounting of a municipality ? 
 
 (17) Make out for an intending purchaser a report of an 
 examination made by you of a gas company, street railway 
 
522 APPENDIX E. 
 
 or electric lighting company, whichever you are most familiar 
 with, covering in your report all points relating to the prop- 
 erty and the accounts which are necessary for an intending 
 purchaser to know, including not only matters divulged by 
 your examination, but referring briefly to the contents of re- 
 ports made by other experts upon examinations made by them 
 at or about the same time as your own, but dealing with 
 affairs outside the field of accounting. 
 
 (i8) You are instructed by the receiver of an importing 
 and trading concern to examine the accounts and report to him 
 upon 
 
 (a) the financial position of the concern, and 
 
 (b) the causes that have mainly contributed to the 
 failure. 
 
 In your answer prepare a statement of the assets and lia- 
 bilities in such form as you think should be used for the 
 information of the receiver and the creditors and under (b) 
 state the matters to which you would direct your attention, 
 having in mind the nature of the business, and how you would 
 proceed with your investigation. 
 
 NEW YORK. 
 
 Examination held June 24, 1908. 
 
 (i) In the preparation of a manufacturing and trading 
 account and a balance sheet, state on what basis the following 
 assets should be valued : 
 
 (a) Raw materials. 
 
 (b) Product in process of manufacture. 
 
 (c) Manufactured product. 
 
 (d) Bills receivable. 
 
 (e) Accounts receivable. 
 
 Give fully your reasons. 
 
APPENDIX E. 523 
 
 (2) In preparing a statement of the earnings of a business, 
 covering a period of five years, how, in order to determine 
 what the average earning capacity of said business has been, 
 should the expenditure for interest paid on bills payable and 
 loans, and on accounts payable be considered? 
 
 (3) An examination of the minutes and other records of 
 the books of a corporation, preceding an audit, discloses that a 
 revaluation of its buildings, plant, and machinery, had been 
 made by expert appraisers called in for the purpose. The 
 report of these appraisers states that the values as determined 
 by them were greater than those shown on the books. Should 
 such increased value be entered on the books of the corpora- 
 tion ? What entries should be made to show this in the profit 
 and loss account and balance sheet? 
 
 (4) What kind of expenditures of a manufacturing business 
 would you classify as being in the nature of maintenance and 
 repairs of equipment, machinery, and plant, and what would 
 constitute actual betterments ? How should such expenditures 
 be dealt with on the books and shown in the profit and loss 
 statement, and on the balance sheet? 
 
 (5) Define and differentiate an audit conducted for the 
 purpose of reviewing past transactions and establishing the 
 significance thereof and an audit precedent to determining the 
 verity of a bill or of a claim. Give a brief outline of the pro- 
 cedure in each case. 
 
 (6) State (a) for what class of assets provision for depre- 
 ciation should be made, (b) what would constitute an adequate 
 rate for depreciation on buildings and on plant and machinery 
 respectively. Give reasons. 
 
 (7) How should a leasehold be treated in the accounts of 
 a company, and how should it be shown on the balance sheet? 
 
 (8) Give a brief description of the books of a corporation 
 that should be examined and inspected by the auditor, and state 
 
524 AUDITING. 
 
 the reasons why such examination or inspection should be 
 made. 
 
 (9) What is the value of a bank pass-book for the purpose 
 of an audit? How would you reconcile the pass-book balance 
 with the cash book balance ? 
 
 (10) In auditing an account the auditor finds that Robert 
 Brown had bought a bill of goods amounting to $500 payable 
 on August ID, less 2 per cent. He had, however, made pay- 
 ments thereon as follows: 
 
 June 2 $100 
 
 June 15 100 
 
 July 3 100 
 
 On what date would he be required to make payment of 
 the remaining $200 to entitle him to the 2 per cent, discount 
 under the original terms of sale? 
 
 (11) What generally constitutes capital expenditure ? What 
 expenditures are properly chargeable against revenue? Ex- 
 plain and give illustrations in each case. 
 
 (12) The accounts of a steel and iron manufacturing com- 
 pany show large additions to plant and machinery. It is 
 found that these charges include considerable amounts from 
 pay-rolls. In the absence of specific explanations as to the 
 pay-roll element, what method should be employed by the 
 auditor to determine the accuracy and the propriety of these 
 charges ? 
 
 (13) If the auditor has not verified or had opportunity to 
 verify the actual cash on hand at the date of the balance sheet 
 what should be his procedure to prove the correctness of the 
 balance sheet as stated, before giving his certificate? 
 
 (14) In auditing the accounts of a railway company how 
 should the auditor determine whether or not the net earnings 
 are correctly stated? 
 
APPENDIX E. 525 
 
 (15) What test of the prime cost of manufactured goods 
 should be made to guard against loss of raw material through 
 theft by employees? 
 
 ILLINOIS. 
 
 Examination held May 4, 1908. 
 
 (i) In a case where preferred shares of a company are 
 issued under a provision that the annual dividends to which 
 they shall be entitled shall be " cumulative," would you con- 
 sider it necessary to show any arrears of dividend as a liability 
 upon the balance sheet, or how would you deal with it? 
 
 (2) What special points in the balance sheet of a com- 
 pany, aside from the correctness of the figures require careful 
 consideration by the auditor? 
 
 (3) In making an audit of the accounts of a corporation, 
 would you consider it part of your duty to verify the trans- 
 fers of the certificates of capital stock occurring during the 
 period covered by your examination ? 
 
 (4) In financing a manufacturing company it is considered 
 necessary to arrange for an issue of $300,000 first mortgage 
 5 per cent. 20-year bonds ; $500,000 6 per cent, non-cumulative 
 preferred stock, which may be retired any time after five years, 
 and $1,000,000 common stock. The bonds are disposed of 
 at 90 per cent, of their face value and proceeds used for erect- 
 ing buildings and purchase of machinery and equipment. 
 
 The preferred stock is sold at 85 and one share of common 
 stock is given with each share of preferred stock, the common 
 stock remaining being disposed of at 40. How would you 
 deal with the discount in each case? 
 
 ( 5 ) A company whose capital stock is $250,000, divided into 
 $100,000 6 per cent, non-cumulative preferred shares, and 
 $150,000 common shares, begins its life with an excess of lia- 
 bilities over real assets to the extent of $10,500, which sum is 
 debited to suspense account. During the first few years small 
 
526 AUDITING. 
 
 losses are made and carried forward on the profit and loss ac- 
 count but finally sufficient profits are earned to wipe out the 
 losses of the previous years and leave a balance of $16,500. 
 
 The holders of the preferred stock claim that any surplus 
 profit, after payment of the preference dividend, should be 
 used to extinguish the suspense account. 
 
 The holders of the common stock claim that all of such sur- 
 plus is properly available for their dividend on the ground that 
 the original deficiency carried to suspense account was in effect 
 a charge to goodwill. 
 
 Give briefly your understanding of " goodwill." State how 
 you would deal with it in this case, and whether the directors 
 may pay any dividend on the common stock. 
 
 (6) A suburban traction company, after equipping its line at 
 a very considerable expense for overhead trolley, and operating 
 same for several years, decides to adopt the third-rail system. 
 Extensive changes are necessary in changing power houses, 
 re-arranging tracks, and altering cars, involving an expendi- 
 ture of $25,000. In addition considerable machinery and roll- 
 ing stock, the original cost of which had been treated as a 
 capital outlay and was carried on the books at a valuation of 
 $25,000, is rendered obsolete, and is disposed of for $3,500, 
 showing a loss of $21,500. The profits from operation for 
 the year $18,000. 
 
 State how you would recommend that the matter be dealt 
 with in the company's accounts, and whether the company can 
 pay a dividend? 
 
 (7) A firm having several branches maintains an account 
 with each branch in the ledger and charges to such account all 
 goods sent to the agents for stock. When stock is taken the 
 balance of each branch account is treated as ordinary accounts 
 receivable and is included in the general debts owing to the 
 firm. If you see any objections to this method, state them, 
 and say how you would deal with the accounts. 
 
APPENDIX E. 527 
 
 (8) Presuming that upon examination of a merchant's ac- 
 counts the balance shown by the bank pass-book, or certified 
 by the bankers, agreed with the balance shown in the mer- 
 chant's cheque-book, would you consider any further examina- 
 tion necessary? 
 
 State reasons for your reply. 
 
 (9) Define your understanding of principle involved in de- 
 termining what are and what are not expenditures from capital. 
 
 (10) You are instructed to make an audit by a merchant 
 selling finished goods, or by a manufacturer. State all your 
 responsibilities. Name the financial statements you should 
 make and give a form of certificate. 
 
 CALIFORNIA. 
 
 Examination held May 28, 1908. 
 (Part of questions only.) 
 
 ( 1 ) State the different kinds of audits and describe them. 
 
 (2) What would be required from a firm or corporation by 
 an auditor before entering upon the audit of the books? 
 
 ( 3 ) In making the first periodical audit of a corporation that 
 had personally taken over the business of a firm, what would 
 you include in your examination beside the usual books and 
 accounts, and for the purpose of ascertaining what facts? 
 
 (4) From the information gathered and noted throughout 
 an audit, what matters would you call especial attention to, 
 and what schedules and statistical statements would you furn- 
 ish the client? 
 
 (5) What constitutes capital expenditure? 
 
 (6) Would an auditor be justified in certifying to the accu- 
 racy of accounts in which such expenditure appeared without 
 making inquiry into the real character of same. If not, why 
 not? If he would, why? 
 
$28 APPENDIX E. 
 
 W^ASHINGTON. 
 
 Examination held August 7, 1908. 
 
 (i) What are the responsibilities of an auditor and what 
 should be his qualifications? 
 
 (2) (a) Give some reasons why a firm or corporation 
 should have periodical audits. 
 
 (b) What advantage has a firm or corporation in em- 
 ploying a Certified Public Accountant for the work ? 
 
 (c) How far should an auditor enquire into the work 
 of his predecessor. 
 
 (3) Draw up a form of certificate you would give where 
 you found the accounts properly kept. Also where accounts 
 are incorrect. 
 
 (4) (a) Explain how you would proceed in auditing th« 
 affairs of a corporation. 
 
 (b) In an audit where an exhaustive examination of 
 the books is not practicable, what are the particular points 
 to which the attention of an auditor should be directed? 
 
 (5) State briefly your duties as an auditor in reference to 
 the following matters: 
 
 (a) Machinery the value of which has not been regu- 
 larly depreciated. 
 
 (b) Loans from bankers. 
 
 (c) Doubtful debts. 
 
 (d) Goodwill. 
 
 (6) How would you as auditor of an incorporated company 
 satisfy yourself of the existence of shares or bonds given as 
 security for loans to the company? 
 
 (7) What important items would you look for in auditing 
 accounts of a county, a city and a school district? 
 
APPENDIX E. 529 
 
 (8) A firm of export merchants desires a thorough investi- 
 gation of the past year's transactions, having reason to suspect 
 fraud. State concisely upon what Hues you would proceed to 
 satisfy yourself that: 
 
 (a) Goods had been taken out of the store on bond in 
 the way shown by the books. 
 
 (b) They had been shipped to account of proper con- 
 signee. 
 
 (c) That no goods had been removed without being 
 charged. 
 
 (d) That no fictitious entries had been made in the 
 books. 
 
 MICHIGAN. 
 Examination held June 26, 1908. 
 
 ( 1 ) What is an auditor's duty with regard to the following 
 items appearing upon a balance sheet? Imprest cash, notes 
 receivable, customers' accounts, sundry debtors, mortgages 
 payable, certificates of deposit, patents, goodwill, preliminary 
 (or organization) expenses, stocks and bonds, purchase cred- 
 itors' accounts and sundry creditors. 
 
 (2) What do you understand by the term " secret or hidden 
 reserves?" Mention four (4) bona fide uses of a secret re- 
 serve and state your opinion as to the propriety or otherwise 
 of the creation of such " reserves," giving reasons. 
 
 (3) The J. B. & B. Coal Mining Company has acquired a 
 leasehold right to a certain area of coal, and also owns free- 
 hold coal. What would you require as auditor, to satisfy 
 yourself that revenue was bearing its proper annual charge in 
 respect of the coal mined? 
 
 (4) Chart the following accounts of a street railway com- 
 pany under their proper classification and logical order, as to 
 
530 AUDITING. 
 
 assets (active, fixed, and passive), liabilities (funded, floating^ 
 reserves and capital), expenses (transportation, including 
 operating of power plant and car service), general (including 
 administrative, emergencies and fixed charges), maintenance,, 
 (including repairs and depreciation) and revenue (a) from 
 operation and (b) from other sources. 
 
 Organization expenses, preliminary engineering and superin- 
 tendence, right of way, track and roadway, notes payable, cash 
 in office, profit and loss, power plant wages, salaries of general 
 officers, damages, taxes, electric line, investment real estate, de- 
 bentures, vouchers payable, stocks and bonds of other compa- 
 nies, hired power, wages of conductors and motormen, car serv- 
 ice supplies, insurance, first mortgage bonds, Ninth National 
 Bank, cleaning and sanding tracks, printing and stationery,, 
 legal expenses, rent of land and buildings, notes receivable^ 
 shop tools and machinery, passenger receipts, rolling equip- 
 ment, dividends, material and supplies, freight receipts, interest 
 on deposits, track rentals, common stock, sinking funds, good- 
 will, mail receipts, sale of power, dividends on securities, sal- 
 aries of clerks, removal of snow and ice, advertising and attrac- 
 tions, storeroom expenses, steam plant, items in suspense, im- 
 pairment and surplus, first preferred stock, repairs to equip- 
 ment, reserves, accounts receivable, second preferred stock, 
 second mortgage bonds, fuel and water for power buildings, 
 and fixtures. 
 
 (5) A $100.00 bond is issued at $115.00 and is payable as to 
 $35.00 on allotment and to the remaining $80.00 in four equal 
 instalments at intervals of two months, the first instalment 
 being due two months after the allotment. If after a year a 
 dividend of $6.00 is paid on each bond, what is the average 
 rate of interest on the investment for the whole year? 
 
 (6) John Adams, a capitalist, contemplates purchasing the 
 stock of the American Grain Exporting Company, a corpora- 
 tion organized with a capital of $200,000.00, divided into 1,000 
 shares preferred stock and 1,000 shares common stock, par 
 
APPENDIX E. 531 
 
 value $100.00 each, six per cent. (6%) dividends, payable upon 
 the preferred stock before any dividends are declared upon the 
 common stock. 
 
 This stock has been offered to Mr. Adams at $60.00 per 
 share for the preferred, and $40.00 per share for the common. 
 
 You are requested to audit the books of the company and 
 give your opinion as to the value of the stock. You find the 
 following accounts to be correct, covering a period of one year. 
 
 Cash $900.00 
 
 Accounts receivable: 
 
 Good $15,000.00 
 
 Doubtful 4,000.00 
 
 Bad 6,000.00 25,000.00 
 
 Plant and machinery 75,000.00 
 
 Horse and wagons 4,000.00 
 
 Merchandise — Inventory 29,000.00 
 
 GoodwiU 50,000.00 
 
 Furniture and fixtures 2,000.00 , 
 
 Expenses 3,000.00 ' ' 
 
 Wages 15,000.00 
 
 Purchases . 325,000.00 
 
 Claims and rebates 8,000.00 
 
 Ordinary repairs 9,000.00 
 
 Sales $260,400.00 
 
 Mortgage on plant 25,000.00 
 
 Accounts payable 42,000.00 
 
 Surplus 18,500.00 
 
 Capital stock 200,000.00 
 
 Totals $545,900.00 $545,900.00 
 
 Inventory submitted $129,000.00. The company started 
 business six years ago and built the plant and machinery and 
 purchased the property pertaining to fixed capital. Write the 
 report, commenting upon the advisability of the purchase and 
 submit profit and loss statement and balance sheet, after clos- 
 ing books. 
 
 (7) The cashier of a firm has disappeared. The cash book 
 is left written up and balanced off, the custom being to pay 
 any cash balance into the bank each day. What course would 
 
532 AUDITING. 
 
 you take to ascertain whether there were any defalcations, if 
 you were called upon to audit? 
 
 (8) You are asked by a client how to treat inventories at 
 the time of closing the books, e. g., should they be figured at 
 cost or market price, or otherwise ? Is the common, old-fash- 
 ioned method of adding the inventory of merchandise on hand, 
 to the credit side of the merchandise account before closing 
 the books, theoretically correct? Explain fully. 
 
 (9) What evidence would you require as to the validity of 
 expenditure in respect of wages paid in a large manufacturing 
 plant, and as to the value of the inventories of stock on hand 
 credited to loss and gain? It is assumed that the above manu- 
 facturing concern kept a complete cost system, which was an 
 integral part of the general books. 
 
 (10) The market value of the investments of a trust com- 
 pany has fallen considerably, while the company has earned 
 enough income to pay the usual dividend. How should you 
 deal with this position of affairs in auditing the annual ac- 
 counts ? 
 
 FLORIDA 
 
 Examination held April 22, 1908. 
 
 (i) A trading company discounts some of its bills receiv- 
 able. How would you treat such transactions in the books, 
 and how would you show such discounted bills on the balance 
 sheet ? 
 
 (2) What do you consider the proper way to handle cash 
 in accounts? What advantages are there, if any, in banking 
 each day the exact receipts of the previous day? 
 
 How would you verify the correctness of a cash book, and 
 ensure the entry of all cash received? 
 
 (3) Define " periodical audit " and " continuous audit." 
 Give two or three reasons for and against each. 
 
APPENDIX E. 533 
 
 (4) What is an " internal check? " How does such a check 
 affect the work of auditing a given set of accounts? 
 
 Give at least one example. 
 
 (5) What are the objects of and differences between an 
 audit and an examination? 
 
 (6) Give in detail the method you would follow in auditing 
 some company with which you are familiar. 
 
 (7) What especial duties has auditor in connection with 
 accounts relating to: — 
 
 Patents owned by a corporation. 
 Timber rights owned by a corporation. 
 Machinery and boilers owned by a corporation. 
 
 (8) Give at least two examples of contingent liabilties, and 
 state how they should be treated in the books and on the 
 balance sheet. 
 
 (9) A company is organized in New York to lend money 
 on real estate mortgages in Florida. 
 
 What examination should an auditor make of such mort- 
 gages, and how would he guard against duplicate mortgages 
 on the same property? 
 
 (10) A new company sells some of its property at a pre- 
 mium. 
 
 State how these premiums should appear in the accounts. 
 
 (11) Suppose you had certified the balance sheet of a manu- 
 facturing concern, and were asked by a stockholder why you 
 had certified it as correct when some of the assets were not 
 salable at the figures placed against them, what reply would 
 you make? 
 
 (12) What duties and responsibilities has an auditor in con- 
 nection with inventories of goods on hand ? 
 
534 AUDITING. 
 
 (13) A firm has been doing business for ten years, during 
 which time no audit has been made and nothing has been 
 charged off on account of bad debts. There are six hundred 
 accounts on the ledger. 
 
 State how you would verify and classify them. 
 
 (14) In auditing the accounts of an executor, what docu- 
 ments would you require ? 
 
 What is the necessity of keeping real estate separate from 
 personal property? 
 
 (15) Give your opinion as to the advantages, or disadvan- 
 tages, of bound and of loose-leaf ledgers ; and give at least two 
 methods for preventing improper abstracting of leaves from 
 loose-leaf books. 
 
 RHODE ISLAND. 
 
 Examination held December 26, 1907. 
 
 (i) What is your understanding of a cash audit? 
 
 (2) What measures do you adopt to protect yourself against 
 imposition by persons who have access to the books while you 
 are auditing them? 
 
 (3) What proofs do you apply to insure the correctness of 
 an audit? 
 
 (4) A company owns all the capital stock of another com- 
 pany. This company has outstanding an issue of bonds not 
 guaranteed by the company holding the stock. The assets of 
 this subsidiary company are deemed insufficient to cover the 
 bonds, so that its capital stock has no value. The owning com- 
 pany desires the auditor to prepare its balance sheet, setting up 
 the assets of this subsidiary company along with other assets 
 directly owned and the bonds as liabilities. Is it proper for 
 him to do so under the circumstances ? Give reasons for your 
 answer. 
 
APPENDIX E. 535 
 
 (5) What do you consider a complete checking of (a) the 
 /general journal (b) the purchase journal? 
 
 (6) What is your method of checking dividends paid? 
 
 (7) A New York company sells its capital stock at a pre- 
 mium and the directors pass a resolution to declare a dividend 
 out of the surplus thus paid in. Would you call attention to 
 this action if asked to make up the accounts, and if so, why? 
 
 (8) In examining the books of a corporation you find that 
 an officer is a partner in a business from which the corporation 
 makes purchases. Upon scrutiny you find that all the trans- 
 actions are at proper figures. Would you, under such condi- 
 tions, call attention to the fact when making your report to the 
 directors ? 
 
 (9) A concern owns a parcel of real estate which cost it 
 $500,000. There is a purchase money mortgage on it of 
 $350,000. You are asked to enter the same in the balance 
 sheet of $350,000 net. Would you comply with thi? request? 
 Give reasons for your answer. 
 
 (10) A person is interested in the profits of a corporation, 
 but is not a shareholder therein. He objects to having the 
 preliminary expenses enter into the profit and loss accounts. 
 Is his position tenable? Give reasons. 
 
 (11) A manufacturing concern buys raw materials in ad- 
 vance for its needs. These are liable to fluctuations. At what 
 prices should they be inventoried? Why? 
 
 (12) Under the law permitting payment of dividends solely 
 out of surplus earned, a corporation pays a dividend out of 
 general surplus after carrying its losses for the period against 
 the account. Would you make mention of the fact in the 
 recital accompanying your statements, or would you let it go 
 without specific mention? Give reasons. 
 
536 AUDITING. 
 
 (13) Three months after the close of the fiscal year you 
 are requested to audit a set of books to the end of the fiscal 
 year. How do you ascertain if the cash called for by the 
 books was actually on hand and in bank? 
 
 (14) A teller is found to be short in his cash. He has 
 been in the position for a period of three years and has a 
 daily record of cash on hand. His bond of suretyship ante- 
 dates the discovery of the shortage by a period of six months, 
 and it contains a clause that the surety shall not be liable for a 
 shortage existing at the date the bond became effective. You 
 are employed by the surety to ascertain if the shortage falls 
 within the period of the bond. What steps would you take? 
 Do you think that you would be successful ? 
 
 (15) What is the objection to loose-leaf depositors' ledgers? 
 
APPENDIX F. 
 
 The following extract from the translation of Sir 
 Walter of Henley's "Tretyce off Housebandry" 
 (a manuscript work of the thirteenth century) 
 is of considerable interest, as showing the 
 remarkable similarity of the duties of the 
 Auditor of the present day with those of the 
 Auditor of seven hundred years ago: — 
 
 " Buy and sell in season through the inspection of a true 
 man or two who can witness the business, for often it happens 
 that those who render accounts increase the purchases and 
 diminish the sales. Have an inspection of account, or cause 
 it to be made by some one in whom you can trust, once a year, 
 and final account at the end of the year. View of Account 
 is made to know the state of things, as well as the issues, re- 
 ceipts, sales, purchases, and expenses, and for raising money. 
 If there is any (money), let it be raised and taken from the 
 hands of the servants. For it often happens that servants by 
 themselves, or others, make merchandise with their lord's 
 money to their own profit; and if arrears appear in the final 
 account, let them be speedily raised, for often servants are 
 debtors themselves, and make others debtors whom they ought 
 not — and this they do to conceal their disloyalty. Those who 
 have the goods of others in their keeping ought to keep well 
 four things : to love their lord and respect him ; as to making 
 profit, they ought to look on the business as their own; as to 
 outlays, they ought to think that the business is another's. 
 But there are few servants who keep these four things alto- 
 gether, as many take, right and left, where they judge that 
 their disloyalty Vv^ill not be perceived. Look into your affairs 
 
 537 
 
538 AUDITING. 
 
 often, and cause them to be reviewed, for those who serve you 
 will thereby avoid the more to do wrong, and will take pains 
 to do better. 
 
 " In the first place, he who renders account ought to swear 
 that he will render a lawful account, and faithfully account 
 for what he has received of the goods of his lord, and that 
 he will put nothing in his roll save what he has to his knowl- 
 edge spent lawfully, and to his lord's profit. And the clerk 
 shall swear that he has lawfully entered in his roll what he 
 understands his master has received of the lord's goods, and 
 has entered nothing in the roll but what he understands may 
 be to the profit of the lord. And then, if he has rendered ac- 
 count before, see how it compares; and if he is found in 
 arrears of money, corn, or stock, put the whole in a stated 
 money valuation, and charge it at the commencement of his 
 roll, also charge it with receipts of rents and many other 
 things. 
 
 " At the end of the year, when all the accounts shall have 
 been rendered of the lands, the issues, and all expenses of the 
 manor, take to yourself all the rolls, and by one or two of 
 the most intimate and faithful men you have, make very 
 careful comparison with the rolls of the accounts rendered, 
 and of the rolls of the estimate of corn and stock, and accord- 
 ing as they agree you shall see the industry or negligence of 
 your servants' and bailiffs. 
 
 " The lord of the manor ought to command and ordain that 
 the accounts be heard every year, not in one place, but on all 
 the manors, for so can one quickly know everything, and 
 understand the profit and loss. The lord ought to command 
 the Auditors on the manors to hear the plaints and wrongs of 
 everybody who complains of the steward or others, that full 
 justice be done, and that the Auditors do right at their peril. 
 
 " The Auditors ought to be faithful and prudent, knowing 
 their business, and all the points and articles of the account 
 in rents, outlays, and returns of stock. And the accounts 
 
APPENDIX F. 539 
 
 ought to be heard at each manor, to know the profit and loss, 
 and then can the Auditors take inquest of the doings which 
 are doubtful, and hear the plaints of each plaintiff and make 
 the fines. The steward ought to be joined with the Auditors, 
 not as head or companion of the account, but as sub-ordinate, 
 for he must answer to the Auditors on the account for his 
 doings, just as another. It is not necessary so to speak to 
 the Auditors about making audits, for they ought to be so 
 prudent, and so faithful, and so knowing in their business, 
 that they have no need of others' teaching about things con- 
 nected with the accounts." 
 
APPENDIX G. 
 
 CORPORATION TAX LAW. 
 
 Text of the law, criticism thereof from an account- 
 ing standpoint, and suggestions for making the 
 returns required from corporations. 
 
 With the exception of the period from 1817 to 1842, Great 
 Britain has taxed incomes for over a century, the need of 
 funds caused by the Napoleonic wars being the occasion of the 
 first income tax law, which was enacted in 1798. The law in 
 force at the present time was passed in 1853, having been mod- 
 ified in some particulars by amendments at different times 
 since. 
 
 In the United States an income tax was proposed in 1812 
 as a means of raising revenue for the prosecution of the war 
 with Great Britain, but it found no favor with Congress, and 
 the act was never passed. In 1861, however, at the time of 
 the Civil War, a law taxing incomes was enacted, such taxation 
 continuing until 1872, when it was discontinued. 
 
 In 1894 there was passed by Congress, as a part of the 
 Wilson tariff bill, a law levying a tax of two per cent, on 
 incomes in excess of $4,000. This act was declared unconsti- 
 tutional by the Supreme Court as being in conflict with clause 
 4 of Article I, Section IX of the Federal constitution, which 
 reads : 
 
 " No capitation or other direct tax shall be laid, unless in 
 proportion to the census or enumeration hereinbefore directed 
 to be taken." 
 
 540 
 
APPENDIX G. 541 
 
 The income tax levied in the years 1862 to 1872 was open to 
 the same constitutional objection, but this seems to be one of 
 the cases in which the Supreme Court reversed itself, the older 
 law having been upheld by that Court. 
 
 The act passed by Congress in 1909 as a part of the Payne 
 tariff bill, taxing the net income of corporations, is — any legal 
 fiction to the contrary notwithstanding — an income tax, though 
 in this instance limited to the " net income " of corporations 
 as distinguished from all incomes, whether of corporations, 
 partnerships or individuals. This is quite clearly seen when 
 a comparison is made of the act recently passed with that sec- 
 tion of the act of 28th August, 1894, pertaining to the tax on 
 the net profits or income of corporations. On this point it is 
 interesting to note the opinion of one of the leading experts 
 on taxation in this country — Lawson Purdy, President of the 
 Department of Taxes and Assessment of New York City, 
 who is quoted as saying : " From whatever point of view the 
 Federal Corporation Tax is studied, it is unworkable and un- 
 just; it encroaches upon the powers of the States; it is not 
 productive of revenue ; it is needlessly inquisitorial ; the pub- 
 licity required is rash and dangerous in the extreme. Its 
 name is a subterfuge. It is an income tax, and not an excise 
 tax. It has the vices of income taxes, without the merits 
 of an income tax scientifically framed." 
 
 The text of the present law, being Section 38 of the Payne 
 tariff bill, approved 5th August, 1909, is as follows: 
 
 Sec. 38. That every corporation, joint stock com- * Corporations 
 pany or association, organized for profit and having Subject to Tax. 
 a capital stock represented by shares, and every in- 
 surance 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, 
 
 ♦The marginal notes are not an integral part of the law, but have been added for 
 the convenience of the reader. 
 
542 
 
 AUDITING. 
 
 J Per Cent, of 
 '*Net Income" 
 Over $5,000. 
 
 Foreign 
 Corporations. 
 
 Corporations 
 Not Subject to 
 Tax. 
 
 How ''Net In- 
 come" Shall Be 
 Ascertained. 
 
 shall be subject to pay annually a special excise 
 tax with respect to the carrying on or doing busi- 
 ness by such corporation, joint stock company or 
 association, or insurance company, 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 re- 
 ceived by it as dividends upon stock of other cor- 
 porations, joint stock companies or associations, or 
 msurance companies, subject to the tax hereby im- 
 posed; or if organized under the laws of any for- 
 eign 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 as- 
 sociations, or insurance companies, subject to the 
 tax hereby imposed : Provided, however, That noth- 
 ing in this section C9ntained shall apply to labor, 
 agricultural or horticultural organization, or to 
 fraternal beneficiary societies, orders, or associa- 
 tions operating under the lodge system, and provid- 
 ing for the payment of life, sick, accident, and' 
 other benefits to the members of such societies, 
 orders, or 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. 
 
 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: 
 
 ist. All the ordinary and necessary expenses ac- 
 tually paid within the year out of income in the 
 maintenance and operation of its business and prop- 
 erties, including all charges^ such as rentals or 
 franchise payments, required to be made as a con- 
 dition to the continued use or possession of prop- 
 erty. 
 
 2nd. All losses actually sustained within the year 
 and not compensated by insurance or otherwise, in- 
 cluding a reasonable allowance for depreciation of 
 property, if any, and in the case of insurance com- 
 panies 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. 
 
APPENDIX G. 
 
 543 
 
 3rd. 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, out- 
 standing 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 
 deposits. 
 
 4th. 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 condi- 
 tion to carrying on business therein. 
 
 5th. All amounts received by it within the year 
 as dividends upon stock of other corporations, joint 
 stock companies or associations, or insurance com- 
 panies, 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: 
 
 I St. All the ordinary and necessary expenses act- 
 ually paid within the year out of earnings in the 
 maintenance and operation of its business and prop- 
 erty within the United States and its Territories, 
 Alaska, and the District of Columbia, including all 
 charges such as rentals or franchise payments re- 
 quired to be made as a condition to the continued 
 use or possession of property. 
 
 2nd. All losses actually sustained within the year 
 in business conducted by it within the United 
 States or its Territories, Alaska, or the District of 
 Columbia not compensated by insurance or other- 
 wise, including a reasonable allowance for depre- 
 ciation of property, if any, and in the case of insur- 
 ance 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 indebtedness to an amount of such 
 bonded ^ and other indebtedness, not exceeding the 
 proDortion 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 
 -iny 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. 
 
 How "Net 
 Income" of 
 
 Foreign Corpo- 
 rations Shall Be 
 Ascertained. 
 
544 
 
 AUDITING. 
 
 Tax to Be 
 Computed on 
 " Net Income " in 
 Excess of 
 $5,000. 
 
 Annual Reports 
 Required. 
 
 What Shall Be 
 Included in 
 Returns. 
 
 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. 
 
 5th. All amounts received by it within the year 
 as dividends upon stock of other corporations, joint 
 stock companies or associations, and insurance com- 
 panies, 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 forego- 
 ing paragraphs of this section, the sum of five thou- 
 sand dollars, and said tax shall be computed upon 
 the remainder of said net income of such corpora- 
 tion, joint stock company or association, or insur- 
 ance company, for the year ending December thirty- 
 first, nineteen hundred and nine, and for each cal- 
 endar 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 com- 
 panies or associations, and insurance companies, sub- 
 ject 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 association, or insurance company, or- 
 ganized 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 Com- 
 missioner of Internal Revenue, with the approval of 
 the Secretary of the Treasury, shall prescribe, set- 
 ting forth : 
 
 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 com- 
 pany 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 
 
APPENDIX G. 1 545 
 
 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 ; also the amount received by such cor- 
 poration, joint stock company or association, or in- 
 surance company, within the year by way of divi- 
 dends 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 business and 
 properties of such corporation, joint stock company 
 or association, 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 prop- 
 erty, 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. 
 
 5th. The total amount of all losses actually sus- 
 tained during the year and not compensated by in- 
 surance 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 an- 
 nuity 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, or- 
 ganized 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 bj' insurance or other- 
 wise, stating separately any amounts allowed for 
 depreciation of property, and in the case of insur- 
 ance 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 corpora- 
 tion, joint stock company or association, or insur- 
 ance 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 
 
546 
 
 AUDITING. 
 
 Incorrect 
 Reports. 
 
 Failure to 
 Report. 
 
 Books May Be 
 Examined. 
 
 Aid of Courts 
 May Be Invoked. 
 
 insurance company, 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 indebtedness not exceeding 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. 
 
 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 sep- 
 arately the amount so paid by it for taxes imposed 
 by the government of any foreign country as a con- 
 dition to carrying on business therein. 
 
 8th. The net income of such corporation, joint 
 stock company or association, or insurance company, 
 after making the deductions in this section author- 
 ized. All such returns shall, as received, be trans- 
 mitted forthwith by the collector to the Commis- 
 sioner of Internal Revenue. 
 
 Fourth. Whenever evidence shall be produced 
 before the Commissioner of Internal Revenue which, 
 in the opinion of the Commissioner, justifies the be- 
 lief 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, joint stock company or association, or 
 insurance company, has failed to make a return as 
 required by law, the Commissioner of Internal Rev- 
 enue may require from the corporation, joint stock 
 company or association, or insurance company mak- 
 ing 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 a return where none has been made, is here- 
 by 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 associa- 
 tion, or insurance company, and to require the at- 
 tendance of any officer or employee of such cor- 
 poration, joint stock company or association, or in- 
 surance company, and to take his testimony with 
 reference to the matter required by law to be 
 included in such return, with power to administer 
 oaths to such person or persons; and the Commis- 
 sioner of Internal Revenue may also invoke the 
 
APPENDIX G. 
 
 547 
 
 aid of any court of the United States having juris- 
 diction to require the attendance of such officers or 
 employees and the production of such books and 
 papers. Upon the information so acquired the Com- 
 missioner of Internal Revenue may amend any re- 
 turn or make a return where none has been made. 
 All proceedings taken by the Commissioner of In- 
 ternal Revenue under the provisions of this section 
 shall be subject to the approval of the Secretary of 
 the Treasury. 
 
 Fifth. All returns shall be retained by the Com- Additions to 
 missioner of Internal Revenue, who shall make as- Tax for False 
 sessments thereon; and in case of any return made q^. ^q Return. 
 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 sick- 
 ness or absence of an officer of such corporation, 
 joint stock company or association, or insurance 
 company, required to make said return, or for other 
 sufficient reason, the collector may allow such fur- 
 ther time for making and delivering such return 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 amount so added shall 
 be paid by the delinquent corporation, joint stock 
 company or association, or insurance company, im- 
 mediately upon notice given by the collector. All 
 assessments shall be made, and the several corpora- 
 tions, joint stock companies or associations, or insur- 
 ance 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 
 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 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 association, 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 Delinquent 
 after notice and demand thereof by the collector, Taxes. 
 there shall be added the sum of five per centum on 
 the amount of tax unpaid and interest at the rate 
 
548 
 
 Reports 
 
 Public 
 
 Records. 
 
 Information 
 Not to Be 
 Divulged. 
 
 AUDITING. 
 
 Penalty for 
 False or No 
 Return. 
 
 Internal 
 Revenue Laws 
 Apply. 
 
 United States 
 Circuit and Dis- 
 trict Courts Have 
 Jurisdiction. 
 
 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 information obtamed 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 di- 
 rection of the President ; and any offense against 
 the foregoing provision 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 associations, 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 company or associa- 
 tion, or insurance company, shall be liable to a pen- 
 alty 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 intent to de- 
 feat 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 prose- 
 cution. 
 
 All laws relating to the collection, remission, and 
 refund of internal revenue taxes, so far as applicable 
 to and not inconsistent with the provisions 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 dis- 
 trict 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. 
 
APPENDIX G. 549 
 
 As is under our American legislative methods so fre- 
 quently the case, those best qualified to advise on special phases 
 of contemplated legislation are not consulted, and laws are 
 passed which impose an tmnecessary burden on those subject 
 thereto. An apt illustration of this is the corporation tax act 
 just quoted. 
 
 To an accountant perusing the provisions of this act, it is 
 at once evident that no member of the profession could have 
 been consulted when the law was framed. Inasmuch as the 
 determination of the tax to be paid under a law of this kind is 
 primarily an accounting question, the omission to call into con- 
 sultation those most competent to advise as to the simplest 
 basis on- which to determine the amount of tax to be paid by 
 the corporations is incomprehensible. It is obvious that no 
 consideration at all was paid to the convenience of those who 
 must pay this tax, viz., the corporations. Even if the law is 
 declared to be unconstitutional, no decision can be expected 
 until after the time for the first returns has passed. 
 
 As soon as the text of the proposed law was published, 
 however, public accountants were quick to perceive the gross 
 errors from an accounting standpoint contained therein, and a 
 copy of the following letter, signed by twelve prominent firms 
 of New York City, was sent to each member of Congress and 
 to the Attorney General of the United States : 
 
 New York City, July 8th, 1909. 
 Dear Sir: 
 
 On reading the text of the proposed corporation tax law, as reported 
 in the Commercial and Financial Chronicle of July 3rd, 1909, we have 
 formed the opinion that some of its provisions are absolutely impos- 
 sible of application, 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, 
 . . . ascertained as provided in the foregoing paragraphs of this 
 section, the sum of $5,000.00, and said tax shall be computed upon the 
 remainder of said net income of such corporation ... for the 
 
S50 AUDITING. 
 
 year ending December 31st, 1909, and for each year thereafter, and on 
 or before the ist day of March, 1910, and the ist 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 corpo- 
 rations is not, and for business reasons camiot 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. 
 
 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," 
 
 (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 neces- 
 sarily 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 l 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 complete confusion between income and income received, 
 which can only lead to endless complication. 
 
 Two methods may be adopted for taxation purposes, either 
 
 (1) To tax the difference between actual cash receipts on revenue 
 account and actual cash payments on revenue account, which difference 
 will seldom if ever represent the profits of a manufacturing concern ; or 
 
APPENDIX G. 55 1 
 
 (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 when- 
 ever 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 
 suggest that in the said clauses i, 2 and 3 of paragraph 2, the words 
 "actually paid" and "actually sustained" be changed to read "actu- 
 ally 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, 
 
 Deloitte, Plender, Griffiths & Co., 49 Wall Street. 
 
 Price, Waterhouse & Co., 54 William Street 
 
 Haskins & Sells, 30 Broad Street. 
 
 Lybrand, Ross Bros. & Montgomery, 165 Broadway. 
 
 Wilkinson, Reckitt Williams & Co., 52 Broadway. 
 
 NiLES & NiLES, III Broadway. 
 
 GuNN, Richards & Co., 43 Wall Street. 
 
 Edward P. Moxey & Co., 165 Broadway. 
 
 Geo. H. Church, 55 Wall Street. 
 
 Barrow, Wade, Guthrie '& Co., 25 Broad Street. 
 
 LooMis, CoNANT & Co., 30 Broad Street. 
 
 Marwick, Mitchell & Co., 79 Wall Street. 
 
 To this letter the Attorney General replied as follows : 
 
 Washington, D. C, July 12th, igog. 
 Messrs. Deloitte, Plender, Griffiths & Co., 
 
 49 Wall Street, New York. 
 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 
 are absolutely impossible of application and others violate all the 
 accepted principles of sound accounting. 
 
552 AUDITING. 
 
 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 institu- 
 tion, 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 com- 
 pany subject to the law, from " all sources during such year." It has 
 been the uniform practice 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 cal- 
 endar 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 proposed law, particularly as the 
 return requires statements of actual receipts and payments, and not, as 
 you recommend in your communication, of expenses " incurred," inter- 
 est " 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 advisedly. The same may be said with respect to losses ac- 
 tually 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 addi- 
 tion of the word " received" ; and in Clause 3, Paragraph 3, it refers to 
 "gross income received," and you comment: "There is here a com- 
 plete 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 
 
APPENDIX G. 553 
 
 " gross income received," his doubt would be removed by the provisions 
 in Paragraph 3 of Cause 31 
 
 Your further statement that " as accountants actively engaged in the 
 audit and examination of a number of varied businesses and enter- 
 prises, we imhesitatingly say that the law as framed is absolutely 
 impossible of 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 statement of objections made in your letter is entirely 
 insufficient to support the conclusion which you express. 
 I am, respectfully yours, 
 
 (Signed) Geo. W. Wickersham, 
 
 Attorney-General. 
 
 On receipt of this letter the following reply was written, 
 giving in somewhat more detail the reasons for stating that the 
 law as framed was practically impossible of application : 
 
 New York, July 21st, 1909. 
 Hon. Geo. W. Wickersham, 
 
 Attorney-General of the United States, 
 Washington, D. C 
 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 incurred. 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 
 
554 AUDITING. 
 
 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 frequently termed "Net Income"; and the accounts 
 of corporations prepared in the regular course of business for their 
 respective fiscal years are and always have been accepted as the basis 
 of taxation, subject to minor provisions 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 altogether 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 collected in cash or not, and of Expenses, whether paid or 
 not, which in both cases accrued 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 con- 
 siderably 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 distribu- 
 tion between Capital and Income of large payments for stores, the 
 ultimate use of which is not and cannot be known at the time of pay- 
 ment. 
 
 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 Account is a practical impossibility at any time. Cash Re- 
 ceipts arising from sales of products can be ascertained without much 
 difficulty beyond requiring considerable extra work. But no system 
 
APPENDIX G 555 
 
 of accounting can give even approximately " the ordinary and necessary 
 expenses actually paid within the year out of Income in the main- 
 tenance 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 accounting 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 pur- 
 chased 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 user 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 in 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 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 fur- 
 ther details here ; but the facts must, in the opinion of any one familiar 
 with the operations and accounts of a compHcated modern manufactur- 
 ing concern, fully justify the conclusions which we expressed in our 
 letter of July 8th, and which we now emphatically endorse. 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 institu- 
 tion, 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 
 to arriving at a satisfactory solution, which we are satisfied can be 
 
55^ AUDITING. 
 
 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, 
 Deloitte, Plender, Griffiths & Co., 49 Wall Street. 
 Price, Waterhouse & Co., 54 William Street 
 Haskins & Sells, 30 Broad Street. 
 LyBRAND, Ross Bros. & Montgomery, 165 Broadway. 
 Marwick, Mitchell & Co., 79 Wall Street. 
 NiLEs & NiLES, III Broadway. 
 GuNN, Richards & Co., 43 Wall Street. 
 Edward P. Moxey & Co., 165 Broadway. 
 Barrow, Wade, Guthrie & Co., 25 Broad Street. 
 LooMis, CoNANT & Co., 30 Broad Street. 
 SuFFERN & Son, 165 Broadway. 
 
 The following letter from the Attorney General closed the 
 correspondence : 
 
 Washington, D. C, July 22, 1909. 
 Messrs. Deloitte, Plender, Griffiths & Co., 
 49 Wall Street, 
 New York. 
 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 
 corporation tax amendment bill on the basis of such proposition. 
 Respectfully yours, 
 
 (Signed) Geo. W. Wickersham, 
 
 Attorney-General. 
 
 It is unfortunate that the scientific income earned and ex- 
 pense incurred basis of determining the net income subject to 
 taxation should have been abandoned for the crude and — as 
 
APPENDIX G. 557 
 
 pointed out in the accountants' letter — unsatisfactory, if not im- 
 possible, cash receipts and payments basis, which the Attorney- 
 General states is contemplated by the law. Particularly strange 
 is this, as the framers of the present law had the Act of 1894 
 to guide them. That act unquestionably contemplated a true 
 income and expense basis of determining the net profits or 
 income, as it stated inter alia: 
 
 " The net profits or income of all corporations, companies or 
 associations shall include the amounts paid to shareholders, or 
 carried to the account of any fund, or used for construction, 
 enlargement of plant, or any expenditure or investment paid 
 from the net annual profits made or acquired by said corpora- 
 tions, companies or associations." 
 
 An examination of the forms required under that act by the 
 Commissioner of Internal Revenue further substantiates this 
 view. The wording of the following items in the form of 
 return are in point: 
 
 " I. Gross receipts, credits, earnings and gains from any 
 business. ... 
 
 " 2. From interest or coupons, due or paid on any 
 bonds. . . . 
 
 " 4. From undivided profits of any corporation, company or 
 association. 
 
 " 8. From interest received or accrued on all notes, bonds, 
 mortgages, or other forms of indebtedness not included in the 
 foregoing items. 
 
 " 10, From rents received or accrued." 
 
 The following items among the " Operating and Business 
 Expenses " likewise show the intention to have the net income 
 ascertained on a scientific basis : 
 
 " I. Interest paid or accrued within the year on bonded or 
 other indebtedness. 
 
55^ AUDITING. 
 
 " 7. Cost price of material purchased for manufacture or 
 resale, not increasing stock on hand (at beginning of year)." 
 
 It is true that that act, or the interpretation of it, was also 
 open to some criticisms from an accounting standpoint, but not 
 to the same extent as the present law which, instead of being 
 an improvement on the previous act, is the reverse. 
 
 Aside from the direct accounting principles involved, one 
 of the most serious objections to the basis prescribed by the 
 law for making returns thereunder is that the returns made will 
 be quite independent of and not at all in agreement with the 
 books of account of the corporations making the returns. Of 
 course, if any corporation should keep its books on a purely 
 cash basis without attempting to determine its actual profit, 
 then its books would, or, rather, should, be in agreement with 
 the government returns. It is doubtful, however, whether the 
 accounting officers of such a corporation (if such a one exists) 
 would know enough to fill out the simplest kind of blanks so 
 that the government officials would probably find quite as much 
 trouble in verifying its returns as may be expected in the case 
 of the ordinary corporation. Hence it will not be possible for 
 the Internal Revenue Commissioner or his agents to verify the 
 returns without exhaustive examination of all the details on 
 which they are based. Even in the case of wilful misstate- 
 ments it will be extremely difficult, if not in many instances 
 impossible, to prove fraudulent intent, as the excuse of clerical 
 error or mistaken opinion can be pleaded to the limit, there 
 being no permanent records of the corporation to which the 
 returns must conform, as there would be if the returns were 
 required on the same basis on which the accounts of corpora- 
 tions are ordinarily kept. 
 
 Government control is being pushed rather far, but one can- 
 not even consider the possibility of corporations being required 
 to keep two sets of books — one to meet the actual necessities 
 of business conditions and the other to satisfy the possible 
 curiosity of an Internal Revenue Collector. Followed out to 
 
APPENDIX G. 559 
 
 its logical conclusion, the collector would have to compare the 
 two sets of books so that in time there would be several hun- 
 dred thousand inspectors. 
 
 At the time of signing the tariff bill the President made the 
 following statement : 
 
 " The corporation tax is a just and equitable excise measure, 
 which, it is hoped, will produce a sufficient amount to prevent 
 a deficit, and which, incidentally, will secure valuable statistics 
 and information concerning the many corporations of the coun- 
 try and will constitute an important step toward that degree 
 of publicity and regulation which the tendency in corporate 
 enterprises in the last twenty years has shown to be necessary." 
 
 Subsequently, in a speech made at Denver, he stated : 
 
 "Another feature of it (the corporation tax law) is that, 
 incidentally, it will give the Federal Government an opportunity 
 to secure most valuable information in respect to the conduct 
 of corporations, their actual financial condition, which they are 
 required to show in general terms in a public return." 
 
 And he is also quoted as saying, " It is . . . in effect 
 an income tax — that is, it taxes earnings actually made." 
 
 From the letters quoted, it is quite clear that the returns will 
 have little statistical or informative value, as they will not show 
 the true net income of the corporations for any fiscal period, 
 nor will there be any showing of the " actual financial condi- 
 tion " of the corporations, as the only return of that kind called 
 for by the law is a statement of the paid-up capital stock and 
 bonded and other indebtedness, no mention whatever being 
 made of assets or surplus. 
 
 If the government is really seeking to secure greater or 
 more effective control of corporations — and the President says 
 this is the case — an excellent opportunity to exercise indirectly 
 effective control of the accounts of corporations is being 
 neglected. The powers to prescribe the form in which the ac- 
 
560 AUDITING. 
 
 counts of interstate common carriers shall be kept, to compel 
 the submission of reports prepared therefrom, and to inspect at 
 its pleasure the records kept by carriers, are rightly considered 
 as among the most comprehensive powers enjoyed by the Inter- 
 state Commerce Commission. While the submission of reports 
 prepared on a true income and expense basis and for the cor- 
 poration's fiscal year would not have given the government the 
 same control of the accounting of other corporations as it has 
 of common carriers, it would have resulted in an annual return 
 which would show the real operations of the corporation and 
 one which could be readily verified by reference to the corpora- 
 tion's books of account. Still more important would be the 
 indirect control acquired of the course to be followed with 
 regard to such questions as those of depreciation of property 
 and losses sustained. By providing that only such depreciation 
 and losses as were actually written off on the books would be 
 allowed as deductions from gross income, it would be to the 
 interest of directors to face the facts and take cognizance of 
 them in the corporation's records instead of ignoring them to 
 the ultimate detriment of the stockholders' interests, as has 
 happened in more than one instance in the past. By fixing, on 
 the other hand, maximums of depreciation which would be 
 allowed as deductions in any one year, the possible tendency to 
 write off excessive amounts for depreciation of property, thus 
 reducing the net income on which the tax would be payable 
 and incidentally creating large secret reserves, would be cor- 
 rected. 
 
 Coming finally to the question of how to make the returns 
 required by the law, it may as well be frankly admitted that, 
 as pointed out in the letters of the accountants, it will, in the 
 case of many corporations, be impossible to comply literally 
 with the requirements of the act and that the returns must, 
 therefore, necessarily be only an approximation. 
 
 In view of the proposed testing of the constitutionality of the 
 law, it is suggested that all statements, reports and payments 
 (if any) be made under protest. 
 
APPENDIX G. 561 
 
 Insurance Companies; In the case of banks and insurance 
 companies, aside from the unnecessary additional labor 
 involved, there will be little or no difficulty in making a return 
 which will be in precise compliance with the law as interpreted 
 in the Attorney-Generars letter. In fact, insurance companies, 
 whose accounting systems are quite crude as compared with 
 those of railroads and industrial corporations, can base their 
 returns on the so-called " Income and Disbursements " state- 
 ment required by the State Insurance Departments. The fol- 
 lowing modifications will, however, be necessary: 
 
 Elimination from the " disbursements " — which 
 become " deductions " from the gross income under 
 the wording of the act — dividends paid to or allowed 
 to policy-holders (including the " dividends " of mu- 
 tual fire insurance companies), and in the case of 
 stock companies dividends paid to stockholders. 
 
 Add to the disbursements for the purpose of ob- 
 taining the total deductions from the gross receipts 
 which will be allowed — 
 
 Additions to the Insurance Reserve * 
 
 Dividends received upon stocks of corporations sub- 
 ject to the corporation tax. 
 
 No specific provision is made for the deduction of the amor- 
 tized premium on bonds, though it might be construed as 
 coming within the scope of " all losses actually sustained within 
 the year." In one sense it may be argued that it is a loss, vis., 
 that the premium is by the effluxion of time disappearing. The 
 fact is that it is being gradually repaid to the investor — ^in 
 this case the insurance companies — and thus the true net 
 income is not shown until there is deducted from the gross 
 amount of interest received on bonds that portion which repre- 
 
 *To judge from the wording of the act, ''required by law," the amount of reserves 
 made in excess of the standard required by the State Insurance Departments will not 
 be allowed as a deduction. 
 
^^2 AUDITING. 
 
 sents the partial return of principal, or the premium written off 
 during the year on an amortization basis. 
 
 Banks and Trust Companies: In the case of banks and trust 
 companies, from the gross amount of receipts from interest, 
 discount and other sources, there will be deductible expenses 
 and taxes paid, interest on deposits (presumably interest cred- 
 ited to depositors* accounts will be considered as " actually 
 paid "), losses due to uncollectible loans and the like, an allow- 
 ance for depreciation of banking house and fixtures and divi- 
 dends received on corporation stocks owned. If real estate, 
 other than the banking house, be owned, it would also be 
 proper to claim deduction for depreciation of any buildings, as 
 well as of any ground, which had depreciated in value. 
 
 Mercantile Corporations, whose operations are confined 
 strictly to trading, will find comparatively few difficulties in 
 preparing the returns required. The figures will naturally be 
 worked up from the cash-book, all receipts being carefully 
 scrutinized so as to eliminate from the so-called " gross 
 income " all items which are in the nature of capital receipts, 
 such as additional capital invested, money borrowed, real estate 
 or fixtures sold, investments (if any) matured or sold, etc. 
 The payments will necessarily have to be analyzed so as to 
 state the totals of the various classes of deductions allowed, 
 and to eliminate those items which will not be allowed as 
 deductions from the gross income. This last group will consist 
 of such items as loans repaid, interest on bonded or other 
 indebtedness exceeding the paid-up capital stock of the corpo- 
 ration, dividends paid, etc. To the permissible deductions as- 
 certained from the cash-book will be added an allowance for 
 depreciation of property and any losses sustained which are 
 not represented by payments made in the year. From an ac- 
 counting standpoint, however, there are certain losses for 
 which credit should not be claimed. Since the " gross income " 
 is to be only that actually collected in cash, losses by bad debts 
 would not be a proper deduction. Depreciation in the value 
 of merchandise would not be a proper deduction, as the entire 
 
APPENDIX G. 563 
 
 cost of merchandise will be claimed as a deduction when pur- 
 chased. 
 
 Transportation and Public Utility Corporations will find 
 their principal difficulty in making returns to lie in the treat- 
 ment of the payments for stores, *. e., materials and supplies 
 which are not purchased for immediate consumption, but which 
 are added to the stock necessary to be kept on hand and forth- 
 with lose their identity. The subsequent use of the stores at 
 times long subsequent to the date of purchase renders it imprac- 
 ticable, in fact, impossible, to trace most of the stores purchased 
 to their ultimate consumption and thus determine whether the 
 payments therefor are " ordinary and necessary expenses 
 . . . in the maintenance and operation of its business and 
 properties," or are for construction purposes which would not 
 be allowed as a deduction from the gross income receipts. 
 Hence, it follows that a makeshift must be adopted. Two op- 
 tional courses might be followed; either to analyze all pay- 
 ments for stores, eliminating such as are for articles which it 
 is quite certain will be eventually used for construction pur- 
 poses, the remaining payments being considered as on account 
 of maintenance or operation, or to deduct from the total pay- 
 ments for stores purchased, the total of stores issued and 
 charged to construction during the year. Either course will 
 not be entirely satisfactory, but over a period of years the latter 
 would give more accurate results. If the former course be 
 followed, many payments will remain in the expense section, 
 which may in part, at least, eventually find their way into con- 
 struction. This is unavoidable, as so many articles purchased 
 for the storeroom are used for both construction and mainte- 
 nance purposes. 
 
 In any event it will be necessary to analyze all the payments, 
 and, as most companies of this kind charge the bulk of them 
 to Accounts or Vouchers Payable, the voucher register will 
 have to be consulted for the distribution between construction, 
 operation and maintenance, taxes, rentals, interest and stores. 
 
$64 AUDITING. 
 
 With some companies the distinction between rentals and 
 interest will be a very important one, owing to the limit placed 
 on the amount of debt, the interest on which will be allowed 
 as a deduction from gross receipts. When interest on the 
 bonds of an underlying company is paid in pursuance of a 
 lease by which the parent company pays such interest as a 
 rental of the property, such interest payments should be 
 treated as rental, and the bonded debt of the underlying com- 
 pany would not form a part of the debt on which interest is 
 only allowed as a deduction up " to an amount of such bonded 
 or other indebtedness not exceeding the paid-up capital stock 
 of such corporation/' Where there has been an actual merger, 
 however, and the bonds of one company have been assumed 
 by another, the interest paid thereon would come under the 
 head of interest instead of rentals, and such bonds would be 
 taken into consideration in determining the amount of indebt- 
 edness on which interest will be allowed as a deduction from 
 ' gross income received. 
 
 Having analyzed the cash receipts and payments, and ascer- 
 tained the totals of income receipts and the various classes of 
 payments allowed to be deducted therefrom, it then becomes 
 necessary to consider any other deductions than actual pay- 
 ments which the act may permit to be made. The one which 
 suggests itself perhaps first is depreciation of property, the act 
 providing for the deduction of " a reasonable allowance for 
 depreciation of property." It is to be hoped that this clause 
 of the corporation tax law will give a decided impetus to the 
 recognition of and provision for depreciation of plant. The 
 i;endency of many corporations in the past has been rather to 
 ■'ignore depreciation than to make an excessive allowance there- 
 for. Companies operating under limited-term franchises for 
 ^which value has been paid would also be warranted in deduct- 
 ing a proportionate part of such cost of franchise. Losses 
 " actually sustained " are also to be deducted from gross 
 income received. Judging from the Attorney-General's letter 
 of 1 2th July, in the case of, say, damages due to accidents, the 
 
APPENDIX G. 565 
 
 deductions should be based on the accidents occurring within 
 the year rather than on damages actually paid, thus getting 
 away from the receipts and payments basis and getting nearer 
 a true income and expense basis. Losses due to bad debts 
 would not be a proper deduction, as only earnings actually col- 
 lected in cash are included in the '* gross income." Whether 
 the amortization of discount on bonds will be permitted to be 
 deducted from gross income may perhaps be disputed. Cer- 
 tainly, from an accounting and common-sense standpoint, it 
 ought to be, as it is, after all, only interest paid in advance. 
 
 Manufacturing or Industrial Corporations will find the most 
 difficulty in making a return which will comply even approxi- 
 mately with the intent of the new law as expressed by the 
 Attorney-General. The reasons which render a literal compli- 
 ance impossible are very clearly and forcibly stated in the 
 accountants' letter of 21st July. Practically all the factors 
 already considered in connection with other classes of corpora- 
 tions will have to be considered. An analysis of all cash re- 
 ceipts and payments will have to be made, eliminating from the 
 receipts everything which is not on income account. From 
 the payments will have to be eliminated all items not applying 
 on income account, such as loans paid off, dividends paid, and 
 all items which can be identified as being clearly construction 
 or plant items. With many companies which have a complete 
 stores system and buy materials and supplies in large quan- 
 tities, using them for both manufacturing saleable products 
 and additions to plant, as well as manufacturing machinery 
 for their own use, there will be made payments for labor, 
 materials, supplies, etc., the ultimate disposition of which it 
 will be impossible to foretell or trace. With regard to these 
 items, all that can be done is to exercise the best judgment 
 possible and to do it in good faith. The separation must needs 
 be quite arbitrary in many instances, and naturally income 
 should have the benefit of every doubt. 
 
 The analysis of the receipts and payments will be followed 
 by the determination of other deductions than actual cash 
 
566 AUDITING. 
 
 payments from gross income permitted by the law. Deprecia- 
 tion of property and any losses not represented by actual pay- 
 ments during the year will come under this head. Corporations 
 which have issued bonds at a discount will also need to con- 
 sider the disposition of the discount, which has already been 
 mentioned. 
 
 The blank forms on which the Commissioner of Internal 
 Revenue will require returns to be made have not yet been 
 issued, and probably will not be until 1910, as the first year 
 for which the tax must be paid is the year ending 31st Decem- 
 ber, 1909. These forms will probably be accompanied by rules 
 to be observed in making the returns. If, however, the meth- 
 ods followed in preparing the forms correspond with the 
 attitude of the Attorney-General (evidenced by his corre- 
 spondence with the accountants), it may be impossible to even 
 approximate a correct return without prohibitive expense. It 
 is to be expected that, on account of the difficulties mentioned 
 herein and for other reasons, the law will be subjected to 
 judicial scrutiny and interpretation, which may modify mate- 
 rially some of the impressions first created by the law. Cer- 
 tainly, no law which so flagrantly violates the principles of 
 true accounting will stand unchanged for many years. 
 
 It is to be hoped, however, that the foregoing criticisms and 
 suggestions will be found interesting and perhaps instructive 
 to the student, even though the act of August 5, 1909, may be 
 materially modified before this volume has been off the press 
 for a month. 
 
APPENDIX G. 566 a 
 
 Since the foregoing was written, the Treasury Department 
 has issued full instructions covering the returns required, 
 which are reprinted here, with the exception of certain details 
 of interest only to the tax collectors. 
 
 It will be noted that the Attorney-General of the United 
 States and the Secretary of the Treasury have arrived at 
 interpretations of the law diametrically opposite to each other. 
 Under the circumstances it will not be strange if accountants 
 and corporation officers arrive at the conclusion that the 
 framers of the law could not possibly have produced more 
 confusion, no matter how hard they tried. 
 
 The Treasury Department's Explanation 
 
 OF THE 
 
 Federal Corporation Tax Law 
 
 Regulations Under Which the Law W^ill Be Administered 
 
 Corporation Excise Tax 
 
 PREPARATION OF BLANKS AND REGULATIONS. 
 
 In the preparation of blanks and regulations for the admin- 
 istration of the Corporation Excise Tax, provided for in section 
 38 of the tariff act of August 5, 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 unrea- 
 sonable interference with ordinary practices of business. The 
 standard adopted in making the regulations was that they 
 
566 b AUDITING. 
 
 should be fair, just, and reasonable to the taxpaying corpora- 
 tions as well as to the Government. 
 
 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 con- 
 strued liberally for the purpose of producing revenue for the 
 Government. 
 
 2. That the real intent of the law is to collect a tax of i 
 per cent on the net income, less $5,000 of the individual cor- 
 poration, joint-stock company, 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 in- 
 come received from these outside sources, whereas there might 
 be some question as to whether or not such items would be 
 included in the expressions " 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 
 misapprehension 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 
 
APPENDIX G. 566 c 
 
 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 statu- 
 tory deductions therefrom would not leave net receipts, but 
 would leave merely an arbitrary sum. It also appeared from 
 calculations that if these interpretations 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 identical with " gross profits " and 
 "net profits," they are yet more embrasive and consequently 
 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 authorizes certain de- 
 ductions such as " ordinary and necessary expenses actually 
 paid out of earnings in the business and property of such 
 corporations * * * 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 expres- 
 sions 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 income 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 
 
566 d AUDITING. 
 
 great number of accountants throughout the country declared 
 that the law was impossible of administration, and if their in- 
 terpretation of the law had been correct, there would indeed 
 have been the most serious difficulty. 
 
 Upon first reading the law and studying the authorities re- 
 lating to the language used, it would appear that the words 
 admit of no interpretation other than that an item must have 
 been evidenced by the actual disbursement of cash, or some- 
 thing of equal value, before it could be considered 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 cor- 
 poration concerned solely with its own accounts from which 
 alone the law requires this return for taxation to be 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 impos- 
 sible 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 busi- 
 ness transacted by the corporation is done in cash and the trans- 
 actions 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 represented 
 by cash transactions will vary from the real net income some- 
 what in proportion as the business transacted by the corpora- 
 tion varies from the absolutely cash basis. 
 
 This is viewing the matter in its simplest aspect. When we 
 contemplate 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 ; 
 
APPENDIX G. 566 e 
 
 its many advances of funds and long-deferred statements of 
 accounts, purchases of supplies and materials at one time, 
 which are mixed 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 cash- 
 book and to settle the accounts of such complicated actions of 
 a corporation on the cash book instead of on the ledger, would 
 result in inextricable confusion, uncertainty, and inaccuracy, 
 and the friction occasioned the business world by such an at- 
 tempt 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 deter- 
 mine whether or not an item is to be taken account of in mak- 
 ing 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 tax- 
 payers (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, wilful intent to de- 
 fraud the Government of revenue. If an honest error is made 
 in calculating 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, 
 
566 f AUDITING. 
 
 the regulations 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 require- 
 ment is simply that the transaction be so recorded that accurate 
 returns can be made therefrom and verified when necessary. 
 
 In many corporations, mercantile and manufacturing partic- 
 ularly, 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 inventory 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 sup- 
 plies, etc. 
 
 Great numbers of communications have been received rela- 
 tive to the publicity clause. While there is apparently some 
 inconsistency between 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 prinicipal 
 office of the corporation is located, 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 : 
 
APPENDIX G. 566 g 
 
 REGULATIONS 
 
 Relative to 
 
 Excise Tax on Corporations, Joint Stock Companies, Associa- 
 tions and Insurance Companies. 
 
 Imposed by authority of Section 38, Act of August 5, 1909. 
 
 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 in- 
 surance companies described (except those specifically ex- 
 empted), 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 companies, which shall be calculated by subtracting 
 from the gross income received from all sources during the 
 year certain deductions specifically set forth in the statute. 
 
 Every corporation, joint-stock company, association, or in- 
 surance company 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, associa- 
 tions or insurance companies organized under the authority 
 of the United States or any State or Territory thereof, includ- 
 ing Alaska and District of Columbia, such net income relates 
 not only to the business carried on within the confines 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 countries the terms " Gross income," " Net 
 income," and " Authorized deductions " relate only to business 
 transacted within the United States or any state or territory 
 thereof. 
 
566 h AUDITING. 
 
 Article 2. — Gross Income. 
 
 The following definitions and rules are given for deter- 
 mining the gross income of the various classes of corporations : 
 
 I A. Banks and other financial institutions. — Gross income 
 consists of the gross revenue derived from the operation and 
 management of the business and property of the corporation 
 making the return, together with all amounts of income (in- 
 cluding dividends received on stock of other corporations, 
 joint-stock companies, associations, and insurance companies 
 subject to this tax) derived from all other sources, as shown 
 by the entries on its books from January i to December 31 of 
 the year for which return is made. 
 
 I B. Insurance companies. — Same as I A above. 
 
 2. Transportation companies. — Same as i A above. 
 
 3. Manufacturing companies. — Gross income received dur- 
 ing 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 manu- 
 factured 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 manufac- 
 tured 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 
 
APPENDIX G. 566! 
 
 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 inventory 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 dividends received on stock of other 
 corporations, joint-stock companies, associations, and insurance 
 companies subject to this tax. In determining this amount no 
 account shall be taken of allowances for depreciation of prop- 
 erty, nor for losses sustained which are to be taken account of 
 in ascertaining the net income subject to tax under the proper 
 heading in the authorized deductions. 
 
 5. Miscellaneous. — Gross income consists of the gross rev- 
 enue 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 corporations, joint-stock companies, 
 associations, and insurance companies subject to this tax) 
 derived 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 corporation, 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 corporation 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, 1909, the difference between the selling price 
 and the buying price shall constitute an item of gross income 
 
566 j AUDITING. 
 
 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 determine 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 de- 
 termining 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 defini- 
 tions above, applicable thereto. 
 
 Article 3. — 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; (second) all losses actually sustained 
 within the year and not compensated by insurance or other- 
 wise, including a reasonable allowance for depreciation of prop- 
 erty, 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 ; (third) interest 
 
APPENDIX G. 566 k 
 
 actually paid within the year on its bonded or other indebted- 
 ness 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, outstand- 
 ing 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 deposits." 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 derived 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 associations, 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 transacted and its 
 capital invested within the United States and any of its Terri- 
 tories, Alaska, and the District of Columbia. 
 
 Also that : 
 
 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 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 
 
5661 AUDITING. 
 
 of each of such corporations, joint-stock companies, or asso- 
 ciations, 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 4. — Deductions. 
 
 The specified deductions actually paid within the year, set 
 forth in the statute and as described in Article 3 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 business 
 and properties of the corporation should not, however, embrace 
 allowances for depreciation of fixed property which are other- 
 wise to be 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 ascertaining 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 mate- 
 rials and supplies only to the amount that the same are actu- 
 ally 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 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, 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 differ- 
 ence between the cost value and salvage value of the property 
 
APPENDIX G. 566 m 
 
 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 following 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 pay- 
 ments 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 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 ascertainment of gross income, but must 
 be made out of accumulative allowances deducted for depre- 
 ciation in current and previous years. 
 
 Article 5. — Inventories. 
 
 It will be noted that an inventory or its equivalent of mate- 
 rials, 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 opera- 
 tion. 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 re- 
 turn on the regular form. Such supplemental statement shall 
 be verified under oath by the treasurer or principal financial 
 officer in submitting the same. 
 
 Where any item under any of the deductions is of an un- 
 
566 n AUDITING. 
 
 usual nature a special explanatory note referring to such 
 item shall be made and attached 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 company, 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 there- 
 after, 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 insur- 
 ance 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 Secretary of the Treasury, 
 shall prescribe. 
 
 Each return so made is required to set forth : 
 
 (a) The total amount of the paid-up capital stock of such 
 corporations, joint-stock companies or associations, or insur- 
 ance companies, outstanding at the close of the year ; 
 
 (b) The total amount of bonded and other indebtedness of 
 such corporation, joint-stock company or association, or insur- 
 ance 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, re- 
 ceived 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 
 
APPENDIX G. 5660 
 
 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 4), also the net income after such de- 
 ductions have been made. 
 
 Article 6. 
 
 Under the authority conferred by this act forms of return 
 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 ex- 
 cepted, on or before January i, 19 10, and on or before Janu- 
 ary I of each year thereafter. Failure on the part of any cor- 
 poration, joint-stock company, association, or insurance com- 
 pany liable to this tax, to receive a blank form will not 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. Corporations not supplied with the proper forms for 
 making the return should make application therefor to the col- 
 lector of internal revenue in whose district is located its prin- 
 cipal 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 ac- 
 counting will be required by the Department. However, the 
 business transacted by corporations, 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 
 examination 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 can not be accepted. 
 
566 p AUDITING. 
 
 Corporations organized during the year or going into liqui- 
 dation during the year should nevertheless render a sworn 
 return on the prescribed form. 
 
 Royal E. Cabell, Commissioner. 
 
 Approved : 
 
 Franklin MacVeagh, 
 
 Secretary of the Treasury. 
 
INDEX. 
 
 Accountants, Opinion of, on extent of investigations, 319 
 Accounts, Corrections in, 31 
 
 of Architects, Points in the audit of, 165 
 
 Banks, Points in audit of, 114 
 
 Branch Establishments, 82 
 
 Breweries, Points in audit of, 96 
 
 Building and Loan Societies, Points in audit of, 161 
 
 Cash Businesses, Points in audit of, 93 
 
 Churches, Points in audit of, 159 
 
 Clubs, Points in audit of, 99 
 
 Colleges and Schools, Points in audit of, 160 
 
 Collieries, Points in audit of, 109 
 
 Commercial, .91 
 
 Consignments, 81 
 
 Contractors, Points in audit of, 95 
 
 Cost, 59 
 
 Electric Lighting Bodies, Points in audit of, 141 
 " Railways, Points in audit of, 146 
 
 Executors and Trustees, Points in audit of, 155 
 
 Financial Undertakings, Points in audit of, 114 
 
 Fire Insurance Companies, Points in audit of, 122 
 
 Gas Companies, Points in audit of, 139 
 
 Gold Mines, &c., 112 
 
 Hotels, Points in audit of, 98 
 
 Institutions, Points in audit of, 158 
 
 Insurance Companies, Points in audit of, 121 
 
 Investment Companies, 126 
 
 Lawyers, Points in audit of, 164 
 
 Life Insurance Companies, Points in audit of, 124 
 
 Manufacturing Traders, Points in audit of, 92 
 
 Medical Men, Points in audit of, 160 
 
 Merchants, Wholesale, Points in audit of, 91 
 
 Mines, Points in audit of, 109 
 
 Newspapers, Points in audit of, 107 
 
 567 
 
568 INDEX. 
 
 Accounts of Public Authorities, Points in audit of, 152 
 
 Public Service Corporations, Points in audit of, 132 
 Publishers, Points in audit of, 105 
 Railways, Points in audit of, 142 
 Restaurants, Points in audit of, 99 
 Retailers, Points in audit of, 92 
 Shipping Companies, Points in audit of, 150 
 Single-ship Companies, Points in audit of, 152 
 Speculative Finance Companies, Points in audit of, 132 
 Steam Railways, Points in audit of, 143 
 Street Railways, Points in audit of, 145 
 Stockbrokers, Points in audit of, 129 
 Stores and Stock, Points in audit of, 71 
 Theatres, Points in audit of, loi 
 Theatrical Companies, Points in audit of, 103 
 Traders, Points in audit of, 73, 211 
 
 Trust and Investment Companies, Points in audit of, 126 
 Water Companies, Points in audit of, 141 
 Published form of. Auditor's duty as regards, 206, 239 
 Action against auditors. Procedure by way of, 310 
 Additions and betterments expenditures, Steam Railways, 143 
 
 " Checking, 32 
 Adjustments of profits in investigations as to profits, 322 
 Advantages of a "completed audit," 28 
 " "continuous audit," 28 
 
 " an audit, 25 
 
 " double-entry bookkeeping, 246 
 
 " keeping proper Stock Accounts, 7 1 
 
 " making each Ledger self -balancing, 66 
 
 " opening Suspense Accounts, 76 
 
 " statistical information, 215 
 
 Tabular Cash Book, 60 
 " use of an Audit Note Book, 17 
 
 After discovered evidence, 205 
 Agency Accoimts, Treatment of, 81 
 Agents' Accounts, 80 
 
 Agreement, Partnership, Points to be considered in drawing up, 85 
 Agreements, Hire-Purchase, 185 
 
 " Partnership, 85 
 
 Alterations during audit. Methods of detecting fraudulent, 45 
 Amateur auditors, 266 
 American Malting case, 180, 250, 386 
 Amortization, 50 
 Amount of reserve necessary for insurance company, 122 
 
INDEX. 569 
 
 Annuity system of depreciation, 190 
 
 Annuity Tables, Charles E. Sprague on, 190 
 
 Anticipated Profits, 181 
 
 Appleton V. American MalUng Company, case considered, 250 
 
 Apportionment between capital and revenue, Examples of, 136 
 
 " of capital and income in Executorship Accounts, 155 
 
 Architects, Accounts of, Points in audit of, 165 
 Arrears of cumulative preference dividends, Treatment of, 184 
 ■Assets and liabilities. Reason for transposing in Balance Sheet, 217 
 " " secret reserves, Fluctuations in, 203 
 " Auditor's duty with regard to writing-up of, 203 
 ' ' Definition of term, 216 
 " in books of account. Methods of depreciating, 187, 217 
 
 Legality of writing-up, 203 
 " of bank. Method of vouching, 11^4 
 " Outstanding, Verification of, 182 
 " Principle in valuation of, 169, 225 
 " Side of Balance Sheet, 220 
 " Verification of existence of, 114, 174 
 Astrachan Steamship Company, case considered, 311 
 Attorney-General of U. S. Correspondence re Corporation Tax, 549 
 Audit, system of conducting an, 1 7 
 clerks, Qualifications of, 275 
 completed. Disadvantages of a, 28 
 continuous. Description of, 28 
 
 " Disadvantages of a, 28 
 
 Detection of fraud as an object of an, 22 
 fee. Treatment of, in accounts, 184 
 Importance of ascertaining general system under, 24 
 Instructions as to preparation for, 88 
 
 " for, 20 
 
 Limitation of, 270 
 Method of an, 28 
 
 New, Duties of principal at commencement of, 2 1 
 not an insurance against fraud, 270 
 Note Book, description of, 17, 19 
 
 form of, 18 
 Object and scope of an, 22 
 of brewery, saloons in connection with, 97 
 Capital Stock Accoimts, 49 
 Corporations Accounts, 48 
 payments for dividend or interest, 5 1 
 Purchase Ledgers of retailer, 93 
 railway, Programme of, 145 
 Sales Ledgers of retailer, 92 
 
570 . ' INDEX. 
 
 Audit of trust companies, Valuation of investments in, 121 
 " Stamps, Rubber, 42 
 
 " System on which, should be conducted, 17 
 Auditing, examination questions, 510 
 
 Auditor, Liability of, with regard to predecessor's errors, 33 
 of a bank, Liability of, 114 
 
 " company, Position of an, 26 
 on behalf of creditors. Position of, 278 
 Position of, who disagrees with directors, 284 
 Qualifications of an, 274 
 Removal of, how effected, 284 
 Responsibility of, for errors, 299 
 Right of, as to resignation, 282 
 to a firm, Position of, 277 
 " an individual. Position of, 276 
 Auditor's duties, 292 
 
 " duty as regards examination of Pass Books in bank audit, r il 
 
 " " '* " form of published accounts, 206, 239 
 
 *' " " " individual partners, 277 
 
 ** " " " secret reserves, 204 
 
 " " " " ultra vires Acts, 205 
 
 " " " " valuation of stock-in-trade, 1 74 
 
 " " "to verification of cash in hand, 301 
 
 " " " " public, 126 
 
 ' " •' who is refused permission to inspect Minute Book, 2o« 
 
 ' " " with regard to book debts, 176 
 
 " " " " writing up of assets, 204 
 
 " examination of the books, Extent of, 23 
 
 ' " liability for defalcations of employees, 290 
 
 " " Limits to, 311 
 
 " position, 276 
 
 " responsibility for values, Decision in London and General Bank 
 
 case, 173, 358 
 ' ' right of inspection of Minute Book of company, ao i 
 
 " " to his remuneration, 276 
 
 Auditors, Amateur, 266 
 
 " Civil liability of, 309 
 
 " Criminal liability of, 307 
 
 " Distinction between various classes of, a66 
 
 " Duties of, 285 
 
 " in the 13th Century, 537 
 
 " Liabilities of, 290 
 
 " Liability of, for libel, 305 
 
 " Methods of proceeding against, civilly, 309 
 
 " OflBcial, 271 
 
INDEX. 571 
 
 Auditors, position under English Companies Act, 286 
 " "Privilege" of, 283, 306 
 
 " Procedure by way of action against, 309 
 
 " Professional, 269 
 
 Rights of, 285 
 Bad and doubtful debts. Provision for, 196 
 " " " " Treatment of, 77 
 
 " debts, Extract from Accountant on provision for, 197 
 " " in investigations as to profits. Method of dealing with, 332 
 " " Methods of providing for, 77 
 " " Provision for, by percentage of sales, 78 
 " figures in accoimts, 31 
 Balance Sheet, Comparison of Ledgers with previous, 32 
 " " Consolidated, 239 
 
 " " Criticism of American, 221 
 
 Forms of, 217, 411, 427, 430, 436, 454, 459, 463, 484-492 
 " " Principles of compiling a, 169 
 
 * " " Reason for transposing liabilities and assets in, 2 1 7 
 
 " " Responsibility for values in, 173 
 
 " Sheets in investigations, Necessity of inspecting, 327 
 Balances, Necessity for checking starting, 32 
 Balancing books. Importance of, exactly, 46 
 
 " Methods of, 46 
 
 Bank Account, Method of vouching, 40 
 " assets of, Method of vouching, 114 
 " auditor of a. Liability of, 114 
 " balance. Verification of, 177 
 " borrowers' statements. Forms, 409, 495 
 " charges. Advisability of checking, 62 
 " Pass Book, English system contrasted with American, 40 
 " " " Ideal way of writing up, 40 
 
 " " " Method of checking, with Cash Book, 40, 122 
 
 " Points in Revenue Account of, 119 
 " Reports, national, Forms, 404, 455 
 Bankers' credit information committee report, 26 
 Banks, accoimts of. Points in audit of, 114 
 " certified borrowers' statements for, 26 
 " Corporation Tax Law, 562 
 " methods of computing interest, 342 
 Beneficiaries, Procedure on division of estate between, 155 
 Bills of exchange, Method of vouching, 43 
 " receivable. Examination of, 44 
 " " Verification of, 179 
 
 Bonds in Balance Sheet, Treatment of, 225, 230 
 " Treatment of, discount on, 50 
 
57^ INDEX. 
 
 Book debts, Auditor's duty with regard to, 176 
 
 " " Verification of, 176 
 
 Bookkeepers, Instructions for, 5 7 
 Bookkeeping by Card system, 70 
 " Criticism of card, 7 1 
 
 " Double-entry, Advantages of, 246 
 
 Loose-Leaf system of, 70 
 Borrowers' statements, Forms, 409, 495 
 
 Branch Accounts of banks, Extent of auditor's examination of, 114 
 " establishments. Accounts of, 82 
 
 " Stock Accotints in, 84 
 
 Breweries, accounts of. Points in audit of, 96 
 Brewery, audit of, Saloons in connection with, 97 
 
 plant. Depreciation in connection with, 97 
 Building and Loan Associations, Accoimts, Frauds in, 161 
 
 Forms, 405, 459 
 Points in the audit of, 161 
 Buildings and land, Verification of, 190 
 
 " Depreciation of, 190 
 Burleigh, Herbert Alfred v. Ingram Clark Lint,, Decision in, 374 
 By-Laws, Necessity of perusing, 53 
 Calculating interest, rules for, 342 
 Calling back postings, 29 
 Cancellation of vouchers, 42 
 
 Capital and income in Executorship Accounts, Apportionment of, 155 
 revenue. Distinction between, 85, 109, 136, 142, 144 
 " Examples of apportionment between, 137 
 expenditure, Treatment of discounts on, 61 
 ' " in Balance Sheet, Treatment of, 230, 247 
 
 " Stock accounts, 75 
 Capital Stock Accounts, audit of, 49 
 Capitalization of preliminary expenses, 171, 200 
 Car Trust Bonds, Treatment of, 185 
 Card bookkeeping, 70 
 
 Cash and trade discount, distinction to be made between, 198 
 Book, Form of 60 
 
 " Method of checking Bank Pass Book with, 39 
 " Tabular, Advantages of, 60 
 businesses, Accounts of. Points in audit of, 94 
 in hand. Auditor's duty as to verification of, 303 , 
 
 Decision, with regard to verification of, 373 
 " Verification of, 178, 303 
 
 receipts, Method of vouching, 34 
 Certificate after investigation. Extent of, 316, 325, 338 
 " of incorporation, Necessity of perusing, 53 
 
INDEX. 573 
 
 -Certification, Extent of auditor's, 290 
 
 " Legislative requirement, 280 
 
 C. P. A. examination questions, 510 
 
 Charitable institutions. Accounts of. Points in the audit of, 1 58 
 Charter, necessity of perusing, 53 
 Checking additions, 32 
 
 Churches, accoimts of, Points in the audit of, 1 59 
 City accoimts, Forms, 410, 421, 497 
 Civil liability of auditors, 309 
 Clerks, Qualifications of, 275 
 Clubs, accounts of. Points in audit of, 99 
 Coal mines, accounts of. Points in audit of, 109 
 Code of professional ethics, 380 
 
 Colleges and schools, accounts of. Points in the audit of, 160 
 Columnar Cash-book, advantage of, 60 
 Commercial Law, examination questions, 511 
 Commission on the underwriting or placing of shares, 49 
 
 " profits from, Treatment of, on underwriting shares, 259 
 
 Companies (English) Act, extracts from, 253, 286 
 Comparative Depreciation Table, 189 
 Comparison of Ledgers with previous Balance Sheet, 32 
 
 " Revenue Accounts in investigations as to profits, 329 
 
 "Completed audit," Advantages of a, 28 
 
 " " Disadvantages of a, 29 
 
 Confirmation of customers' accounts, 37, 117 
 Consignment Accounts, 81 
 
 Method of vouching, 45 
 Consolidated Balance Sheets and Profit and Loss Statements, 239 
 " " " A. Lowes Dickinson's opinion on, 239 
 
 Contingent assets in Balance Sheet, 229 
 
 " liabilities in Balance Sheet, Treatment of, 238 
 
 " " Verification of, 184 
 
 "Continuous audit," advantages of a, 28 
 " " description of, 28 
 
 " " disadvantages of a, 28 
 
 Continuing Partners, duties of, 337 
 Contractors, Accounts of, Forms of, 214 
 
 " " Points in audit of, 95 
 
 •Contracts, Uncompleted, Valuation of, 180 
 Conversions, Treatment of expenditure on, 139 
 Cooper, John A., Code of Ethics, 380 
 -Copyrights, Depreciation of, 195 
 
 " Valuation of, 106 
 
 Corporation Accounts, audit of, 48 
 
 Tax Law, U. S. (1909), 540 
 
574 INDEX. 
 
 Corrections in accounts, 31 
 
 Cost Account of shipping company, Meaning of, 151 
 ** Accounts, 59 
 
 ** ** Necessity of having proper, 59, 95, 214 ^ 
 
 Coupon Accounts, 52 
 Coupons, Method of filing cancelled, 52 
 
 Creditors, Position of auditor on behalf of, 278 j 
 
 Criminal liability of auditors, 307 
 Criticism of American Balance Sheets, 221 
 
 *• Card Bookkeeping, 70 
 
 Current assets, 170, 172, 221 
 Customers' accoimts. Manipulation of, 35 
 
 '• " Verification of, 37 
 
 "Dating forward," Danger of, invoices for purchases, 185 
 Dead or minimum rents in Mining Accounts, Definition, of no 
 Debts, book, Auditor's duty with regard to, 176 
 Ledger, Doubtftil, Explanation, of, 78 
 " owing to company. Treatment of, in Balance Sheet, 223 
 Decision in American Malting case, 251 
 
 '* " Appletonv. American Malting Company, 2 $0 
 
 *• *' Dovey and others v. Cory, 348 
 
 '* " DumhelVs Banking Company, Lim., 308 . 
 
 • * " Foster v. The New Trinidad Lake A sphalte Company, Lim. ,249 
 
 *• " Herbert Alfred Burleigh v. Ingram Clark, Lim., 374 
 
 " ** Lee V. Neuchatel Asphalte Company, Lim., 247 
 
 *• " London and General Bank case as to auditor's responsibility 
 
 for values, 173. 3 5^ 
 " '* London Oil Storage Company, Lim., v. Seear, Hasluck & Co., 
 
 with regard to verification of cash in hand, 373 
 *• " Lubbock V. The British Bank of South America, Lim., 248 
 
 " Martin v. Isitt, 299, 374 
 ** *' Moxham and others v. Grant, 313 
 •' " Newton v. Birmingham Small Arms Co., Lim., 377 
 " " Richardson V. Buhl, 2 S7 
 '* " Short & Compton v. Brackett, 319, 372 
 •• " Smith V. Sheard, 376 
 " " The Astrachan Steamship Company, Lim., and others v. Har- 
 
 mood-Banner & Son, 311 
 ** *' The Edinburgh United Breweries, Lim., v. James A. Molleson 
 
 {Nicholson's Trustee), 317 
 *• " The Irish Woollen Company, Lim., v. Tyson, 367 
 " " The Kingston Cotton Mill Company, Lim., 363 
 " " The Leeds Estate Building and Investment Society, Lim., v. 
 
 Shephard, 310, 358 
 *• *' Wilde and others v. Cape & Dalgleish, 299, 367 
 
INDEX. 575 
 
 Decision in Wilmer v. McNamara & Co., Lim., 248 
 Defalcations of employees, Auditor's liability for, 299 
 Definition, Buckley's, of term "profits," 254 
 of depreciation, 187 
 
 minimum or dead rents in Mining Accounts, 110 
 term "assets," 216 
 " "profits," 253, 254, 391 
 " "Reserve Fund," 228 
 vouching, 34 
 
 words "sale as a going concern," 169 
 Departmental Accounts, 94 
 
 Ledger, 67 -*^" 
 
 Depositors' Pass Books, Inspection of, 117, 120 
 Depreciating assets in books of accoimt, Methods of, 187, 217 
 Depreciation allowed for in Electric Lighting Accounts, Instances of, 142 
 " and fluctuation in values. Distinction between, 171, 187 
 
 " Annuity system of, 190 M 
 
 Definition of, 187 W 
 
 " Fund necessary where company holds lands on lease, 140 
 
 " in connection with brewery plant, 97 
 
 " Instalment system of, 190 
 
 " investigations as to profits, Method of dealing with, 331 
 
 " Necessity of providing for, 217 
 
 Depreciation of copyrights, 195 
 " buildings, 190 
 
 " electric lighting plant. Necessity of increased, 142 
 
 " " Railways, 147 
 
 " furniture, 194 
 
 " goodwill, 190 
 
 " horses, 191 
 
 " investments, 191 
 
 " landlord's fixtures, 196 
 
 " lands, 189 
 
 leasehold land and premises, 191 
 " leases, 66 
 
 " licensed houses, 192 
 
 " machinery, 192 
 
 *' . mines, 112, 193 
 
 " patents, 194 
 
 " plant, 194 
 
 " under hire-purchase agreements, 186 
 ships, 195 
 
 street railway companies, 147 
 theatrical plant, 195 
 • " Sinking fimd system of, 188 
 
576 INDEX. 
 
 Depreciation of table, Comparative, 189 
 Detection of errors in books in investigations, 317 
 " fraud as an object of an audit, 22 
 
 " "in investigations, 322 
 
 Devising system of books. Points to be considered in, 55 
 Dickinson, A. Lowes, Introduction, 1 1 
 
 Consolidated Balance Sheets, 239 
 Exhaustion of Minerals, 112 
 Marketable Investments, 224 
 Sinking Funds, 229 
 Stocks on hand, 221 
 Dilapidations to be considered in depreciation of leasehold premises, 191 
 Directors' fees, Vouching of, 199 
 
 Directors, Position of auditor who disagrees with, 285 
 Disagreement of auditor with directors, 285 
 Discount and interest, Treatment of, 50, 61, 342 
 Discounts, Method of providing for outstanding, 198 
 " on capital expenditure, Treatment of, 62 
 
 Dividends or interest. Audit of payments for, 51 
 " out of capital. What is payment of, 247 
 
 " regtilations respecting same in English Companies Act, 253 
 
 " to be paid only from earnings or surplus ,247 
 
 " Treatment of arrears of cumulative preference, 184 
 
 Double entry bookkeeping, Advantages of, 246 
 Doubtful, and bad debts, Provision for, 196 
 " " " " Treatment of, 77 
 
 " Debts Ledger, Explanation of, 77 
 Dovey v. Cory, case considered, 248 
 DumbelVs Banking Company, Lint., case considered, 308 
 Duties of auditors, 23, 119, 285 
 
 '* liquidating and continuing partners, 337 
 
 " official auditors, 271 
 
 " principal at commencement of new audit, 21 
 
 Edinburgh United Breweries, Lim., &c., v. James A. Molleson, case 
 
 considered, 317 
 Electric Light, Heat and Power Companies, Forms, 400, 427 
 Electric Lighting Accounts, depreciation allowed for in, 142 
 " " •' Points in audit of, 141 
 
 " Railways, Depreciation of, 147 
 " " Forms, 399, 422 
 
 " " Points in audit of, 146 
 
 Employees, defalcations of, Auditor's liability for, 299 
 Errors, Localizing, 47 
 
 " Responsibility of auditors for, 307 
 Ethics, Code of Professional, 380 
 
INDEX. 577 
 
 Ethics, Rules, 384 
 
 Examination questions, C. P. A., 510 
 
 Executors and trustees, accounts of. Points in audit of, 155 
 
 Executorship Accounts, Apportionment of capital and income in, 155 
 
 Expenditure on conversions, Treatment of, 139 
 
 " " new works, in place of old. Treatment of, 137 
 
 Expenses, Distinction between various classes of, 260 
 " of revenue, 260 
 
 " which may be spread over a number of years, 260 
 
 Extent of an auditor's examination of the books, 23 
 " auditor's certification, 290 
 " certificate after investigation, 316, 324, 337 
 " investigations as to profits, 316 
 Fees, directors'. Vouching of, 199 
 Figures, Bad, in accoimts, 31 
 
 Finance companies, speculative, accounts of. Points in audit of, 126 
 Financial tmdertakings, accounts of, Points in audit of, 114 
 Fire Instirance Companies, accounts of, Points in audit of, 122 
 Firm, Position of auditor to a, 277 
 Fixed and floating assets, Distinction between, 170 
 " assets in Balance Sheet, Treatment of, 220 
 " " Definition of, A. L, Dickinson, 224 
 
 " " Valuation of, 171, 263 
 
 Fixtures, landlord's, Depreciation of, 196 
 Floating and fixed assets, Distinction between, 171 
 '* assets in Balance Sheet, Treatment of, 221 
 " " Valuation of , 172, 263 
 
 Fluctuation and depreciation in values, Distinction between,'! 71, 187 
 •' in assets and secret reserves, 203 
 
 " of values in accounts. Treatment of, 187 
 
 Foreign exchanges, Treatment of, 204 
 Forfeited shares, 202 
 Form of Audit Note Book, 
 Balance Sheet, 208 
 Cash Book, 60 
 
 published accounts. Auditor's duty as regards, 206, 239 
 Revenue Account for traders considered, 209 
 for Borrowers from Banks, 409, 495 
 " Building and Loan Associations, 405, 459 
 " Electric Light, Heat and Power Companies, 400, 427 
 " Electric Railway Companies, 399, 422 
 " Gas Companies, 401, 436 
 Insurance Companies, 405, 463 
 Mtinicipal Reports, 410, 421, 497 
 " National Bank Reports, 404, 455 
 
578 INDEX. 
 
 Form of Public Service Corporations, 399, 421 
 " " Steam Railroads, 396, 411 
 " " Water Supply Enterprises, 401, 441 
 Forms of accounts for contractors, 214 
 
 " " manufacturers, 212, 407, 484 
 
 " " mines, 215 
 
 " " traders, 211, 408, 492 
 
 Foster V. The New Trinidad Lake Asphalte Co., Ltd., decision, 249 
 Fraud, Audit not an insurance against, 271 
 
 " Detection of, as an object of an audit, 22 
 " in investigations, Detection of, 322 
 Fraudulent alterations during audit, Methods of detecting, 43 
 Funds, meaning of word, 232 
 Furniture, Depreciation of, 194 
 
 Future Deliveries, dangers of anticipating profits on, 181 
 Gas companies, accounts of, Points in audit of, 139 
 
 " " Forms, 401, 436 
 
 General accounting, examination questions, 511 
 Gold Mines, &c., accounts of, Points in Audit of, 112 
 Goodwill, Depreciation of, 190 
 
 " in accounts. Treatment of, 190 
 " Meaning of, in Balance Sheet, 190 
 Governmental supervision, 273 
 Gross Profit, Meaning of term, 211 
 
 " use in checking stock accounts, 71 
 Heat and Power Companies, Forms, 400, 427 
 Hire-purchase agreements, 185 
 
 " " Depreciation of plant under, 194 
 
 Holding Companies, Consolidated Balance Sheets in connection with, 241 
 Horses, Depreciation of, 191 
 Hospitals, Points in audit of, 158 
 Hotels, accounts of, Points in audit of, 98 
 
 Hutchinson & McElheny v. American Malting Co., decision, 386 
 Imprest system of petty cash, 56, 62 
 
 Income and capital. Apportionment of, in Executorship Accounts, 155 
 Individual, Position of auditor to an, 276 
 Inspection of Minute Book, 201 
 securities, 117, 162 
 Instalment system of depreciation, 188 
 Instructions as to general system of accounts, 57 
 " preparation for audit, 88 
 " for audit, 17, 20 
 
 Insurance Company, Amount of reserve necessary for, 121 
 " Companies, accounts of, Points in audit of, 121 
 " " Corporation Tax Law, 561 
 
INDEX. 579 
 
 Insurance Companies, Life, Forms, 405, 463 
 
 " funds in shipping companies, Limitations of, 150 
 Interest and discount. Treatment of, 61 
 " Calculation of, 342 
 
 " or dividends. Audit of payments for, 51 
 " Rules governing, 355 
 Internal check, system of. Essential points in, 56 
 Interstate Commerce Commission, powers of, 133 
 Investigation, Extent of certificate after, 317, 324, 337 
 Length of period to be covered by, 325 
 Limits of an, 321 
 " Method of procedure in an, 325 
 
 " on behalf of a projected company, 320 
 
 Investigations as to profits, Adjustments of profits in, 332 
 
 " " " Comparison of Revenue Accounts in, 327 
 
 " " " Examination of Revenue Accounts in, 327 
 
 " " " Exceptional losses and profits in, 334 
 
 " " " Extent of, 316 
 
 " " " General course of procedure in an, 327 
 
 " " " Inspecting Balance Sheets in, 327 
 
 " Method of dealing with bad debts in, 331 
 " " " Method of dealing with depreciation in, 331 
 
 " Detection of errors in books in, 317 
 
 " fraud in, 322 
 " Opinion of accountants on extent of, 319 
 
 ** Purposes for which, are made, 315 
 
 Investment Companies, Accounts of. Points in audit of, 124 
 " Fluctuation Accounts, Meaning of, 232 
 
 " of Reserve Funds, 236 
 
 Investments, Depreciation of, 191 
 
 " in Balance Sheet, Treatment of, 223 
 
 " " stocks and shares. Verification of, 175 
 
 " Valuation of, in audit of Investment Companies, 126 
 
 Invoices for purchases. Danger of "dating-forward," 183 
 Irish Woollen Company, Lim., case considered, 300, 367 
 Journal, Method of vouching, 42 
 
 Use of the, 41, 79 
 Kingston Cotton Mills, case considered, 295, 363 
 Land and buildings, Verification of, 174 
 Landlord's fixtures, Depreciation of, 196 
 Lands, Depreciation of, 189 
 
 " on lease. Depreciation Fiind necessary, 191 
 Lawyers, Accoxmts of. Points in audit of, 164 
 Leasehold land and premises. Depreciation of, 191 
 Leases, Depreciation of, 66 
 
580 INDEX. 
 
 Ledger, Advantages of making each self -balancing, 66 
 " doubtful debts, Explanation of, 77 
 " Tabulation of the, 48 
 Ledgers, Accounts for which Tabular, are suitable, 67 
 
 Comparison of, with previous Balance Sheet, 32 
 Purchase, of retailer. Audit of, 93 
 Sales, of retailer, Audit of, 92 
 Self -balancing, 47, 57, 66, 83 
 Tabular, 68 
 
 Lee V. Neuchatel Asphalte Company, Lint., case considered, 247 
 Leeds Estate Building and Investment Society v. Shephard case considered, 
 
 310. 358 
 Legislative requirements, 280, 296 
 Length of period to be covered by investigation, 325 
 Liabilities and assets in Balance Sheet, reason for transposing, 217 
 Contingent, Verification of, 184 
 in Balance Sheet, Treatment of contingent, 238 
 " " " " general, 226 
 
 " of auditors, 27, 290 
 
 " outstanding. Verification of, 183, 230 
 
 Liability, auditors for libel, 305 
 
 " Civil, of auditors, 309, 356 
 
 " Criminal, of auditors, 307 
 
 " Insurance Companies, Accounts of, 125 
 
 of auditor of a bank, 114 
 " " with regard to predecessor's errors, 33 
 
 Libel, Liability of auditor for, 305 
 
 Life Insurance Companies, accounts of, Points in audit of, 124, 225 
 " " " Forms, 405, 463 
 
 " " " Reserve fund of, 232 
 
 Limitations of audit, 272 
 
 " Tabular Ledgers, 68 
 
 Limits of an investigation, 321 
 " to auditor's liability, 312 
 Liquidating Partners, Duties of, 337 
 List of books, preparation of, 24 
 
 " statistical books which companies should keep, 52 
 Localization of errors in Trial Balance, 47, 79 
 London and General Bank case as to auditor's responsibility for values. 
 
 Decision in, 173, 293, 358 
 London Oil Storage Co., Lim., v. Seear, Hasltick & Co., with regard to 
 
 verification of cash in hand, Decision in, 303, 373 
 Loose-Leaf System of bookkeeping, 70 
 
 Lubbock V. British Bank of South Africa, Lim., case considered, 248 
 Machinery and plant. Verification of, 177 
 
INDEX. 581 
 
 Machinery, Depreciation of, 192 
 Magazines, accounts of, Points in audit of, 107 
 Manufacturers, accounts of. Forms of, 212, 407, 484 
 Manufacturing and trading profits. Distinction between, 172 
 " Corporations, Corporation Tax Law, 565 
 
 *' traders, accounts of. Points in audit of, 92 
 
 Martin v. Isitt, case considered, 299, 374 
 Mechanical bookkeeping, 40f 84 
 
 Medical men, accounts of. Points in the audit of, 166 
 Mercantile Corporations, Corporation Tax Law, 562 
 
 " Enterprises, Forms, 407, 484 
 
 Merchants, Wholesale, accoimts of. Points in audit of, 91 
 Meter rents, Method of vouching income from gas rates and, 140 
 Mines, accotints of. Forms of, 215 
 
 " " Points in audit of, 109 
 
 " Depreciation of, no, 193 
 Mining Accounts, Definition of minimum or dead rents in, 109 
 Minute Book, Auditor's duty, who is refused permission to inspect, 201 
 " " Inspection of, 53, 201 
 
 " " Liabilities recorded therein, 184 
 
 " " of company. Auditor's right of inspection of, 201 
 
 Montgomery, Robert H., Accounts of Public Service Corporations, 134 
 
 " " Accounts of New York City, 154 
 
 Mortgages, Treatment of, in Balance Sheets, 227, 231 
 Moxham v. Grant case considered, 313 
 Municipal accotmts, 152 
 
 " ownership, 132, 152 
 " reports, Forms, 410, 421, 497 
 National Banks Reports, 404, 455 
 "Net Profit" and "Profit safely divisible," distinction between, 264 
 
 " " meaning of term, 216, 252 
 Newspapers, accounts of. Points in audit of, 107 
 Newton v. Birmingham Small Arms Co. decision, 377 
 New works in place of old. Treatment of expenditure on, 137 
 Nicholson's, Trustee, &c., case, 317 
 Notes payable. Vouching of, 44 
 
 " promissory. Calculation of interest on, 342 
 " receivable. Vouching of, 44 
 Object and scope of an audit, 22 
 " of investigations, 3 1 5 
 
 Revenue Accounts, 209 
 Official auditors. Duties of, 271 
 
 Opinion of accoimtants on extent of investigations, 319 
 Outstanding Assets, 182 
 
 discounts, 198 
 
582 INDEX. 
 
 Outstanding liabilities, 183 
 
 Partners, Auditor's duty as regards individual, 277 
 
 " retiring, Duties to, 338 
 
 Partnership agreement, Points to be considered in drawing up, 85 
 
 " agreements, 85 
 
 Pass Books in bank audit, Examination of , 1 1 6 
 Patents, Depreciation of, 194 
 
 Payment of dividends out of capital, What is, 248 
 Payments for dividends or interest, Audit of, 51 
 Pennsylvania C. P. A. questions, 513 
 
 " Legislature, Bill introduced in 1905 session, 280 
 
 Percentage of profits, Method of calculating, 73 
 Periodicals, Accounts of. Points in audit of, 107 
 Petty Cash Book, Method of keeping, 38, 62 
 
 " " Imprest system of, 57, 63 
 . " " Method of vouching, 38, 94 
 " payments, Treatment of, 63 
 Plant and machinery. Verification of, 177 
 
 " brewery. Depreciation in connection with, 96 
 " Depreciation of, 194 
 
 " Necessity of increased depreciation of electric lighting, 142 
 " theatrical, Depreciation of, 195 
 Postings, Calling back, 29 
 Powei Companies, Forms, 400, 427 
 Preliminary expenses, Capitalization of, 172, 200 
 
 " " in accounts. Treatment of, 104, 200, 264 
 
 " " Vouching of, 200 
 
 Premium income of insurance office. Method of vouching, 123 
 Premiums received on issue of shares. Treatment of, 49, 202 
 Preparation for audit, Instruction as to, 88 
 Previous Balance Sheets, Treatment of, 32 
 Principal, Duties of, at commencement of new audit, 2 1 
 Principles in valuation of assets, 169 
 
 of compiling a Balance Sheet, 168 
 of valuing work in progress, 179 
 "Privilege" of auditor, 306 
 Procedure by way of action against auditors, 310 
 
 " on division of estate between beneficiaries, 155 
 
 Professional auditors, 269 
 
 *' " number in United States, 269 
 
 " ethics, 380 
 
 Profit and Loss Account, consolidated, 239 
 
 ** safely divisible and "Net profit," Distinction between, 264 
 Profits available for dividend, 386 
 " Definition of term, 254, 255 
 
INDEX. 583 
 
 Profits Distinction between various classes of, 258 
 Extent of investigations as to, 316 
 
 from commission on underwriting shares, Treatment of, 259 
 in investigations as to profits, Adjustments of, 332 
 Method of calculating percentage of, 73 
 of Public Service Corporation, paper on, 134 
 on sales of investments, Treatment of, 127 
 Testing if, are safely divisible, 264 
 Promissory Notes, 44 
 
 Prospectus of company, N"ecessity of perusing, 53 
 Provision for bad and doubtful debts, 196 
 
 " " debts by percentage of sales, 77 
 
 Public Authorities, Accounts of, Points in audit of, 152 
 
 " Service Corporations, Accounts of, Points in audit of, 132, 134,15* 
 " " " Corporation Tax Law, 563 
 
 " " " Forms, 399, 421 
 
 " " " Report on, Paper of R. H. Montgomery, read 
 
 at St. Louis Congress of Accountants, 134 
 Published accounts, form of, Auditor's duty as regards, 206, 239 
 Publishers, accounts of, Points in audit of, 105 
 Purchase Ledger of retailer, Audit of, 92 
 Purchases, Danger of ' ' dating forward ' ' invoices for, 183 
 
 " Method of recording, 58 
 
 Qualifications of an auditor, 274 
 
 " audit clerks, 275 
 
 Questions C. P. A., 510 
 Quick Assets, 221 
 
 Railways, Steam, accounts of, Points in audit of, 143 
 " Street, accoimts of. Points in audit of, 145 
 Receipts of revenue, 258 
 
 Redeemable stocks and bonds. Treatment of, 202 
 Removal of auditor, how effected, 284 
 Remimeration, Auditor's right to his, 276 
 Rent roll. Necessity of keeping proper, 64 
 Rents received and paid, Method of treating in accounts, 64 
 Reserve, Amount of, necessary for insurance company, 123, 235 
 
 for depreciation and Reserve Fund, Distinction between, 217, 263 
 Fund, 2c^, 232 
 
 " Definition of term, 232 
 
 in Balance Sheet, Method of stating, 232 
 " Investment of, 236 
 Reserves, regulation respecting same in English Companies Act, 253 
 " secret. Auditor's duty as regards, 204 
 " Treatment of, A. L. Dickinson on, 229 
 Resignation, Right of auditor as to, 282 
 
'584 INDEX. 
 
 Responsibility for values in Balance Sheet, 173 
 
 " of auditor for errors, 307 
 
 Restaurants, accounts of, Points in audit of, 99 
 Retailers, accounts of. Points in audit of, 92 
 Revenue account for traders. Form of, considered, 211, 408, 494 
 " of bank. Points in, 119 
 accounts in investigations as to profits. Comparison of, 32 7 
 
 " Object of, 209 
 
 and capital, Distinction between, 85, 109, 148, 386 
 expenses, 260 
 receipts, 258 
 Richardson v. Buhl decision, 257 
 Rights of auditors, 285 
 Salaries, Method of recording, 80 
 Sale of an undertaking to continuing partner, 337 
 " as a going concern. Definition of words, 169 
 Sales for future delivery. Treatment of, 181, 386 
 " " " " Verification of, 181 
 
 Ledgers of retailer. Audit of, 92 
 " of investments. Treatment of profits on, 127 
 Saloons in connection with audit of brewery, 97 
 Savings Banks, audit of, 120 
 
 Schools and colleges, accounts of. Points in audit of, 160 
 Scope of an audit, object and, 22 
 Secret Reserves and assets, Fluctuations in, 203 
 Securities, Inspection of , 1 1 7, 154 
 Self -balancing Ledgers, 47, 57, 58, 66, 83 
 Share Capital Accotmts, Audit of, 48 
 Shipping companies, accounts of. Points in audit of, 150 
 Ships, Depreciation of, 150, 152, 195 
 Short & Compton v. Brackett, Decision in, 319, 372 
 Sinking Fund, Explanation of, 233 
 " " in mining account, no 
 
 " system of depreciation, 189 
 " " torepay loans, Distinction between, and depreciation, 233 
 
 Smith V. Sheard, Decision, 376 
 
 Societies, building and loan, accounts of. Points in audit of, 161 
 Speculative finance companies, accounts of, Points in audit of, 126 
 Sprague, Chas. E., annuity tables, &c., 189 
 Staff, System of work of, 55 
 Statistical books, List of, which companies should keep, 52 
 
 " information, Advantages of, 215 
 
 Steam Railways, accounts of. Points in audit of, 143 
 
 " Forms, 396, 411 
 Sterrett Jos. E. Professional Ethics, 380 
 
INDEX. 585 
 
 Stock Accounts, Advantages of keeping proper, 71, 73, 74 
 *' " in branch establishments, 84 
 
 " " Method of keeping, 7 1 
 
 " and Bonds Redeemable, Treatment of, 202 
 " and Share Accounts of companies, 75 
 Stockbrokers, accoimts of. Points in audit of, 129 
 Stock-in-trade, Auditor's duty as regards valuation of, 174, 221 
 Stocks and shares, investments in, Verification of, 175 
 Stores and Stock accoimts. Points in the audit of, 7 1 
 Street Railways, accoimts of. Points in audit of, 145 
 Suspense Accounts, 76 
 
 System of books, Points to be considered in devising, 55 
 " " bookkeeping, necessity of mastering, 24 
 
 " work of staff, 55 
 " on which an audit should be conducted, 17 
 Tabular Cash Book, Advantages of, 60 
 
 Ledgers, 68 
 Tabulation of the Ledger, 47 
 Theatres, accounts of. Points in audit of, loi 
 Theatrical Companies, accounts of. Points in audit of, 103 
 
 plant. Depreciation of, 195 
 Title Guarantee Insurance Companies, accounts of, 125 
 Trade and cash discoimts. Distinction to be made between, 198 
 Traders, accounts of. Forms of, 211, 407, 484 
 " " " Points in audit of, 73 
 
 " manufacturing, accounts of. Points in audit of, 92 
 
 Stock Accoimts, 73 
 Trading and manufacturing profits. Distinction between, 172 
 Transportation Corporations, Corporation Tax Law, 563 
 "Tretyce off Housebandry," Extracts from, 440 
 Trial Balance, Importance of retaining books until, is audited, 45 
 
 " Localization of errors in, 47, 79 
 
 Trust Companies, essential points in audit of, 121 
 Ultra vires acts, Auditor's duty as regards, 205 
 Uncompleted contracts. Valuation of, 182 
 Underwriting or placing of shares. Commission on the, 49 
 
 " shares, Treatment of profits from Commission on, 259 
 
 Usury, 345 
 
 Valuation of assets, Principles in, 169, 225 
 copyrights, 105 
 current assets, 172, 211, 262 
 fixed assets, 171, 263 
 
 investments in audit of investment companies, 126 
 marketable investments, 224 
 uncompleted contracts, 182 
 
586 INDEX. 
 
 Values in Balance Sheet, Responsibility for, 173 
 Vouchers, Cancellation of, 42 
 
 " Definition of, 34 
 
 " Examination of, 34 
 
 Wa:es, Frauds in, 39 
 
 " Method of vouching, 39 
 Water companies, accounts of. Points in audit of, 141 
 
 " Supply Enterprises, Forms, 401, 441 
 Weiner v. Wurtemburg Electro Plate Company and another, case con- 
 sidered, 306 
 Wholesale merchants, accounts of. Points in audit of, 91 
 Wilde and others v. Cape and Dalgleish, Decision in, 299, 367 
 Wilkinson, George, Audit of insurance companies, 124 
 Wilmer v. McNamara & Co., Lim., 248 
 Work in progress, Verification of, 179 
 
 OF THE 
 
 UNIVERSITY 
 
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WILL. BE ASSESSED FO^J^'^g THE PENALTY 
 
 thVs book on the date DUE^ ^^^^^„ 
 
 ^TlI INCREASE TO 50^^ENTS^0^^^^^^ ^^^ 
 
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