it Digitized by the Internet Archive in 2007 with funding from IVIicrosoft Corporation http://www.archive.org/details/auditingtheoryprOOmontrich •AUDITING THEORY AND PRACTICE BY ROBERT H. MONTGOMERY, C. P.A. of the firm of Lybrand, Ross Bros. & Montgomery. Assistant Professor of Economics, Columbia University. Formerly Lecturer on Auditing, University of Pennsylvania and New York University. Ex- President American Association of Public Accountants. Attorney-at-Law. SECOND EDITION REVISED AND ENLARGED NEW YORK THE RONALD PRESS COMPANY 1916 Copyright 1912 by ROBERT H. MONTGOMERY Copyright 1915 by ROBERT H. MONTGOMERY Copyright 1916 by THE RONALD PRESS COMPANY All rights reserved TO E S. M. WITHOUT WHOSE INSPIRATION THIS BOOK WOULD NOT HAVE BEEN WRITTEN M7 ■ PREFACE There is a demand for a practical book on auditing which up to this time has not been met. If my twenty- four years of continuous experience in professional accountancy work is a sufficient practical training, I trust I have established a prima facie excuse for the presentation of this book, which contains more of practice than of theory. Auditing, in its broadest sense, is the most important branch of accountancy. During the early years of my clerk- ship in the office of John Heins, of Philadelphia (then Presi- dent of the American Association of Public Accountants), and later, while acting as an instructor in the School of Accounts and Finance of the University of Pennsylvania, I strongly felt the need of a dependable text-book on the subject. My attention was all the more directed to the paucity of books on auditing and on other accounting and cognate subjects by contrast with the full and comprehensive literature of the legal profession which I had found of such great assistance in my studies preparatory to admission to the bar. Mr. Dicksee's work on auditing was for many years an authority in American offices. In 1905 I published an American edition of his book, in which I omitted the statutes and other matter which related solely to British practice, and rewrote, or left unchanged, the parts applicable to American practice. The book met with such success that in 1909 a second edition was required. During the last few years, however, I have noted in the profession a radical departure from the principles and pro- V VI PREFACE cedure enunciated by Mr. Dicksee. More is now expected of the auditor, and, happily, many of the profession have met this broader demand and have shown that the services of the practitioner must extend over the whole field of busi- ness activity. In view of these recent and important de- velopments, I feel justified in giving a subordinate place in this work to what were formerly regarded as the chief objects of an audit; and what I consider to be the major objects of a modern audit are discussed exhaustively. It may be that I am too radical in some of my interpreta- tions of the ideal procedure. Perhaps to follow strictly the rules laid down in this book would require more time than any auditor is willing to devote to a single engagement. The exigencies of a particular case may make the opportunities for investigation more limited than the auditor would wish them to be. But the student and the young practitioner particularly should, nevertheless, be careful not to restrict the scope of their theory and practice until they have con- sidered the last safeguard which can be applied to business transactions and have followed up the slightest hint which may throw light upon any irregularity in a concern under audit. I would not have the courage to present this book to the profession if it had not been for the commendatory assur- ances and helpful suggestions of my partners, William M. Lybrand, C.P.A., and Walter A. Staub, C.P.A., and my friend Joseph E. Sterrett, C.P.A., who read all my manu- script and to whom I am tremendously indebted. I am also indebted to John R. Wildman, C.P.A., of the New York University, who also read my manuscript and from whom I received many suggestions which I am sure will make the book more helpful to students. The very comprehensive chapter on Municipal Auditing was (with very minor exceptions) prepared by U. L. Leon- PREFACE vii hauser, C.P.A., Secretary of the Metz Fund for Promoting Efficient Municipal Accounting and Reporting. Other suggestions of value have come to me from my friends in the profession, among whom I must mention Herbert M. Temple, C.P.A., Waldron H. Rand, C.P.A., George T. Klink, C.P.A., E. G. Shorrock, C.P.A., Seymour Walton, C.P.A., Edward L. Suffern, C.P.A., and John B. Geijsbeek, C.P.A. Necessarily much of my work was done at irregular intervals, which meant that my notes required careful re- vision and arrangement This work was done for me by Gerald van Casteel, Esq., of the New York Bar, and I take this opportunity to express my appreciation of his able and conscientious work. As my friends did not undertake to rewrite all of my manuscript, I am conscious of many imperfections in the present volume, and I shall gratefully receive any construc- tive criticism with which I may be favored by those who feel enough responsibility in connection with accountancy literature to contribute to another edition of this book, which I suppose will appear in the course of time. Robert H. Montgomery 55 Liberty St., New York, September 2, 1912. vi PREFACE cedure enunciated by Mr. Dicksee. More is now expected of the auditor, and, happily, many of the profession have met this broader demand and have shown that the services of the practitioner must extend over the whole field of busi- ness activity. In view of these recent and important de- velopments, I feel justified in giving a subordinate place in this work to what were formerly regarded as the chief objects of an audit; and what I consider to be the major objects of a modern audit are discussed exhaustively. It may be that I am too radical in some of my interpreta- tions of the ideal procedure. Perhaps to follow strictly the rules laid down in this book would require more time than any auditor is willing to devote to a single engagement. The exigencies of a particular case may make the opportunities for investigation more limited than the auditor would wish them to be. But the student and the young practitioner particularly should, nevertheless, be careful not to restrict the scope of their theory and practice until they have con- sidered the last safeguard which can be applied to business transactions and have followed up the slightest hint which may throw light upon any irregularity in a concern under audit. I would not have the courage to present this book to the profession if it had not been for the commendatory assur- ances and helpful suggestions of my partners, William M. Lybrand, C.P.A., and Walter A. Staub, C.P.A., and my friend Joseph E. Sterrett, C.P.A., who read all my manu- script and to whom I am tremendously indebted. I am also indebted to John R. Wildman, C.P.A., of the New York University, who also read my manuscript and from whom I received many suggestions which I am sure will make the book more helpful to students. The very comprehensive chapter on Municipal Auditing was (with very minor exceptions) prepared by U. L. Leon- PREFACE vii hauser, C.P.A., Secretary of the Metz Fund for Promoting Efficient Municipal Accounting and Reporting. Other suggestions of value have come to me from my friends in the profession, among whom I must mention Herbert M. Temple, C.P.A., Waldron H. Rand, C.P.A., George T. Klink, C.P.A., E. G. Shorrock, C.P.A., Seymour Walton, C.P.A., Edward L. Suffern, C.P.A., and John B. Geijsbeek, C.P.A. Necessarily much of my work was done at irregular intervals, which meant that my notes required careful re- vision and arrangement This work was done for me by Gerald van Casteel, Esq., of the New York Bar, and I take this opportunity to express my appreciation of his able and conscientious work. As my friends did not undertake to rewrite all of my manuscript, I am conscious of many imperfections in the present volume, and I shall gratefully receive any construc- tive criticism with which I may be favored by those who feel enough responsibility in connection with accountancy literature to contribute to another edition of this book, which I suppose will appear in the course of time. Robert H. Montgomery 55 Liberty St., New York, September 2, 1912. PREFACE TO SECOND EDITION Since the publication of the first edition of this book in September, 1912, no radical changes have occurred in theory or practice. There has been a gratifying increase in the value attached to the certificate of the professional auditor. With the increased responsibility arising out of such recognition, there is observable a commendable tendency to disclose upon the face of a balance sheet more information relative to financial affairs than was formerly considered necessary or desirable. In the first edition the author repeatedly argued for a balance sheet built upon theoretical lines rather than upon one which merely represented the debits and credits taken from the face of the ledgers. The successful auditor must visualize a business as a whole, and a true balance sheet must reflect all assets and all liabilities, irrespective of what are, or are not, in the books. It is believed that a careful study of an audit program (which this book purports to be) will aid the auditor in his efforts to set forth the true and full financial position of the concern under audit. Considerable matter appearing in the first edition such as the chapters on ethics, legislation, C. P. A. questions, etc., has been omitted in this edition to make room for new matter and revision of old matter believed to be of more interest and importance. The income tax has come to stay. Its importance from the point of view of the professional auditor cannot be over- estimated. Special skill, study, and experience are necessary to prepare the returns, and this means that in the future viii PREFACE IX those most conversant with the law and the procedure there- under will be intrusted with the preparation and super- vision of returns. It is hoped that the rather exhaustive treatment of the subject in the Appendix will be helpful. In the absence of uniform practice and court decisions (which alone will settle many ambiguous parts of the law), it cannot be expected that the discussion herein will be complete or without errors. It is, however, the author's intention to revise the matter from time to time. In the meantime, if it will help solve some of the present difficulties, its purpose will have been accomplished. The author takes this opportunity to thank his friends for many helpful suggestions and criticisms. May they continue! Robert H. Montgomery 55 Liberty St., New York, January 4, 1916. CONTENTS Chapter Page I Introductory - i Legal Responsibility of Auditors Summary of Decisions . II The Purposes and Advantages of an Audit 9 The Purposes of an Audit The Minor Objects of an Audit 1. The Detection of Fraud 2. The Detection of Errors Advantages of an Audit 1. Condition of Affairs 2. Bank Loans 3. Partnerships 4. Fire Loss 5. Bonding 6. Protection of Stockholders and the Public 7. Sale of a Business 8. Recovery for Negligence III How TO Begin an Audit .... 29 1. As to the Client 2. Proper Starting Conditions 3. Co-operation of Client's Staff Tact Required 4. Compensation Must Depend on Service Rendered Contingent Fees 5. As to Where the Work Is Done 6. Working Papers Permanent Filing 7. Familiarity with System in Use 8. Schedules of Books, Records, and Names of Clerks xi xii CONTENTS Chapter Page 9. Procedure where Previous Audits Have Been Made K). Final Considerations: Detailed or Balance Sheet Audit? The Detailed Audit Balance Sheet Audit Suggestions to Clients' Staff before Commencing Work System of Internal Check Incoming Mail Cash Invoices for Purchases Sales Invoices Customers' Accounts Collections Pay-Rolls Stock Records Vacations Branch Store Accounts IV Balance Sheet Audit — Assets . . 59 General Principles Limitations of Balance Sheet Audits Must be Understood Assets • Current Assets Liens and Hypothecations Proportion of Current Assets to Other Liabilities and Capital Cash Cash in Bank Cash on Hand Accounts Receivable Trade Debtors Miscellaneous Receivables Fictitious Accounts Receivable Deposits Verification of Outstandings by Correspondence CONTENTS xiii Chapter Page V Balance Sheet Audit — Assets (Con- tinned) . 80 Current Assets (Continued) Notes Receivable • Stock Subscriptions Instalment Contracts Inventories Raw Materials, and Stock Purchased to be Resold in the Same Form Rules for Verifying Inventories Goods in Process Finished Goods Interest Not an Element of Cost The Turnover Supplies, Stores, etc. Investment Securities Securities as Stock-in-Trade Temporary Investments Postage and Other Stamps Deferred Charges to Operation VI Balance Sheet Audit — Assets (Con- tinued) 104 Fixed Assets Period to be Covered Value as a Going Concern Land and Buildings \. Land 2. Buildings Leaseholds Machinery and Equipment Small Tools Furniture and Fixtures Containers Horses Wagons, Automobiles, etc. Patterns, Drawings, Lasts, etc. Electrotypes, Woodcuts, etc. Patents Copyrights xiv CONTENTS Chapter Page VII Balance Sheet Audit — Assets (Con- tinued) 123 Fixed Assets (Continued) Good-Will Sinking Funds Reserve Funds Fund and Other Permanent Investments Bonds and Mortgages Treasury Stock Unissued Capital Stock Wasting Assets Values to be Written Down 1. Mines 2. Timber Land Contingent Assets Capital Stock Calls and Assessments Liabilities of Directors Secret Reserves VIII Balance Sheet Audit — Liabilities . 146 Accounts Payable Trade Creditors Consignments Notes Payable Mortgages Bonds Judgments ■ . Interest Payable Taxes Water Rates, etc. Wages Rent Freight Traveling Expenses and Commissions Legal Expenses Audit Fees Damages Coupons, Unused Tickets, etc. ' Deposits ^ ' , Unclaimed Dividends CONTENTS XV Chapter Page IX Balance Sheet Audit — Liabilities (Con- tinued) i68 Contingent Liabilities Notes Receivable Discounted Indorsements Guarantees Acceptances Unfulfilled Contracts The Minute Book Reserves Partnerships Partnership Agreements Capital and Surplus Capital Stock Premiums on Capital Stock Sinking Fund Accounts Reserve for Working Capital Preferred Stock Accumulated Dividends, etc. Surplus Investment of Surplus X Profit and Loss Account . . .201 Legal Definition of Profits Economic Definition of Profits Accountant's Definition of Profits Earnings Gross Earnings Returns Ordinary Transactions Only to be Included Allowances and Rebates Bad Accounts Work in Progress Departmental Profits "Inter-Company Profits" Sales for Future Delivery Participations and Underwritings Profit on Sale of Assets Appreciation in Value of Assets xvi CONTENTS Chapter Page XI Profit AND Loss Account (Continued) . 219 Expenses and Losses Reserves Depreciation Obsolescence Accrued Expenses, etc. Cash Discounts Trade Discounts Disposition of Profit Principal and Income Dividends Must Not be Paid from Capital Decedents' Estates Wasting Assets Interest Dividends Stock, and Extraordinary Cash Dividends XII Certificates and Reports . . . 235 Something More Than Figures Are Wanted in a Report Terminology Scope of Report Certificate of Audit Form of Balance Sheet Statement Required by Banks Standard Form of Borrowers* Statement Federal Reserve Board Requirements Statement of Financial Condition XIII Certificates and Reports (Continued) . 268 Statements Requested by Credit Managers Liens and Hypothecations Profit and Loss Statement Use of Charts and Graphs Sales Charts Gross and Net Profit Charts Combined Purchase and Sales Charts Preparation of Charts Value of Comparative Statistics CONTENTS xvii Chapter Page What Not to Report Restrictions on Client's Use of Reports Misleading Advertisements Compulsory Reports XIV The Detailed Audit .... 293 General Principles Completed Audit Continuous Audit Auditing by Tests and Scrutiny The Audit of Income and Expenses General Principles Prior Periods Verification of Footings and Postings 1. Purchase Records 2. Sales Records Controlling Account Cheques Received Must be Deposited Periodical Verification of Bank Balances 3. Cash Receipts 4. Cash Payments Summary Other Records XV The Detailed Audit (Continued) . • 313 Verification of Income Sales Cash Discounts Collections Not Accounted for Confirmations of Outstandings Income from Investments Interest Receivable Discount for Prepayment Trade Discounts Rents Receivable Realizations from Items Previously Charged to Profit and Loss Consignments and Goods Out on "Memorandum" Goods Received for Sale Sales Not Delivered Sales of Building Lots XVIU CONTENTS Chapter Page XVI The Detailed Audit (Continued) . . 334 Purchases and Expenses Vouchers Purchase Invoices Missing Vouchers Vouchers for Petty Cash Payments, Pay-Rolls, etc. Petty Cash Organization and Similar Expenses Which Affect More Than One Year's Operation Legal Expenses and "Graft" Repairs and Renewals Allowances and Returns Empties Salaries Employees' Bonds Salesmen's Commissions Traveling Expenses, Entertaining, etc. Wages Duties • Interest and Collection Charges Insurance Premiums Freight and Express Postage Journal Vouchers Purchase Returns Cancellation of Vouchers XVII The Detailed Audit (Continued) The Trial Balance Outstanding Accounts Bad or Doubtful Accounts Asset and Liability Items Notes Receivable Notes Receivable Protested Inventories Premiums and Discounts on Bonds to be Amortized Premiums on Capital Stock Branch Accounts Capital Expenditure Cash Discounts on Capital Payments 369 CONTENTS xix Chapter Page Real Estate Buildings Improvements and Extensions Machinery, etc. Notes Payable Partners* Withdrawals Dividends Stock Dividends Capital Stock Bonds Taxes Office Methods Styles of Books and Records Filing Systems Copying Mailing Department Stock on Hand Controlling Subsidiary Ledgers Columnar Ledgers Efficiency of Organization XVIII Depreciation 401 Causes for Depreciation Repairs and Maintenance Methods of Applying Depreciation in the Books Sinking Fund Requirements to Retire Bonds, etc., Must Not be Confused with Depreciation Allow- ances Depreciation Is an Operating Expense Depreciation a Local Issue Investment of Depreciation Reserves Importance of Provision for Obsolescence Depreciation of Different Classes of Property Land Buildings Leaseholds Machinery and Equipment Small Tools Furniture and Fixtures Landlord's Fixtures Horses XX CONTENTS Chapter Page Wagons, Automobiles, etc Ships Patents Good-Will Wasting Assets Mines Timber Lands XIX Investigations 430 Scope of the Work Instructions from Clients Working Papers to be Preserved Detail Which May be Omitted Previous Audits Where Assets Are Appraised Definite Report Wanted Handling Books and Records False Entries Sometimes Forgeries Books as Evidence Loose-Leaf Records Erasures Original Records Necessary The Auditor as an Expert Witness 1. Preparation Is Always Essential 2. A Witness Can Testify to His Own Work Only 3. Information Should Not Be Volunteered 4. Conclusions and Opinions 1. On Sale or Purchase of a Business (a) Requirements Something More Than Figures Wanted (b) Period Covered (c) Analysis of Earnings and Expenses Gross Earnings Net Earnings Verification of Sales The Turnover Profits on Fluctuations Decrease in Expenses Advertising and Other Deferred Charges Leases Inventories Other Factors Which Affect Earnings CONTENTS xxi Chapter Page (d) Future Requirements and Economies An Auditor Should Not Prophesy Insufficient Capital Economies Exaggerated Former Owners' Attitude Competition (e) System of Accounts Criticisms Should be Postponed Condition of Accounts an Index to Proprietors Preparation for New System XX Investigations (Continued) . . . 469 On Sale or Purchase of a Business (Continued) (f) Elimination of Unusual Items Earnings Income from Assets Not Taken Over Interest on Deposits Sales of Assets Appreciation of Assets Insurance Profit Damages for Change of Grade, etc. Expenses Excessive Reserves Embezzlements Fire and Other Losses Not Insured Actions at Law (g) Adjustments and Qualifications Partners' Salaries Contracts Taxes Royalties Orders of Public Service Commissions (h) Errors in the Books (i) Investigations on Behalf of a Retiring Partner When the Business Is Being Sold to a Con- tinuing Partner (j) Investigation for Those in Charge of Re- organizations 2. Investigation for Creditors, Etc. Investigation on Behalf of a Present or Prospec- tive Creditor xxii CONTENTS Chapter Page (a) Examinations for Bankers Extension of Business Collateral v. Integrity Future Business Bank Loans to be Repaid (b) Investigations After Bankruptcy (c) Investigation for Purely Credit Purposes Unscientific Methods Lack of Capital Credit Risks Insurance Errors of Principle Fraud Character (d) Investigation in Patent Litigation General Accounting Principles Do Not Govern 3. Fraud Possibilities to be Studied Extent of Fraud Attitude Toward an Embezzler Definitions XXI Holding Companies .... 508 Consolidated Balance Sheets and Profit and Loss Statements Balance Sheet Form of Balance Sheet Accounts Receivable Profit and Loss Account Partial Ownership of Subsidiaries Comparative Statements XXII Interest ....... 520 Principal Rate of Interest Time Custom In Banks and Trust Companies Custom Among Biisiness Houses Custom Among Stock-Brokers New York Clearing House The Treasury Department of the United States The Unit Period CONTENTS xxiil Chapter XXIII Special Points in Different Classes OF Audits . . . . . Introductory Financial National and State Banks Cash and Securities Correspondents' Accounts Confirmation of Demand Notes, etc. Certificates of Deposit and Certified Cheques Capital Stock Depositors' Accounts Verification of Income Expenses Secret Reserves Internal Checks Scope of Report Instances of Fraud Savings Banks Trust Companies Investment Companies Stockbrokers Use of Abbreviations Program of Audit Instance of Fraud Building and Loan Associations By-Laws and Minute Books Verification of Income Expenses Inspection of Securities Distribution of Profits Page 530 XXIV Special Points in Different Classes OF Audits (Continued) Insurance Fire Insurance Companies Liabilities Life Insurance Companies Casualty, Health, Surety, Title Guarantee, and Other Companies Insurance Companies and the Income Tax 573 XXIV CONTENTS Chapter Page Manufacturing Publishers of Books Publishers of Magazines and Newspapers Breweries Mining Coal Mines Gold Mines Trading Wholesale Merchants Retail Merchants Retail Shoe Stores Department Stores Miscellaneous Data for Retail and Department Stores Automobile Dealers Branch Accounts XXV Special Points in Different Classes OF Audits (Continued) . . .631 Public Utilities Rate Regulation Appraisals of Public Utilities Steam Railroads Shipping Companies Electric Railway's Taxicab Companies Electric Light and Power Companies Gas Companies Water Companies Telephone Companies Depreciation Special Points in Different Classes OF Audits (Continued) . . . 685 Municipal Preparation of Budget Fixing the Tax Rate Authorization of Expenditures Business Departments of a City Sources of Revenue XXVI CONTENTS XXV Chapter Page Control of Receipts and Expenditures Periodical Examinations Audit of Revenue Taxes Assessments Rents and Franchises Audit of Outstanding Accounts Audit of Property and Equipment Audit of Expenditures Sinking Funds Financial Statements General Account Balance Sheet Capital Account Balance Sheet Trust Fund Balance Sheet Current Operation and Surplus Account Fund Balance Sheet — General Account Fund Balance Sheet — Capital Account Summary Consolidated Balance Sheet XXVII Special Points in Different Classes OF Audits (Continued) . . . 713 Executors and Trustees Institutional Educational Institutions Charitable Organizations Churches Clubs Professional Architects Doctors Lawyers Miscellaneous Contractors Real Estate Land and Development Companies Hotels Restaurants Advertising Agencies Theaters Theatrical Companies XXVI CONTENTS Chapter XXVIII The Liabilities of Directors Board Minutes* Inspection Directors' Dealings with Company Compensation of Directors Directors May Inspect Books Legal Liabilities of Directors Page 748 Appendix — Federal Income Tax 759 Auditing — Theory and Practice CHAPTER I INTRODUCTORY The purpose of this book is to set forth the principles underlying the theory and practice of auditing and to outline the work which must be done in whole or in part in every audit. An ideal audit cannot be made without a full perspective of the science of accounts, for many who have a good work- ing knowledge of the details of practical accounting find it difficult to visualize, as it were, the records of business transactions. The auditor who best accomplishes his task is the one who is able to put himself in the place of those for whom the accounts are intended, and he will not find this easy unless he has been trained to make the most of the figures which appear in a balance sheet or profit and loss statement. To present correct accounts is not enough, because correct accounts may not be clear to those for whom they are in- tended. A scientific system of accounts is a method whereby a graphic and intelligent record of facts may be assembled and by logical processes reduced to readable form. Auditing is the analytical, as practical accounting is the constructive, branch of accountancy . But the modern auditor is more than an analyst. The logical development of his profession and the increased 2 AUDITING appreciation of the value of his work have added to his former duties certain constructive functions which must be fulfilled in connection with a large proportion of his engage- ments. The average business man has been trained from boy- hood to read facts and figures from continuous printed pages. The trial balance of a ledger means nothing to him-, except that part of it which contains the accounts receivable and payable, and these must not be called "Debit Balances'* or "Credit Balances" if we would avoid the chance of being misunderstood. Many intelligent people fail to grasp the usual and con- ventional hypothesis underlying the theory of double-entry bookkeeping, and therefore facts or figures presented to them in a technical or formal shape may not accomplish the intended result. Therefore, the study of auditing is essential to those who desire to study business. It forces training in the fundamental essentials of every business. It also enables a business man to know whether an auditor whom he may later employ is doing his work properly. Probably the majority of business men have been shown trial balances from their books which mean nothing to them, and this applies to the usual monthly balance as well as to the one made after closing the books. A balance sheet in con- ventional form is perfectly clear to the eye trained to read and understand figures and is perhaps as concise and satis- factory an exhibit as could be desired for the person who understands iigures, but thousands of business men frankly acknowledge that they do not grasp, the full import of a financial statement in the accepted form. But if the man who is entitled to know all the facts con- tained in these balance sheets cannot or will not understand this method of presentation, is it not our duty to try another form and keep on trying until the results of his business INTRODUCTORY 3 become as interesting reading to him as the daily trade reports? If the cHent had his own way he would ask for a report on his business prepared so that he could read it. This is the point of view to which every accountant must direct his attention until he can so connect figures and trans- actions that an audit will no longer mean a mere verification of the figures in the books, but will include a lively apprecia- tion of every ramification of the business. In other words, the auditor must visuaUze the transactions themselves to see that their conversion into dollars and cents is reflected in the books of account. The proprietor knows intuitively all of the possible func- tions of his business ; the auditor may not know them intui- tively, but he must ascertain how and why the proprietor looks at the business as he does, otherwise there will be no meeting of m ind s between the auditor and his clie nt. With out a complete understanding of each other's point of view ideal professional relations can never be maintained. There are many ramifications of business affairs which cannot be understood without more or less actual experience and technical training, and which therefore cannot be satis- factorily elucidated within the limits of one book; but it is the firm belief of the author that a common-sense knowledge of bookkeeping and a general acquaintance with business affairs are the most necessary foundation of the student of auditing. It is not expected that a clerk with a little knowledge of accounts or a business man with no practical experience in other lines than his own can by a mere reading of these pages acquire at once the skill necessary for the professional accountant. Nevertheless, this book is intended for the in- struction of those having but little experience as well as for the guidance of the qualified public accountant. Accountancy is a science, and it should be possible to present its underly- :) 4 AUDITING ing principles so that they may be comprehensible to the average mind. Theory alone, however, will never qualify anyone to practice as a public accountant any more than a medical student is qualified to practice medicine, no matter how thorough a knowledge of the science of medicine he may have acquired through lectures and books, unless he has had an opportunity to verify his book knowledge and demonstrate his skill in the hospital and the clinic. If anyone who proposes to take up the study of auditing has not had a fairly thorough training in bookkeeping, and in addition has not had sufficient practical experience in business affairs to enable him to keep his poise when he is required to think and act quickly, he had better postpone his course until he has acquired enough experience to lay the necessary foundation. It is absurd for any student to take it for granted that a good memory applied to a book on auditing will make him a good auditor. The work of the auditor engaged in public practice is important enough to raise this work to the dignity of a pro- fession. It has been called the profession of business advice. Some one has defined a profession as a calling which de- mands of its members a high order of intellectual attain- ment, which can be acquired only by long and arduous preliminary training. Legal Responsibility of Auditors In my opinion the quickest way to weed out the incompetent men who now hold themselves out as public accountants would be to make them understand the civil responsibility of a professional accountant. Naturally, an unreliable, incompetent man cares nothing about his moral responsibility, and so long as he knows that American courts have never laid down specific rules regulating the duties or INTRODUCTORY 5 obligations of public accountants, he probably feels safe from any legal responsibility. One sure and very desirable result of the weeding out process would be the raising of the professional standard, for a few irresponsible men can offset the good work of ten times their number. As is well known, there are numerous English decisions dealing with the rights and liabilities of professional auditors. In view, however, of the total number of ac- countants in practice and the number of years the decisions cover, the number does not seem at all appalling. While the fact that we have no reported decisions speaks well for the integrity and good judgment of our accountants, yet it is felt that occasions have arisen where a test case would have been made had it not been known that any judgment involv- ing money damages which might have been rendered would have been worthless so far as the possibility of collection was concerned. It is unfortunate that anyone should be permitted to practice as a public accountant who, in case of gross negli- gence or malpractice, has so little financial responsibility that a judgment against him would be worthless, and who, more- over, is beyond the legal reach of his fellow practitioners, who at present have no opportunity to prefer charges against one who is neither a member of a state society nor certified by a state board. The absence of decided cases, however, does not alter the principle of law that anyone who holds himself out to be skilful in any trade or profession, and who is negligent in the performance of what he undertakes, becomes responsible in damages for such failure. This civil responsibility is settled and cannot be debated, but it should not be passed over lightly and should be emphasized on all occasions. The measure of legal responsibility, however, is much too low for a conscientious accountant. The law requires of him only 6 - AUDITING the skill of an ordinarily skilful accountant; the law gives him the privilege of assuming the accuracy of many things unless he has definite suspicions to the contrary, and, as already stated, the law never requires one to measure up to the standard of the most skilful in the same profession or trade. In this respect accountants are to be congratulated, for it is common knowledge that the majority of professional accountants in the United States seek to do more for their clients than the law requires, and every year witnesses a more general desire to advance the quality of services rendered. It is earnestly hoped that further progress will be made in this direction. Since the wish for high standards is general, let each individual accountant do his part toward maintaining them. Public opinion should be aroused so that unqualified practitioners will gradually cease to practice, and in their place a united certified body will control all accountancy matters — not because the law grants them ex- clusive privileges, but by reason of the fact that they can be depended upon at all times and under all circumstances, while the others cannot.* As heretofore stated, the State and Federal courts of the United States appear to be barren of any decisions upon this important question. On the other hand, both the common and statute law of Great Britain are prolific in decisions and enactments, pre- scribing with much exactness the precise nature of the liabili- ties which an auditor may conceivably incur while in the exercise of the multifarious activities incident to his pro- fession.t It is highly probable that in the event of any litigation of importance occurring here and involving that question, the *The author wrote the foregoing article for the Journal of Accountancy several years ago. tFor English cases bearing on the liabilities of auditors, refer to "Auditing, Theory and Practice," first edition. INTRODUCTORY 7 courts of America will look to the English cases as affording, if not binding precedents, at least valuable guides to the considerations and principles of law applicable in such case. Summary of Decisions Based upon the English decisions and upon the principles of the common law in force in the United States, the professional auditor's legal duties and liabilities may be summarized as follows : 1. Anyone who holds himself out as skilled in a profes- sion is charged with a higher degree of responsibility than one who is inexperienced and who does not seek profes- sional work. Acting in a professional capacity, an auditor must do more than ascertain the mere arithmetical accuracy of the accounts. If the accounts do not represent the true financial position of the undertaking under examination, and if that fact is apparent or can reasonably be deduced from the face of the accounts themselves, then the auditor is under a legal obligation to discover and disclose the true state of affairs. 2. The auditor, however, is not an insurer unless he assumes such a position. If he uses reasonable care — the care of an ordinarily skilful auditor, under the circumstances of the case — no legal responsibility is incurred by him. 3. Reasonable care has been stated by the courts to depend upon the circumstances of each case. Where there is no reasonable ground for suspicion of fraud, it is not necessary to take as many precautions as are requisite where the auditor is led to believe that irregularities exist. 4. Ordinarily what is known as a "test and scrutiny" audit is sufficient, but in every case there must be a careful survey of the assets, the liabilities, the income, and the ex- penses, in order that the auditor may satisfy himself that the assets and the income are accounted for, and that the 8 AUDITING liabilities and expenses are properly supported. The auditor need not verify every item, but he must not omit any part of an audit which the custom of the profession decrees should be covered. 5. The experience of other practitioners and access to recognized authorities on the subject being available, a de- fense of ignorance as to what is required in an audit will not save an auditor from responsibility for failure to follow settled rules of practice. 6. The general rule of the common law, that all men are considered honest until proved dishonest, may be observed by an auditor with respect to the staff of the client ; but he is charged with an exceptional degree of diligence in recog- nizing indications of dishonesty on the part of those who occupy responsible positions. 7. An auditor's relation to his client is in the highest degree confidential, and he has no legal right to communi- cate with third parties (debtors or creditors) unless he secures permission to do so. If his position as auditor be- comes incompatible with honesty, he may withdraw at any time, but he is not at liberty to disclose to outsiders the cause of his withdrawal. 8. In communicating with his client, however, the auditor is bound to disclose information, of whatever nature it may be, which is of value to the client, and any suppression of material facts is at his own risk. 9. In the event of loss through an auditor's negligence, the client may recover damages against him. The measure of damages is the amount which the client or other interested party has lost as a legal consequence of the auditor's failure to perform his duty properly. I J CHAPTER II THE PURPOSES AND ADVANT\GES OF AN AUDIT The average business man is not familiar with the purposes and advantages of an audit. A small minority, have retained professional auditors and have gained their impressions of what an audit should be from the experi- ences growing out of such employment. Where the auditor possessed a broad vision and had the advantage of long and varied experience, the result was a revelation to the business man. He found the value received so greatly exceeded the cost of the service that the relation became a continuing one. The client advised other business men to do likewise, and so the prac- tice of the skilful auditor expanded. But why is it that so many business men have never availed themselves of the opportunity to secure a service which has proved to be so valuable to their competitors, and why is it that many practitioners have not succeeded in enlarging their practice during the last few years, while a considerable number of auditors have built up large organizations and now have intrusted to them a very large volume of work? It must be that the business man who does not employ professional auditors is ignorant of the advantages of an audit, and that the would-be auditor who fails to secure enough engagements lacks the full conception of the objects of an audit, and therefore fails to create the proper impression upon the clients whom he does obtain. It follows that he will not be called upon 9 lO AUDITING for subsequent service, and naturally he is not recom- mended to the friends of his client. THE PURPOSES OF AN AUDIT The successful auditor is the best medium through which the business public will gain knowledge of the advantages of an audit. To be successful the auditor himself must have a thorough and definite grasp of the purposes of an audit. The following observations and suggestions are based upon a careful study of actual conditions and may be relied upon by the student as representative of the accu- mulated experience of the auditors who head the pro- fession at the present time. In what might be called the formative days of auditing students were taught that the chief objects of an audit were: 1. The detection or prevention of fraud 2. The detection or prevention of errors but in recent years there has been a decided change in the demand and in the service. That is to say, the financiers and business men who origilially retained professional auditors to look for fraud or errors have enlarged their demands and now require a vastly broader and more im- portant class of work, which those auditors who have advanced in skill and knowledge have been able to under- stand and perform. We must therefore relegate the for- mer "chief objects" to a subordinate position without in any way depreciating their importance. The relative position of the present-day purposes are: 1. To ascertain the actual financial condition and earnings of an enterprise for: ij I THE PURPOSES AND ADVANTAGES n (a) Its proprietors (partners or stockholders). (b) Its executives (managers, officers, or directors). (c) Bankers or investors who are considering the purchase of securities. (d) Bankers who are considering the discounting or purchasing of its promissory notes. 2. The detection of fraud or errors as explained in later chapters of this book. The results secured by auditors are required for the following, among other purposes: (a) In order that stock and bond holders or other owners may have submitted to them at regular intervals a comprehensive, even though a condensed, statement of the financial position and the net results of the operations of the business in which they have a proprietary interest, and that the fairness and accuracy in all essential par- ticulars of the statement submitted may be attested by means of a certificate or report of a disinterested and competent authority. (b) Upon a proposed sale or incorporation or other change in form or management, such as an attempt to bring in additional capital, or the death of a partner or large stockholder. Matters of the highest importance arise in connection with the interests of partners in the event of death or other change in the partnership relations. (c) To submit similar statements in more detail to banks and note brokers as a basis of credit. (d) To submit certified statements to the mercantile agencies and to other organizations which call for periodi- cal reports. (e) To ascertain the true causes of fluctuations in profits or expenses. • (f) To state the facts in disputes or litigation, and to 12 AUDITING investigate the causes of bankruptcy for creditors or stockholders. This is a partial list only of the manifold purposes for which audits or investigations are being demanded. The nineteenth century auditor who looked chiefly for fraud or errors no doubt served a useful purpose, but his methods now illustrate the history rather than the modern practice of auditing. Due consideration will now be given to the subject of fraud and errors. In subsequent chapters the present- day demands for ''higher" auditing will be met with a full discussion of the more important work of the profes- sional auditor. THE MINOR OBJECTS OF AN AUDIT The elementary or minor objects of an audit are: 1. The detection of fraud. 2. The detection of errors, and conversely the pre- vention of fraud and the prevention of errors, particularly of errors of principle. The latter, of course, include the moral effect of an audit, which extends also to that very desirable result of keeping the work of the office staff sharply up to date. This might be classed as a constructive object. I. The Detection of Fraud There can be no doubt but that the business public look upon the discovery of fraud as an important object to be attained by an audit, and experience has demon- strated that sufficient fraud has been so disclosed to war- rant a continuance of the service of auditors who are retained to discover fraud if it exists. Gradually, however, the business man is being edu- THE PURPOSES AND ADVANTAGES 13 cated to understand that the discover; of fraud is one, and only one, of the objects of an audit, and by no means the most valuable to him. The detection of fraud is- first in the logical presenta- tion of the objects of an audit, as less experience is required to unearth it, and more definite suggestions can be made to the student in regard to it than is the case with the more important branches of the auditor's duties. While an auditor who brings to- bear all of his skill and resources, and who leaves no stone unturned in his search for fraud, but fails to discover a well-concealed defalcation, is legally exempt from liability therefor, yet he is, and properly should be, considered professionally responsible for such failure, and his practice suffers accord- ingly. Therefore particular attention must be paid to all possible avenues which are open for the dishonest clerk or official who has an opportunity to manipulate the records of business transactions. Opportunities for wrong-doing vary, as a rule, with the size of the undertaking. In a small business the details are apt to be supervised by one or all of the proprietors, while in a large business much of the detail is necessarily left to subordinates. The auditor must be governed by the circumstances surrounding each engagement and then determine the amount of detail to be covered. (a) Misappropriation of Money or Goods. Usually fraud consists of defalcations involving the misappropria- tion of cash, either by the failure to account for cash receipts or by the entry of payments which are fictitious in part or whole. In the following pages there will be outlined a pro- , cedure based on long experience which will disclose such^ practices in all ordinary cases. 14 AUDITING With respect to the misappropriation of assets other than cash, a far more difficult task is at hand, but experi- ence in such cases has also permitted the outlining of general rules which will materially assist the auditor. (b) Manipulation of Accounts for Other Purposes. The abstraction of cash or of goods is not the only reason for the manipulation of accounts. The auditor who has covered these two classes of frauds fully must, in addition, consider the possibility of other irregularities. In many undertakings the sources of cash receipts and the disposition of cash expenditures are so carefully guarded that a misappropriation of cash is almost impossible. It is hard to convince the business man whose ac- counts are so guarded, that an audit is of value, but rely- ing again on experience, it has been demonstrated time and again that pecuniary profit in such cases may be ^obtained by the manipulation of records. Usually the fraud has been perpetrated by an official (frequently one who has the entire confidence of everyone) who has an interest in, or who receives a bonus based on, the net profits of a business or of a department thereof. In other cases the purpose is to deceive bankers, creditors, or stockholders. The auditor must have all these purposes constantly in mind when determining his course of action. If he does not consider all the elements involved before commencing a given engagement, he may find at the end of a detailed audit that a balance sheet audit would have enabled him to secure satisfactory results in much less time. In discussing hereafter the respective advantages of these two classes of audits, the author will endeavor to assist the practitioner in the selection of a proper line of procedure. THE PURPOSES AND ADVANTAGES 15 2. The Detection of Errors This object of an audit does not receive the attention which it deserves, and the auditor himself is probably to blame for the present condition of affairs in this respect. During the time professional auditing was in a forma- tive state in this country, auditors were frequently en- gaged to adjust accounts which had been badly kept by inefficient clerks. It was found that the books were not in balance, and that in order to adjust them a vast number of en'ors had to be located and corrected. In many cases this work consumed months of time and a correspondingly large fee followed. This was called ''auditing," but in reality it was accounting work of the most elementary kind. A careful bookkeeper unacquainted with most of the principles of accountancy could have performed the service equally well and far more cheaply. This practice cast more or less discredit on professional auditors, so that the tendency during recent years has been to beUttle the importance of locating errors in books of accounts and to magnify the advantages of concen- trating on the search for fraud and the verification of the balance sheet. The author feels that this branch of auditing should be accorded its proper place in stating the objects of an audit, and the attention of the student is particularly called to the points of importance in the detection of errors. For convenience the following classification is made, involving errors caused by ignorance, fraud, or mistake: (a) Errors of Principle. ! (b) Clerical Errors (c) Errors of Omission (d) Errors of Commission (e) Offsetting Errors . l6 AUDITING (a) Errors of Principle. This is the most important class of errors and is one which the auditor must never overlook. Errors of principle usually affect both the profit and loss account and the balance sheet. The most common error is to debit an asset instead of an expense account. For instance, an item- of repairs will be charged to build- ings account, or a payment covering expenses or services will be charged to the personal account of the payee and thus be included among the accounts receivable, instead of being charged to an expense account. Other errprs of principle do not affect the net profit or loss, but may seriously affect the conclusions which are drawn from the various revenue or expense accounts. For instance, an executive may have determined that the advertising appropriation shall be limited to 5 per cent of the sales. A large item of advertising expense may be charged to some other expense account in error, with the result that the executive, depending upon the ledger to give him the total expenditure, will authorize additional advertising and thus incur an unintentional and perhaps unnecessary expense. Errors of principle are most easily detected by making an intelligent analysis of the accounts in connection with the preparation of the profit and loss account and the balance sheet. (b) Clerical Errors. These are the most frequent er- rors which exist, and unfortunately few books of accounts are free from them. They consist of errors in the footings and forwardings of the books of original entry and ledgers; errors in postings other than those mentioned under (a), consisting of postings to wrong accounts in the same class, as to one customer or creditor instead of another, or the posting of an incorrect amount, posting THE PURPOSES AND ADVANTAGES 17 to the wrong side of the ledger, or errors in drawing off the trial balance. These errors are usually due to carelessness, but the auditor is not justified in assuming that accounts in which such errors exist are free from fraud. He must differen- tiate between clerical errors and intentional manipulation of the records. A careful examination must therefore be made of enough of these errors for the auditor to satisfy himself that they are bona fide. For instance, an exces- sive footing of a pay-roll or expense account might be carelessness or fraud; the posting of a greater amount to the credit of a customer's account than is shown in the cash book might be an honest error in posting or it might indicate an attempt to conceal a defalcation. A fair test of these errors, however, is sufficient. It is no part of an auditor's duty (as such) to locate all clerical errors, and the auditor who devotes a considerable part of his time to this work lays himself open to just criticism. ^ Auditors lose sight of the fact that the closing of \ books and the resulting balance sheets are based on esti-__y mates only. Some auditors spend many hours in adjusting balance sheet items in order to correct a few trifling errors, when there are valuations of hundreds of thousands of dollars in plant, merchandise, stocks, etc., all of which are necessarily estimates and which fluctuate from day to day — as must the value of all materials and goods. So long, therefore, as small errors in calculations, extensions, etc., do not, relatively speaking, actually affect the balance sheet, time should not be wasted on such adjustments. (c) Errors of Omission. An auditor is justified in spending more time in looking for errors of omission than in connection with any other class of errors. Where the internal check (see page 53 et seq.) is not perfect, the utmost care must be taken to verify all possible l8 AUDITING sources of revenue to ascertain whether or not all such items are entered in the books. Errors of omission usu- ally do not affect the trial balance and are, therefore, not detected automatically. They are distinguished from the class of errors where items are not posted at all, as with these (except where both sides of a journal entry are not posted) the trial balance is affected and the usual checking back of the postings would locate the differences. Instances of errors of omission are as follows: Goods may be delivered, but not billed; rent may not be charged or collected. On the other hand, purchases may be made and the goods received, but the invoices for same may not be entered in the books. In order to cover this class of errors, the auditor should locate all books of original entry, whether so-called memorandum books or other informal records, then a fair selection of items should be traced into the regular books of account. If the test does not disclose any material differences, it may be as- sumed that the records are accurate. If the test should disclose one or more errors of sufficient size to affect the results favorably or unfavorably, a more extensive test should be made. It might be well, however, before ex- tending the verification to request authority for so doing from the client. In an examination of the accounts of a publisher the auditor compared the advertisements appearing in one issue of a popular magazine with the book in which charges to advertisers were entered. It was found that an insertion of a full page had not been charged for. The item was billed and collected. Thereupon the other eleven issues were carefully checked, but no other omis- sion was found. If the auditor names a fixed fee for an audit, it is always well to state that tests only will be made. If an THE PURPOSES AND ADVANTAGES 19 error is discovered in the test, the auditor has fulfilled his agreement and need not go further unless an addi- tional fee is arranged for. If he will broach the subject as soon as the test is completed there will probably be no difficulty in securing an extra allowance, but if no refer- ence is made to his purpose. to charge extra for additional work, he will usually have difficulty in collecting anything at all additional, no matter how many or how few errors are brought to light. (d) Errors of Commission. These occur chiefly in connection with the books and records of original entry and consist of items which are incorrectly recorded, either in whole or in part. *For instance, an entry in the sales book may be incor- rect as to quantities, or in the extension of the items. These errors do not affect the trial balance and frequently remain undetected. The same tests as are recommended under (c) above should be followed, except that it is not usually necessary to cover as many items. Calculations of purchase and sales items are frequently verified by two persons in the offices where they originate, and almost invariably are checked in the offices to which they are sent. The test, therefore, may be extremely limited, pro- vided it is apparent that care is taken by the clerks in charge of such work. (e) Offsetting Errors. These occur fairly often, and while they could be classed under the other headings mentioned, they are dangerous enough to deserve special mention. An offsetting error is one which is counterbalanced by another error or errors. It is an annoying type. As one error may occur in an asset or liability account and the other in an expense or income account, an auditor is 20 AUDITING not justified in passing any accounts until satisfied that such errors do not exist. Of course, this does not mean the verification of every posting, but it does call for the tests or analyses described more fully hereafter. Few executives realize the great number of clerical errors v^hich are made every day. Perhaps these are mxOst numerous in banks, brokers' offices, and other of^ces where the accounts are balanced daily. An immense amount of work is accomplished in a short space of time. Clerks work at high pressure, and knowing that there will be a check on their work before they leave at night, they do not verify their entries as they go along, as is the case with many clerks who depend on the monthly trial balance to detect their errors. Consequently a great number of errors are made, but as soon as it is found that the day's work must be checked back, they are located and corrected. Many of these errors are of $10, $100, or $1,000. Therefore it is not strange if two errors of the same amount should be made on the same day in dif- ferent departments, so that the accounts for that day actually balance in spite of the two errors. Recently the author was called in by the senior partner of a large stock exchange house who was greatly troubled over the fact that two errors of $100 each had been made on a certain day and had remained undetected for three weeks. He felt that something was wrong with the system of accounts or with his clerks; he could not decide which. He was advised that the discovery and reporting of the mistake by the only clerk who could have benefited by it indicated that fraud was not intended, but that if a similar case arose soon again, a fuller investigation should be made. The rule, therefore, is that an offsetting error may THE PURPOSES AND ADVANTAGES ^I occur at any time, but that the law of averages wx>uld operate against much duplication. ADVANTAGES OF AN AUDIT An auditor's duty is to discover and disclose the truth about accounts, but this is too general a designation of his duties to use when confronted with a specific case. Furthermore, the business world must, for many years to come, be educated up to a proper appreciation of an accountant's functions, so the present-day auditor must be a teacher as well as an adviser. He must be prepared to explain the purpose of his work and set forth clearly the objects to be attained as the result of his labors. The professional auditor, therefore, must give the im- pression of having a scope and purpose far in advance of the old-time auditor, whose work was chiefly confined to ascertaining whether the accounting party had properly recorded all receipts and payments on behalf of his prin- cipal. In fact, the old-fashioned audit was a cash audit. A modern audit, however, although it includes the exami- nation of cash transactions, has as its ultimate pu rpose the verification of the balance sheet. An auditor should be prepared to state that he must make such an examination of the books and records of the undertaking as will enable him to satisfy himself whether or not the balance sheet is properly drawn up so as to exhibit a true and correct record of its financial affairs. An auditor who has not himself a clear idea of the value or advantages of an audit can hardly expect to impress his client as to his purpose. The chief advantages are, of course, identical with the main purposes of an audit. The minor objects, viz., that fraud will be disclosed if it exists; that technical errors. 22 AUDITING if any, will be discovered and corrected; that errors of principle, if they exist, will be detected, and the means of preventing their repetition in the future pointed out, have been discussed. The major advantages which have been mentioned may now be enlarged upon. 1. Condition of Alffairs An accurate statement of affairs, together with a profit and loss account, showing how this position was reached, is prepared by a disinterested expert. In a vast number of cases this statement by the auditor is the first accurate information which the client has ever had as to his own condition. Left alone, a business man seems to love to fool him- self; so he goes along, year after year, overstating his assets, overlooking depreciation, and forgetting his liabili- ties. A correct balance sheet made up by a professional auditor brings him sharply to time. It will never be known how many enterprises have been saved from ulti- mate failure through the presentation of unwelcome facts by an auditor who cannot and will not be influenced by former inaccurate statements of condition. 2. Bank Loans Certified accounts are particularly valuable as a basis for bank loans. All leading bank managers recognize the assistance rendered to them in the course of their busi- ness by public accountants, and even if a business man is in the happy position of not requiring occasional aid from his banker, yet his financial rating is considerably higher if he is thoroughly up-to-date in the care of his books and accounts. The extension of credit by a bank depends on the judgment of its officers as to the ability of the borrower THE PURPOSES AND ADVANTAGES 23 to repay the loan when due. The auditor, by reason of his independence, is able to assist the banker in forming- his judgment. The prospective borrower cannot view the condition of his own business without bias. The bor- rower expects to postpone the time of payment and there- fore anticipates a future condition more satisfactory, doubtless, than is the case at the time of the application. The auditor must, in a measure, pass on the probability and the possibility of the future in the light of past results. This does not excuse an auditor who estimates a defi- nite profit in the future, out of which a bank loan will be paid, but it do€S support the recent statements of promi- nent bankers that the services of professional accountants are becoming of increasing value to them, largely because they are able to report orally the result of their "sizing up" of the borrower or the prospective borrower. If an auditor refrains from expressing any oral opinion on the probabilities of the future of a business the ac- counts of which he has just subjected to the most thorough analysis and scrutiny, it is possibly because he relies upon the ancient fiction that an accountant deals with facts only, and that future results are not facts; or perhaps he is afraid to express his own convictions. If he finds that he is usually rig^ht in his forecast of future business, it would seem only fair that his conclu- sions should be communicated to his client at the time they are formed. It is an unquestioned advantage for any borrower to be able to comply with the requirements of the banker or note broker to whom he applies for a line of credit. The attention of a prospective client, may, therefore, be properly drawn to the official action of the supreme body of American bankers. At the Convention of the x^merican Bankers' Associa- 24 AUDITING tion, held at Denver, Colo., in 1908, the Committee on Credit Information reported, urging ''that every member exert his influence to have all paper purchased from note brokers presented with accompanying statements audited by Certified Public Accountants ...,," and to that end asked that the Association, by the adoption of the Com- mittee's report, ''recommend that its members, in pur- chasing commercial paper from note brokers, give pref- erence to such names as furnish accompanying statements audited by Certified Public Accountants." Prominent bankers, from time to time, have urged their associates in conventions and elsewhere to require all prospective borrowers to furnish certified statements. Unfortunately, competition in banking circles is still too keen to permit this rule to be adopted. Some recent large losses by banks, arising out of gross overvaluations of assets and understatements of liabilities on the part of borrowers, may incline them to require certified state- ments by impartial accountants. 3. Partnerships Partnership books should always be adjusted by a professional accountant if for no other reason than that he will act impartially and comply fully with the articles of copartnership. These accounts are peculiarly liable to disturbances by causes from which corporations on the whole are exempt. Disputes occur as to salaries, division of profits, partner's overdrawings, inattention to business, and many other things which would to a large extent be obviated if the books were regularly audited by a com- petent outsider. A partner dies and there is trouble with his administrator as to the division and withdrawal of the decedent's capital, in many cases resulting in expensive lawsuits and the permanent crippling of the business. THE PURPOSES AND ADVANTAGES 25 A partnership goes into bankruptcy, perhaps through misconduct of a trusted partner. Had a continuous audit been in force the fraud might have been nipped in the bud. Again, for the protection of a limited or special partner and a silent or dormant partner a periodical independent audit is essential. 4. Fire Loss In the case of loss of merchandise by fire, a properly authenticated balance sheet prepared by a public accoun- tant is a material aid in the adjustment of claims. This is not a theory; it has been demonstrated in practice. All business men anticipate the possibility of a fire, but few of them consider just how they will collect their insurance. During the progress of an audit the auditor will ascer- tain the methods of bookkeeping in force, and whether, in case of fire, the records would be properly protected. He will ascertain if a perpetual inventory be maintained, or whether it would be necessary to calculate the amount of the loss upon the usual basis, that is, to take the last recorded inventory, add purchases to date of fire and deduct cost of goods sold, the result being the stock on hand at time of fire. The cost of goods sold is ascertained by deducting from the sales the average gross profit realized in prior periods. Fire insurance adjusters are shrewd and experi- enced and the business man whose records are in poor order is usually forced to settle upon a basis satisfactory to the adjuster. If the business man's accounts are in good shape and he can show that the last inventory had been certified to, he can decline to compromise and insist on the full amount of his claim being allowed. 5. Bonding A cashier whose books are audited regularly has little 26 AUDITING trouble in securing a good company to act as surety for him; in fact, several of the best companies insist, as part of the contract, that this be done periodically. 6., Protection of Stockholders and the Public The interests of the real proprietors of a business (the stockholders in the case of a corporation) should be pro- tected in every feasible and reasonable manner. One way in which such an end might be served would be to con- form to the English method. There stockholders elect at the annual meeting a professional accountant as the auditor of the company for the ensuing year, and his report is made to the stockholders and not to the officers and directors. A corporation which has nothing to hide cheerfully sends its balance sheet out to its stockholders, and if the latter exhibit enough interest in the matter to request that the certificate of a professional auditor be attached, such request will probably be complied with. Therefore, in every possible and dignified way the auditor should impress upon stockholders the many advantages to them- selves of such procedure. The value of the publicity of audited accounts cannot be overestimated. In a general way all corporations are believed to be making unreasonable profits, particularly all corporations which in any way attempt to serve the public. For instance, in New York City, the taxicab com- panies have been attacked in the newspapers and one ordinance after another has been passed regulating fares, all, of course, reducing them. In a few years at least two millions of dollars were lost by three or four of thest companies. During this time they did not make per! odical statements to their stockholders nor to the publi^ THE PURPOSES AND ADVANTAGES 27 setting forth these losses and the reason therefor. For some mysterious reason pubUcity was shunned. It is about as certain as anything can be that if certi- fied statements of operations had been secured and sent to the newspapers annually, a far different state of public opinion would have resulted. Corporations which are secretive about their accounts or which issue statements not certified to, have only themselves to blame if they are made the victims of hostile legislation. 7. Sale of a Business The author has had several experiences in which it was demonstrated that if periodical statements of the results of operations duly certified to by responsible auditors had been available, large enterprises would have changed hands in a few days, but such statements not being promptly available, the sales were not made. In one case the president of a corporation in which he owned a controlling interest was offered two and a half million dollars for control, subject to examination by accountants. He accepted. When an attempt was made to ascertain the earnings for a period of years it was found that no accurate records had ever been kept. Large profits had been realized, but the only reason this v/as known was because the money was in the bank. Physical inventories had never been taken and book inventories had not been kept. At the time of the proposed purchase the plant was operating on an extensive scale, but as no cost records were kept, it was impossible to determine the rate of profit on the current output. The deal was called ofif. The president complained bitterly. He had paid enor- mous dividends, which he knew had been earned, but no 28 AUDITING one could determine just when and how they were real- ized, and the condition of the accounts cast suspicion on the whole enterprise. Practically all business men look forward to retiring sooner or later. It is a kindness to them to indicate how much easier and more certain it will be for them to accom- plish their purpose if they can produce correct certified accounts than to depend upon unaudited accounts, which may fail to meet the requirements of a prospective purchaser. 8. Recovery for Negligence The final advantage of an audit (and one upon which perhaps serious differences of opinion may exist as to the advisabiUty of public discussion) is, that a client who may suffer loss through the dishonesty of an employee may recover an equivalent amount from the auditor, pro- vided that the latter is shown to have performed his work in a grossly negligent manner, and provided, of course, that the defalcation occurred during the period covered by the audit and continued thereafter. I CHAPTER III HOW TO BEGIN AN AUDIT The importance of knowing how to begin an audit can- not be overestimated. Until the business pubHc is educated to a point where it knows just what is required and can ask for specific service, which in turn the auditor can perform without violating his rules of practice, his employment is more or less general in its nature and the scope of the work is left to the auditor. For this reason many practitioners commence the work before they have a clearly defined line of procedure in their own minds. Based on personal experiences of over twenty-five years, the author suggests the following preliminary program : I. As to the Client Uncertainty sometimes exists as to the actual client whom the auditor is serving, to whom he is responsible, and as to who will pay the bill. It may be a banker or a prospec- tive borrower, a corporation or a dissatisfied stockholder, a trustee in bankruptcy or the petitioning creditors, or a creditors' committee, a municipality or an aldermanic com- mittee, a state or an investigating committee of the legisla- ture. In all of these cases and many more, differences of opinion have arisen as to the legal status of the client ; there- fore, this word of caution addressed particularly to the beginner is in order : Fix the legal status of the client before work is com- menced. 29 30 AUDITING 2. Proper Starting Conditions Some auditing engagements have ended disastrously for the auditors because the work was undertaken Mindly. It is not enough that some one should say, ''Here are certain books and records ; I want them audited and a report made to me of what they contain." The client may thmk he knows what he wants, he may be financially able to pay, and to a young practitioner the temptation to jump in and follow instructions is strong indeed. But the client may and does change his mind as the work progresses, and even if the instructions are in writing, he will find some excuse for his change of mind. He may still be able to pay, but he may not want to. There are several notable examples of work done along the lines indicated th-e bills for which have never been paid. Therefore, spend some time with the client, reviewing the work before it is commenced. Map out as definite a program as possible and overstate, rather than understate, the prob- able time which will be required. The client may have a vague knowledge of details, but he should know pretty well what the work should cover, and if the auditor cannot come to a fairly definite agreement with him as to the scope and extent of the work, the responsibility of making good is placed definitely on the auditor. A few hours' talk of this nature may subsequently eliminate many days of useless work — useless because there may have been a mistaken idea as to the results wanted ; or the results striven for might be very valuable and interesting if the work could be completed as originally planned. In most cases the auditor's wide experience enables him to know better than the client just what should be done, and what may be safely omitted, but this does not relieve an auditor from his obligation to assure himself whether in the particular case before him the client's intimate knowledge HOW TO BEGIN AN AUDIT 3I of the business does not justify him in indicating the general lines along which the audit should be made. A full and frank talk with a client cannot do any possible harm and may insure co-operation and harmony, which might be lacking if the auditor shows too much of a disposi- tion to run the whole job himself. 3. Co-operation of Client's Staff A successful auditor told the author recently that in every audit he endeavored to attract, instruct, and convert the office stafif, and in so doing he not only rhade his own work pleasanter and more satisfactory in a professional way, but that he made them co-workers with him, and in many ways they aid the growth of a proper opinion of the value of the pubHc accountant. Many instances are known where auditors have antagonized an office staff and sent them out to an extensive acquaintance charged with a desire to criticize most unfavorably not only the offending auditor (which would not be unfair), but also professional auditors as a class. Some very large engagements have resulted directly from a word of commendation to others from a bookkeeper or clerk who has had a satisfactory experience with the auditor of his accounts. All auditors of experience agree that the majority of men are honest — not a mere majority only, but most men are honest. Furthermore, most men are sensitive about hav- ing their honesty questioned even indirectly. The successful auditor does not conduct himself in such a manner as to indicate to anyone that suspicion exists. He must radiate his belief in the good faith and honesty of purpose of those whose accounts he is examining; but he will be none the less thorough and he will just as surely land any guilty man. 32 AUDITING The honest man is also sensitive to criticism of his work. Here the auditor's task is harder, because the duty to one's cHent must be placed above everything else, and while it is sometimes unpleasant to condemn carelessness and mistakes on the part of the office staff, yet if it is evident that the client's business is suffering therefrom, failure to report actual conditions would be a breach of professional duty. But the auditor who prepares his report and sends it in to the client without considering its effect on the office staff may be doing a positive injury to his client as well as to himself. The clerk whose work is criticized may be one of the most valuable on the staff. His merits m.ay vastly outweigh his shortcomings, yet if he is sensitive he may resign forthwith, thus weakening the client's organization and subjecting the auditor to the wrath which he in a measure deserves. Or again, the clerk or clerks whose work is criticized may not resign, but being in the confidence of the client and having his ear every day, may easily offset all of the good effect which the criticisms and suggestions might have, and, in addition, prejudice the client against the further employment of the auditor. Naturally, the auditor is not informed as to what is taking place, and if his services are not called for when another audit is due, he is ignorant of the true reason for the decision against him. Hundreds of business men have retained a professional auditor once as an experiment, because they had been told it was the proper thing to do, and would have become regular clients had the auditor been able to secure the sympathy and co-operation of the office staff. Who can blame a busy man, necessarily dependent upon an organization of trusted employees, for heeding their opinion of an auditor. 4 HOW TO BEGIN AN AUDIT 23 Tact Required The auditor need not stultify himself by failure to criticize. As a matter of fact, an honest staff resents gratuit- ous commendation if fthey know it is not deserved. All they want is a square deal. In practically all cases the methods in force were initiated by the client himself or by the predeces- sors of the present staff. They are simply following pre- cedents or instructions and should not be personally blamed for unsatisfactory methods or results. Let the auditor proclaim his gospel of helpfulness and ask for co-operation in the interest of the staff and in that of the client. Let him demonstrate quietly that he knows more than they do, but let it be done unobtrusively. Show them that failure to be up to date is detrimental to success, and that modern methods must justify themselves. Get them interested and ask their help in preparing an unbiased report on actual conditions, and obtain their approval of the suggested changes. If this spirit prevails throughout the audit the client will be benefited, the office staff will be enthusiastic over the innovation, and the auditor will receive a unanimous invita- tion to come again. 4. Compensation Must Depend on Service Rendered The professional accountant offers his services to the business public as an adviser as well as an analyst or auditor ; therefore it is obvious that the matter of compensation and status cannot be determined as it can in those occupations where the matter of output or results can be measured. You cannot gauge an output of brains as you can a stated amount of manual labor. Great harm has been done to the profession by certain advertisers who, for the purpose of selling correspondence courses in accountancy, have exaggerated the compensation 34 AUDITING of professional accountants. There is no reason why the profession should be better paid than any other which serves the public to an equal degree. The implication in these advertisements that there is some fixed scale of fees which an accountant can charge is more or less correct, and it is unfortunate that such is the case, for it tends to place the profession on a par with day laborers. If all accountants are to charge alike for their services, where is the incentive to excel and what kind of profession would it be if there were no premium on ability and ex- perience ? The best lawyers and the best doctors sometimes charge lower fees for the same service than less experienced and less competent practitioners, but such reduction is none the less professional. So with accountants, as time goes on there will be less and less uniformity in charges, and the more skilful, capable, experienced accountant will not consider it necessary to place a fixed per diem rate on his services. Nevertheless, under present conditions per diem rates yield the greatest compensation. Where flat fees are charged it almost always means that some concession has been or will be made in the per diem rate, so that the auditor who can always command liberal day rates will reap the greatest financial reward. The one good argument for a stated fee (and it is a strong one) is that the client prefers it in perhaps nine cases out of ten. Professional men should place the adherence to the ethics of their profession and the satisfaction of their clients above pecuniary gain. Therefore, if the work is fully and properly performed and the client is satisfied, the method or rate of compensation should be secondary, and a round fee, under such circumstances, is quite as ethical as a per diem rate. If the fee has not been arranged beforehand and litiga tion is necessary, the auditor will receive the usual profe I HOW .TO BEGIN AN AUDIT 35 sional fee, provided, of course, that witnesses can be obtained to testify that the work measures up to the usual standard of professional work and that the fee is a reasonable one. Juries, however, are apt to be more unreasonable than clients with respect to professional charges, and the rule of arranging fees beforehand should not be deviated from except in special cases. Several years ago an inquiry into the actual rates charged by accountants was conducted in New York City. There was, of course, a wide divergence between the fees named by well-established firms having a large clientele and the accountant just starting in practice. The result of the inquiry is mentioned here for what it is worth, and without any attempt to set it up as a standard for other parts of the country, nor even for accountants practicing in New York City. The questions and ajiswers, with slight modifications in the form, were as follows : Q. What is the maximum rate received per day, and for what class of work? A. $100 per diem was the maximum rate received, and that only for a special class of work, such as an investigation calling for particu- larly expert knowledge. In one case, however, $250 per day was charged for a few days' service. Q. What is the minimum rate per day received? A. $10 per day. Q. What is a fair average rate for accountants of the highest class ? i\. $50 per day. Q. What is a fair average rate for accountants who might be considered as not of the highest class? A. $25 per day. Q. What, in your opinion, would be a standard rate for investiga- tions requiring first-class ability, as a minimum? A. $25 per day. Q. What, in your opinion, should be the rate for ordinary audits and examinations not requiring the highest ability, as a minimum? A. $15 per day. 36 AUDITING Q. If you were establishing standard rates, taking all circum- stances fairly into consideration, what rates would you advise? A. For standard rates the minimum fee for the man in charge should be $25 per day; for ordinary assistants, $15; and for juniors used in clerical checking, $10 per day ; but the restriction of this com- pensation is not advocated, especially for those in charge of work, to $25 per day. Q. To what extent are assistants used ? A. Probably 90 per cent of accountants in active practice use assistants. Q. What are the maximum and minimum per diem rates received for the services of (a) Senior assistants? (b) Junior assistants? A. Senior: maximum, $25; minimum, $15. Junior: maximum, $15; minimum, $10. Contingent Fees One of the proposed amendments to the by-laws of the American Association of Public Accountants provided that : "No member shall agree to perform accountancy work pay- ment for which is contingent upon the result of litigated or arbitrated issues." It is proper that the auditor should avoid even the ap- pearance of evil, but it is a debatable question as to w^hether this rule is not so strict that literal compliance therewith is impracticable. If this is the case, the rule should be re- framed in order to express properly the thought that it is always wrong for an auditor to undertake work which he cannot conscientiously certify to, or to submit figures which may reflect his prejudices rather than his honest convictions. As a matter of fact, auditing work may be performed upon the basis of a contingent fee, the propriety or honesty of which can no more be questioned than if it were under- taken upon a basis of per diem rates. An actual experience will illustrate the point. A cashier w^ho had access to the books of a corporation forged the indorsements on certain customers' cheques and misappro- HOW TO BEGIN AN AUDIT 37 priated the proceeds. The president discovered the fraud and attempted to locate the items in order to recover from the banks which cashed the cheques, but he was unfamiliar with bookkeeping methods and was only partially successful. He suggested to a professional auditor that the books be carefully audited and that the full amount for which the banks could be held responsible be ascertained. He had an unreasonable fear that the work might be very expensive and the results unfruitful, so he suggested to the auditor that the latter should receive one-half of the net amount recovered in full payment for his services. The auditor accepted the proposition, unearthed claims aggregating several thousand dollars, and received for his services some- thing in excess of his regular per diem rates. The banks did not pay willingly and required the most complete proof before making settlement. The auditor could not in any possible way have improperly influenced the results, so that if he had refused the engagement be- cause his compensation depended upon a contingency, he would have suffered an unnecessary pecuniary loss and his client might have lost an equal amount. In the opinion of the author, the auditor should subject each engagement to scrutiny to discover any possible reasons why he should not undertake it. Work which involves his integrity should always be declined. But if he can con- scientiously accept work w here his fee depends upon a con- tingency, he should not refuse the required service. 5. As to Where the Work Is Done This question receives but little consideration in the usual audit until it is too late to make a change. Most audits are made in the office where the general books of account are written up. Provided there are ample space, adequate light, satisfactory and sanitary working conditions such as 38 AUDITING pure air, etc., and reasonable freedom from interruption by unauthorized persons, this is the ideal place. When the audit is being arranged for, all of these points can be discussed, and few clients will hesitate to modify or improve existing conditions in order that the audit work may be performed under favorable auspices. But if this matter is left in abeyance until the audit is actually com- menced, changes are almost impossible to effect, or if not impossible, the auditor usually deems it inadvisable to open up the subject. Therefore, stipulate for the best possible working condi- tions before zvork is commenced. 6. Working Papers It may sound paradoxical, but the time to arrange work- ing papers is before the actual work of the audit begins. The most important point to emphasize is that the more inexperienced an auditor is, the more working papers he produces, so that the student or practitioner who aspires to a high place in his profession will avoid all unnecessary com- pilations and comments; he will try to settle his doubts relative to questionable transactions immediately, for the majority of his questions will be answered satisfactorily; he will eliminate the copying of trial balances, statements, etc., unless he has a clear idea as to their ultimate use, and he will ruthlessly destroy his papers as soon as their value is questionable. It is a pity that the limits of this book make it imprac- ticable to include detailed illustrations of how things should be done and how they should not be done. Perhaps the assertion that the skill of an accountant can always be ascertained by an inspection of his working papers is too sweeping, but it will hold good in so many cases that it may as well be called a general rule, and therefore prospective HOW TO BEGIN AN AUDIT 39 auditors should take notice that some day they may be so judged. If the professional man were as careful with his tools as is the mechanic, he would do better work and he would save himself many hours of duplicated labor. The average lawyer, for instance, makes his notes on scraps of paper and in such an unsystematic way that an orderly filing of them is impossible. Subsequently (in many cases) the notes cannot be found, or if found, they cannot be understood. Fortunately for the lawyer, his notes are, in a majority of cases, not required later, which accounts perhaps for his carelessness. But an accountant must be the personification of order and system; his business is to criticize careless methods in others and construct proper systems for those who have none. Therefore he must convey the impression that he appreciates order and good methods and be able to demon- strate this by an exhibition of the highest degree of perfec- tion in his own working papers. Stationery is cheap, far cheaper in proportion than the implements used by mechanics, yet many accountants will use a scrap of paper or the back of an envelope to make a record in connection with an audit, when the items so noted are important enough to be set down in an orderly way on a whole sheet of specially ruled paper. It really seems absurd to devote much space to this matter, and it is only because there is such a widely prevalent looseness in this respect that emphasis is given to the use of good stationery and im- portance placed on plenty of stationery always being available. An accountant or a bookkeeper should have on hand at all times a complete assortment of specially ruled paper of all sizes. Let him consider this as part of his plant, if need be, for a very small expenditure will secure a large 40 AUDITING supply of paper. The special rulings should cover every form for which there may be the slightest call. With respect to money columns, paper should be ruled having from three to eighteen columns. The former will be the most used, but there is a constant call for the latter. Then, of course, ledger-ruled paper will frequently be used, and it is very desirable to have ledger paper with two money columns on both sides. The paper should be put up in pads of fifty sheets each. In commencing an audit, a full assortment of paper, together with various colored pencils or ink, etc., will be gathered together and carried preferably in a stout leather portfolio with a first-class lock on it and containing con- venient pockets for papers, pencils, rubber stamps, etc. Is it not obvious that a client or a client's clerk will have more respect for an auditor who is fully equipped than for a man who is compelled to borrow first a sheet of paper and next a pencil in order to record details of the petty cash as counted ? First impressions are lasting. It is no excuse to urge that many offices of comparatively wealthy concerns are woefully lacking in good stationery and that a little pile of carefully cut used envelopes for making memoranda is still in evidence in many offices. In most cases such a supply is sufficient for the bookkeeper who is not in possession of ruled paper, and who probably does not see any necessity for having it on hand. He is so blissfully unconscious that there are scores of uses to which he might put some well-ruled paper for the edification an< financial benefit of his employer, and which would almost surely result in an increase in his own salary, that it is no< fair to the wide-awake man to say too much about it. Th< benighted user of old scrap paper will simply make wa^ some day for a more competent successor. The professional auditor, however, cannot afford t< HOW TO BEGIN AN AUDIT 41 start wrong, for he does not have the same opportunity for concealing his incompetency. Stock up, therefore, and keep stocked up, for a few extra dollars invested in a big supply of stationery will be the greatest possible help to the young practitioner. Having the paper, use it. That is, don't even try to economize, for it is not safe to temporize and think that a particular memorandum is unimportant and, there- fore, just as well recorded on a scrap as on a whole sheet which may have cost a quarter of a cent. It will be a great convenience to head up separate sheets of paper at the commencement of an audit along the follow- ing lines : ''Cash Vouchers Lacking'' ; "Errors in Footings — Cash Book''; ''Errors in Footings — Sales Book"; "Errors in Postings — Private Ledger"; "Suggestions and Comments" ; "Defects in System" ; "Missing Internal Checks." There should be an absolute rule strictly adhered to, forbidding the writing of more than one class of errors on the same sheet of paper. If, for instance, an audit develops but three errors in footings and postings, one being in the cash book, one in the journal, and one in the sales ledger, there should be three sheets of paper submitted at the close of the work, one error appearing on each. The reason for this is evident. The work covered is assumed to be a test only, and no one can tell how many errors may develop if additional verification is required. It is almost criminal for an accountant to write and re- write and classify and reclassify his memoranda during the course of an audit, when every bit of the rewriting and reclassification could have been avoided by using one sheet of paper for each class of errors or queries. There is a general habit to minimize the importance of working papers, and while the client suffers most because his affairs are not properly looked after, yet the auditor who 42 AUDITING starts in wrong does himself positive harm by not getting the most out of each engagement. An auditor who is careless about his working papers has taken up an audit, and having forgotten to supply himself with stationery, calls on the client's supply. Irregular pieces of scrap paper are supplied to him, and on these he makes his various notes and comments. He dislikes to ask too often for paper, and so economizes by using both sides of some pieces and fills others to the limit. By the time the audit is completed he has a veritable mess of scraps. He then vainly attempts to make sense out of a lot of notes which were considered of great importance when made and which would have been written out properly if the means had been at hand. How is it possible for such a man to .write a report of the greatest possible value to his client? Even if he finally deciphers all of his notes and does not forget to look on the back of every scrap, he has made so much trouble for himself that in consequence thereof he has written a report in a troubled and irritated frame of mind and his careless style has, of course, permeated the text. Consider the case of an auditor who takes the trouble to provide himself with an ample supply of paper; who uses a separate sheet for each class of error, suggestion, or com- ment. When he is ready to write the report he merely sorts his working papers, and with full notes before him, with no irrelevant matters constantly interrupting his train of thought, has simply to proceed in an orderly manner to the close. Is it worth while? Who has the better chance for another engagement from the client so served ? Permanent Filing After a report has been written great care must be taken to file working papers intelligently and according to a HOW TO BEGIN AN AUDIT 43 well-laid-out and thoroughly understood plan, or serious inconvenience may be sustained on subsequent occasions when a particular schedule or reconciliation sheet is required in a hurry. A plan which has been followed with success is the following : Commencing with the balance sheet submitted to the client each item thereon is assigned a letter. For instance, if plant is the first item among the assets, the letter A is assigned thereto. Each schedule relating to plant would be marked Al, A2, A3, etc., and all papers containing information bearing thereon are grouped accordingly. The same plan applies to the profit and loss statement, and to any other schedules where the supporting papers are numerous. When the single letters are exhausted, double letters may be used as AA, BB, etc. Variations of this plan will suggest themselves to the auditor who has had difficulty in locating working papers. 7. Familiarity with System in Use During the auditor's early training he will have had an opportunity to acquire special knowledge with respect to many lines of commercial activity, so that many of his engagements will cover undertakings the special features of which will be familiar to him. It is impossible, however, for any auditor to have experience in every line of busi- ness, and engagements will have to be made to audit accounts of which he has no technical or special knowledge. He is not expected to have the special knowledge, but he should explain that the fundamentals of all businesses are similar and that he is thoroughly versed therein. An admission as to his unfamiliarity will win greater 44 AUDITING respect than an attempt to conceal his ignorance; progress cannot be made without asking many questions, and it will not take a client long to discover the ignorance if an attempt is made to conceal it. In any event, and despite long ex- perience with the same class of business, the auditor should ask questions about the personnel and the special features of the business under review. Local conditions and peculiarities may sometimes pro- duce strange results, and the auditor will find it easy to acquire a broad knowledge of many things during his pre- liminary conferences which would later take far more time to acquire. The client and his staff expect to be asked a lot of questions (intelligent and tactful ones, of course) at first, and the wise auditor will make copious notes of the informa- tion so derived. The client will probably volunteer the his- tory of his life and the progress of his business in great detail, and advantage should be taken of such an opportunity to grasp the technical points of the business. Later on it may be difficult to catch the client in the same frame of mind. The auditor may be asked whether he can make a satis- factory audit of single-entry books. Of course there is no difference at all so far as auditing principles are concerned. In single-entry, as in double-entry systems, the auditor will see that all assets which should be on hand are properly accounted for; that all income which should have been recorded has been found to be in order ; and will apply all the general principles of auditing. Single-entry books doj not readily lend themselves to tests and automatic checks as do double-entry records, but there are no fundamental differences. More details will have to be verified, and there! will be difficulties in the way of preparing satisfactory bal- ance sheets and profit and loss statements. But these are not] matters which require special treatment in this book. HOW TO BEGIN AN AUDIT 45 8. Schedules of Books, Records, and Names of Clerks A mastery of the general system in use includes a com- prehensive knowledge of the books and records which con- tain the transactions of the business under audit. Books of account are the histories of business enterprises. As a history is not complete unless it records an unbroken narra- tive of facts, the auditor must determine whether or not he will find such a continuous record of the transactions of the business in the books submitted to him. The time to determine this is before the audit begins, and at the time of the inquiry a full description of the records should l:>e made and the names of the clerks responsible therefor carefully noted. These names will be needed subse- quently and when reporting. It arouses suspicion to ask for names when needed. In England, it is customary in most cases, and compul- sory in others, for the auditor to be supplied with a list of the books in use. In this country the advantage of this precaution is strangely neglected. No book should be listed until its use, or abuse, is fully comprehended. This is a favorable opportunity to fill out any gaps in the complete survey of the business which the auditor must possess. The answers to the preliminary questions and a detailed schedule of all the books in use should form the basis for an intelligent study of how to begin. 9. Procedure where Previous Audits Have Been Made A prominent accountant estimates that not more than 10 per cent of the business concerns of this country have their accounts audited. But as most of the work that is done is satisfactory, it is only in rare cases that one auditor replaces another. It is not considered ethical for one auditor to supplant 46 AUDITING another where the only reason for the change is that of remuneration. If a client expresses dissatisfaction with the work of one auditor and announces his intention of retain- ing another, there can be no objection to the appointment. Wherever feasible, the auditor should receive a copy of his predecessor's report, but if it cannot be had, his in- spection of the books, and the unsolicited remarks of the client's staff, will probably indicate the extent of the previous audit. Of course, no auditor could be held responsible for the acts or omissions of another auditor, but he would have no justification for blindly following the procedure of a previ- ous audit, even though tVie client requested it. Therefore the auditor should regard all that he learns of his prede- cessor's work as information purely supplemental to that already pointed out as important, and weighing all together, he will proceed as his own best judgment dictates. Sometimes, from a feeling of delicacy, the auditor will not insist on a full explanation as to why the previous auditor's services have been dispensed with. In view, how- evef, of the fact that auditors have been displaced for failure to discover specific weak spots, it is obvious that the succeed- ing auditor would be at a disadvantage without this knowl- edge, so that in all cases insistence on an explanation can do no harm and may be very useful. Shortly stated, a safe general rule is to proceed as if no previous audit had been made, unless complete reports of another auditor, in whom the fullest confidence is placed, are in evidence, and unless there is no question as to the reason for the former auditor's di-splacement. 10. Final Considerations: Detailed or Balance Sheet Audit? It might be inferred that having studied the matter from so many standpoints, and particularly after having had a HOW TO BEGIN AN AUDIT 47 final interview with the client, there would remain nothing to do but to commence the actual work. This, however, is not the case. Now is the most im- portant time for calm reflection. Up to this point many features were more or less uncertain. The client's under- standing of the state of his books and the detail therein and the explanations of the clerks, together with a survey of the books themselves, all affect the final decision as to what should be done. Frequently a client will make the broad assertion that he wants a complete and detailed examination of his books. Subsequent inquiry may develop the fact that a first-class system of internal check exists, or that the transactions are so numerous that a detailed examination is quite out of the question. Therefore the auditor should reserve final de- cision as to the scope of his work until he has inspected the books and interviewed those in charge thereof. The final point to be decided is: Shall a detailed or a balance sheet audit be made? These two classes of audits are discussed fully in subsequent chapters, but it is desirable that a brief survey of each be made at this point in order that we may now completely cover every phase of prepara- tion up to the actual physical work of the audit itself. In dividing audits into two classes, the author has not failed to consider another class, viz., "cash" audits. The title 1*3 a misnomer^ »however, because many attempts to limit an auditor to an examination of cash records have either resulted in an incomplete and unsatisfactory task, or else the work has naturally extended into other records comple- mentary to the cash account, which, of course, are vitally necessary to a proper audit. A professional auditor probably should not refuse point blank to make a so-called cash audit when requested to do ^ so, but he should explain fully and carefully that most fraud 48 AUDITING and carelessness lie in the transactions which do not reach the books; that the cash account in itself is only a portion of a system, every part of which depends upon and works into the others. He should explain that to accept a cash book as correct is unwise, because it is not what is in the book and accounted for that is of interest, but rather what is not there, evidence of or clues to which might be found in the other books and records. Perhaps the safest answer for the auditor to give would be the statement that there is no such thing as a cash audit, and follow that statement by an explanation of the points usually covered in a detailed audit and in a balance sheet audit. The Detailed Audit In all cases where a complete examination is desired or desirable a detailed audit should be made. In those undertakings where there is no satisfactory internal check, the detailed audit is the only one which will cover the income and expenditures for the period under audit. This applies, therefore, chiefly to small enterprises, but as the organiza- tions which have a complete system of internal check are very much in the minority, the auditor will most frequently have to undertake a detailed audit. But a detailed audit in the sense in which it is used here does not contemplate the verification of every item in the books. Not many years ago one of the principal features of every audit was the inspection and verification of vouchers for cash payments. In many instances certificates stated without reserve that the ''accounts have been audited and found to be correct," when, as a matter of fact, absolutely nothing else was done but to compare certain receipts pur- porting to represent payments of cash and acknowledg- ments thereof, with the payment side of the cash book. The HOW TO BEGIN AN AUDIT 49 certificates appearing at the end of treasurers' statements in most published reports of charitable and religious institu- tions show just such a state of afifairs. It seemed conclusive to many people that if a cashier or a treasurer could furnish a voucher for every item of cash disbursement, there simply could not be anything wrong about the accounts as a v/hole. As the science of accounts developed, some auditors were not satisfied with this, and they supplemented the examination of the vouchers by a complete verification of the footings and postings. Having done this, they were content, and felt that great strides had been made in the art. Add to the above the checking of the trial balance and you will have the full program of a large percentage of audits — certainly up to ten or fifteen years ago. Sad to relate, a considerable number of present-day audits vary little from this procedure, in spite of the fact that professional auditors now have an opportunity to profit by the mistakes of their predecessors and to use more scientific methods in their work. Some auditors, however, do all their thinking after they start to work, and will not take the time and trouble to plan ahead. Careful consideration of a large number of defalcations reveals the fact that most of them would not have been dis- covered by a verification of the vouchers, footings, postings, or trial balances. This fact does not eliminate the necessity for proper attention to such work, but it does emphasize the greater necessity for attention to the work which experience shows is productive of the most satisfactory results. An a,uditor must at all times study and think and appre- ciate the need of preparing all his plans on a relative scale. Conceding the obvious conclusion that no audit can or should embrace a complete verification of all the transactions of the period under review, then the process of elimination must so AUDITING proceed scientifically and with the definite goal in view that the points covered will coincide with the weak spots. In the succeeding chapters the author will outline the procedure for a detailed audit in which proper weight is given to the verification of the routine bookkeeping, but laying more stress on other phases of the accounts which have proven to be those most susceptible to fraud, careless- ness, and ignorance. Where there is a satisfactory system of internal check, the auditor is not expected, and should not attempt, to make a detailed audit. The word ''satisfactory," however, is used advisedly, for more than one large corporation with a comptroller and a force of staff auditors lacks a complete system of internal check. When the staff auditor is also an official in the business, he is seriously handicapped when he endeavors to check the records of other departments of the organization. There are so many opportunities to impose administrative func- tions upon him that within a short time his supervisory and auditing duties are hopelessly entangled. Proof of the fre- quent existence of this condition of affairs is seen in the discovery of defalcations on the part of officials who were not supposed to have access to funds or securities. If the staff auditor is a clerk, his position is still more difficult to maintain. If his superiors are dishonest, he soon has to choose between dismissal or silence. Therefore the mere statement that an auditing department exists is not enough evidence in itself to obviate the necessity for a detailed audit. Balance Sheet Audit If the auditor has satisfied himself that the system of internal check is adequate, he will not attempt to duplicate work which has been properly performed by some one else. HOW TO BEGIN AN AUDIT SI , His duty will then be to verify the assets and liabilities, and to make such an analysis of the profit and loss account as will enable him to certify that it has been properly stated. But there is a much wider field for balance sheet auditing than this. Bankers are awakening to the value of certified statements from borrowers or prospective borrowers, and there are vast possibilities in this class of work. The auditor who can undertake these engagements with a clear outline of what is to be covered, and more important still, what may be omitted, has a tremendous advantage over the auditor who does not appreciate the peculiar circumstances which surround this class of work. Balance sheet audits are also required in many,jithercases. The author will, in another chapter, attempt to set forth as concisely as possible what, in his opinion, should be done in a balance audit, and what need not be done, and what should not be done. Suggestions to Clients* Staff before Commencing Work In the great majority of audits which are made for the first time the client will have informed his entire staff as to his intentions, so that there is no possible chance of gaining any advantage by surprising them. Then, too, it may be that the audit is being made at the request or on the suggestion of one or more of the staff. This occurs very frequently where ambitious bookkeepers and cashiers realize that the methods in use in the office are obsolete. If the auditor desires full co-operation, he should seek an opportunity to ascertain the condition of the books and records as soon as possible after the engagement has been made. He will gain nothing whatever by jumping in before the books kre written up or balanced. / s^ AUDITING As he will probably be asked what he desires in the way of vouchers, etc., the following memorandum has been pre- pared. It is, of course, only suggestive, as the auditor must be governed by local conditions : 1. A correct trial balance, as of the date the audit is to be made, should be prepared. If not ready by the time the audit is to be commenced, the auditor should have a confer- ence with the client and the bookkeeper and determine (a) if the work is to proceed at once; (b) if it is to be postponed until the differences are located; (c) if the auditor, acting as an accountant, is to locate the errors. 2. Controlling accounts in the general ledger should be in agreement with the subsidiary records; if not in agree- ment, the matter should be discussed with the client and an understanding reached as to whether the errors are to be located or allowed to stand. 3. Schedules of notes receivable (whether or not dis- counted), notes payable, bonds, stocks, etc., should be prepared. 4. Monthly statements .from creditors should be pre- served. 5. Paid bank cheques and all other vouchers should be taken from the files and arranged as requested by the auditor. The auditor should not disclose the use he proposes to make of the vouchers. 6. If an inventory has been taken, the auditor will state to what extent he desires the certification of those responsible therefor, and he will insist on the original sheets being pre- served and submitted. 7. If there are many accounts receivable, it may be wise to request that they be divided into groups, showing all those overdue, etc., so that an estimate of the reserve for bad debts may readily be made. HOW TO BEGIN AN AUDIT 53 SYSTEM OF INTERNAL CHECK Reference has several times been made to the fact that the question of whether a detailed audit should be made, or whether a balance sheet audit will accomplish the desired end just as well, depends to a considerable extent upon the existence or lack of a satisfactory system of internal check. Such a system consists in the accounting records, methods and details generally of an establishment being laid out in such a way that no part of the accounts will be under the absolute and independent control of any one person; that, on the contrary, the work of one employee will be complementary to that of another; and that a continuous audit will be made of the details of the business. While the details of a system of internal check vary somewhat in different cases, the following general points usually require careful attention. Incoming Mail Proper provision should be made for safeguarding in- coming mail, so that cash received shall reach the cashier. The opening and handling of incoming mail should be in charge of some responsible person, preferably an officer of the company. All remittances should be listed and the list subsequently compared with the cash records. Cash All cash payments should be made by cheque signed by one of the principals and supported by a duly authorized voucher. All money received, whether in the form of cheques or cash, should be deposited in the bank daily. Small payments that must be made in currency should be made from a petty cash fund set aside for that purpose. 54 AUDITING Receipts or vouchers should be secured for all disburse- ments from this petty cash fund, and at frequent intervals the cashier should prepare a statement of disbursements made from the petty cash fund. Upon surrender of this statement accompanied by the vouchers or receipts and certified to by him as to the correctness of the items, he should be reimbursed by cheque for the total amount shown by the statement. This should also be done at the close of every fiscal period". The cashier should have no access to any of the in- dividual ledgers, nor to statements sent to customers. The bank pass-books should be balanced or a statement of account secured from the bank at least monthly. The outstanding cheques should be listed, and the balance shown to be in bank should be reconciled with the balance called for by the cash book. Invoices for Purchases The issuing of orders for the purchase of goods or materials is one of the most important duties to be per- formed in any organization. While in smaller concerns this work is frequently performed by a principal, still in larger enterprises it is usually necessary to delegate the work to an employee. One person should be responsible for all purchases. Requisitions for requirements of the various departments should be sent to him and formal orders issued from his department, or else all orders issued should be subject to his approval. As a general rule orders should state prices and exact quantities required. Duplicate copies of all orders should be retained and one of these copies should have a place printed upon it for enter- ing the date and amount of invoices received applying HOW TO BEGIN AN AUDIT 55 against that order; thus making it more difficult to pass a duplicate invoice. A careful record should be made of all goods received. In some of the larger concerns copies of orders from which the quantities and prices have been eliminated are sent to the receiving clerk for his information. Then upon receipt of the goods or materials the receiving clerk enters the quantities and sends the copy of the order to the accounting department to be compared with the invoices. If the person in charge of the receipt of the goods is not competent to pass upon the quality he should ask for the assistance of some one from one of the other departments who is competent. The operation of comparing the invoice with the order, the checking of quantities, quality, prices, and extensions should be indicated by the initials of those responsible for each operation respectively. Before being sent to the treasurer for payment, invoices should be approved by the executive in charge of the ac- counting department; and when the cheque is drawn this fact should be noted on the invoice in some manner to avoid a second payment. If the voucher system of payment is not used, the stub of the cheque should show sufficient information to enable the bookkeeper to identify the items paid. The accounts payable accounts or creditors ledger ac- counts should be balanced at regular intervals. The shipping clerk should keep a separate record of pur- chases returned, and this record should be systematically followed up to secure credit from the original shippers. Sales Invoices The quantities, prices, extensions, and additions of all sales invoices should be checked at least once before the 56 AUDITING invoices are sent out. This checking should include a com- parison with the customer's order or an abstract thereof. When possible the duplicate copy method of writing the sales book should be used, the first carbon copy of the invoice becoming the sales record. This gives in the sales book an exact copy of the invoice sent out and is admissible as such in court. A systematic record should be made of all orders re- ceived, and as shipments are made, notation to that effect should be made on these records. The receiving clerk should keep a separate record of sales returned, which record, subject to the approval of some one in authority, should be the basis for rendering credits for such goods to customers. Customers' Accounts As stated previously, the employee in charge of cash receipts should not have access to customers ledgers. Allowances should not be made, except upon written approval of proper authority; and journal entries to close off accounts, such as bad accounts, should be supported by official authorization. If customers' accounts are kept in subsidiary ledgers, the subsidiary records should be balanced with the controlling account at regular intervals. Collections Some systematic method should be followed in the col- lection of accounts. In larger concerns this should be in the hands of a separate department, and in any case it should not be left entirely in the hands of the bookkeeper. Pay-Roils The method of preparing the pay-rolls, should be such that every step receives an independent check by some one HOW TO BEGIN AN AUDIT 57 other than those in direct charge of the work. A record should be kept of the name and rate of each employee and no entries should be made on this record, either in the way of additions or changes, without proper authority, which should be in writing. Payments of money to employees should be made in the presence of two or more persons and both the paymaster and the witness should sign the pay-roll sheets to evidence the payment. Stock Records Where practicable, a perpetual inventory of stock on hand should be maintained and the quantities shown by this inventory should be verified from time to time by comparison with the actual goods or materials. Vacations Every member of the office staff should be required to take a vacation at least once a year, and it is also advisable to transfer employees from one position to another at more or less frequent intervals, dependent upon the class of work which they perform. Branch Office Accounts Where branch offices are purely sales offices, it is cus- tomary for the petty expenses of the office to be paid from a petty cash fund advanced to the branch. Reports of petty disbursements accompanied by vouchers are sent to the home office periodically, and a cheque drawn to reimburse the petty cash fund. The auditor should examine these reports and the vouchers accompanying them. The reports should show the approval of the person in charge of the branch office, and in some cases it is desirable that each voucher show proper approval. Cases have been known where the amounts of express bills have been raised by office boys 58 AUDITING before the bills were presented to the local cashier for pay- ment. The auditor should, of course, examine very closely any bills which show indications of erasures, and make a further investigation if the facts warrant. If invoices are rendered and customers' accounts kept at the branch office, it may be that a complete system of internal check will make it unnecessary for the auditor to visit the branch office, although these cases are rare. Some companies, due largely to the nature of the busi- ness, have an almost infallible check on their branches. A perpetual inventory of all goods shipped to or purchased by the branch is kept at the home office. Copies of all bills rendered by the branch are sent to the home office, where either a controlling account of the branch customers ledger or a duplicate set of customers' accounts is kept. A trial balance of the branch ledgers is sent to the home office at the end of each month ; copies of all credits rendered and journal entries made are sent to the home office, where they are carefully inspected before being approved. Cash collections are deposited in a local bank account, over which the branch has no control, cheques on this account being drawn at the home office. By the use of carbon paper, copies are made of the branch office cash book and one of these copies is sent to the home office each day, accompanied by signed duplicate deposit slips. Statements and canceled cheques are sent direct to the home office by the local bank ; disbursements for petty expenses at the branch are made from a petty cash fund such as has been previously described. The auditor's duty in cases of this kind should be to see that the system as planned is carefully carried out at the home office, making such tests as may be necessary to satisfy himself in this respect. CHAPTER IV BALANCE SHEET AUDIT— ASSETS General Principles The underlying- principles of a balance sheet audit may be reduced to writing and are not subject to change to fit particular businesses or special systems of account. They are few in number and can be applied generally. The principles upon which all balance sheet audits are based are as follows : 1. The auditor must ascertain that all of the assets shown by the books to have been on hand at a certain date were actually on hand. 2. He must ascertain whether ^ny other assets, not on the books, should have been on hand. 3. He must ascertain that the liabilities shown by the books to be owing at a certain date were actual liabili- ties. 4. He must ascertain whether or not all liabilities were in fact shown by the books. 5. He must ascertain whether or not the liabilities so shown were properly incurred. In the following pages these theories will be discussed and the work incident to a balance sheet audit will be explained. 59 6o AUDITING Limitations of Balance Sheet Audits Must be Understood In arranging for a balance sheet audit, the distinction between an audit of that character and a detailed audit should be pointed out to the client. It sometimes happens that after a balance sheet audit, specifically provided for in writing, has been made and the report rendered, it is discovered that petty defalcations have been going on for a long time. It is natural for the client, in such event, to criticize the auditor, but if the latter has a written order, to which he can refer, it can be clearly shown that the detection of the small theft was not within the scope of the engagement. If, how- ever, the auditor has been careless about the preliminary arrangements and has not explained, nor put in writing, the limitations of a balance sheet audit, he will find him- self in an embarrassing position and is fortunate if the worst that happens is the loss of that client. While an auditor cannot be held liable in money dam- ages unless negligence is proved, yet a jury might find that a client who instructed a professional auditor to ''make an audit," without any limitations being men- tioned, could reasonably expect the details of his accounts to be fully covered. For instance, an auditor making a balance sheet audit would rarely prove the footings of the petty cash book; but if it were aftenvards found that these footings had been systematically overstated and the client defrauded, an auditor's freedom from, or liability for, negligence might rest entirely on the conditions of his employment. Assets One definite point to be kept in mind in a balance sheet audit is that an entry on the books which purports to record an asset is nothing rnore than a book record, and BALANCE SHEET AUDIT— ASSETS ^j there can be no good excuse for accepting such entry as final. The data supporting the entry may be in order, but it is the auditor's duty to verify independently, as far as possible, the fact that the asset still exists, or did exist at the date of the balance sheet. CURRENT ASSETS The current assets will be discussed first. These are called ''quick,'* or ''floating," or "liquid." The author prefers the term "current" as applied to all of those assets which are for sale. If any doubt exists, it can be settled by the answer to the question: Is it the purpose of the business to convert these assets into cash at the earliest practicable moment? If the audit occurs some time after the closing date, numerous changes are apt to have been made in the ctir- rent assets and the subsequent entries and changes will have to be carefully scrutinized, for the light they may shed on the past. At the outset the auditor should carefully read the schedule of assets to be verified and outline a specific plan which has for its basis the connection between the entries supporting the asset accounts and the things themselves. In other words, all of the assets which should he on hand must be accounted for, including those on the books and those which may have been omitted from the books. Liens and Hypothecations Throughout the verification of the current assets the auditor should be vigilant in his endeavor to ascertain whether the title to the accounts, the stock-in-trade, the machinery and other items is free and clear, or whether a lien exists thereon which is not fully disclosed on the books and in the financial statements. 62 AUDITING Insurance policies are often good guides to title. The holder of a lien on merchandise or the owner of a chattel mortgage is usually careful to protect his security, and wherever an insurance policy is payable to more than one party ''as their interests may appear," the auditor is put on notice that the property insured is not free and clear. There is a tremendous business being done by com- panies making a specialty of advances upon, or the pur- chase of, accounts receivable. Some of these companies solicit business upon representations that the transactions will be secret and that no information relative thereto will be available to the customers whose accounts are assigned, or to the creditors whose interest in such accounts receiv- able is thus subordinated without their knowledge or consent. In many cases the concerns securing the advances have greatly benefited thereby, being enabled to borrow in this way enough to finance their businesses properly : and instances are known where concerns so financed have thereby escaped bankruptcy and subsequently prospered. An auditor, therefore, should not take a definite stand for or against the practice in general, but he should reserve his criticisms for abuses or objectionable secrecy. The absolute necessity for disclosing assignments is pointed out on page 272. It may be that an effort will be made to conceal from the auditor the transfer of the accounts, but it should not be dif^cult to find some trace of the practice; and. if any accounts are transferred it is a fair assumption that all have been. The name of a ''discount" company among the liabili- ties is, of course, complete notice to the auditor, but the name may be unfamiliar, as there are many such com- BALANCE SHEET AUDIT— ASSE'fS 63 panics in the business. The safest method is to eliminate all regular trade liabilities and investigate the origin of the others. Loans other than from banks or individuals directly connected with a concern are more likely than not to be secured by collateral. The auditor who examines the liabilities with this assumption in mind will be on the safe side. Usually the assignments of accounts receivable involve quite a lot of red tape, such as the authorization of some one in the borrowing concern to collect the accounts and remit the proceeds to the "discount" company; the prepa- ration of schedules of accounts assigned, collected, etc.; and the payment of bonuses, commissions, interest, etc., at rates much higher than the usual bank rate. These precautions are more common with the "non- notification" companies than the others, as the name implies secrecy, and care is taken that customers shall not be inadvertently notified that their accounts have been transferred as security for loans. In many cases the expenses incident to the as- signment of accounts receivable can be avoided and more satisfactory financing arranged for, as outlined under "Acceptances," page 175. In many instances goods are received and so-called trust receipts are issued in connection therewith. These trust receipts usually arise out of importations of raw materials shipped sight draft against bills of lading. Arrangements are then made with bankers to pay the drafts and release the goods to the purchaser in trust, thus creating a first lien thereon. In form the trust receipts are obligations on the part of the purchaser to account to the banker for the proceeds of the sale of the goods. 64 • AUDITING The lien of a trust receipt is frequently of temporary effect only, because the goods are usually taken into the purchaser's warehouse and there mingled with other goods, thereby making it practically impossible to follow up and identify the merc4iandise. When the materials require manipulation and are converted into other forms, the difficulties of identification become almost insur- mountable. The title, therefore, which is supposed* to remain in the name of the banker, becomes of little value and cannot be sustained against general creditors. There are, however, many exceptions where the goods can be readily identified and where the title remains unimpaired. In all cases where the circumstances surrounding purchases indicate the possibility of trust receipts having been issued, the auditor will have to be most vigilant. The author's attention has been called to numerous cases where balance sheets have contained no reference to existing liens of this nature. If a concern conceals an important fact like this from its creditors, there is a strong likelihood that an attempt will be made to deceive the auditor. The head of on'ie concern which failed recently, on being asked by the officer of a certain bank whether its secured creditors could trace the merchandise on which they had made large advances, said laughingly, "They think they can." This so disgusted the banker that he immediately withdrew a $100,000 line of credit from the applicant and told him that he could not borrow a cent there. Any information secured relative to liens or encum- brances must be reflected in the report on the audit, or on the face of the balance sheet if no report is made.' BALANCE SHEET AUDIT— ASSETS 5e Proportion of Current Assets to Other Liabilities and Capital The rules call for a verification of the assets which are on hand and those which should he on hand, but the latter term applies to physical existence only and does not mean that the auditor must necessarily pass upon the propriety of the aggregates of the various classes of assets. At the same time, in order to be as valuable as possible to a client, whether a borrower or a banker, the auditor should endeavor to determine whether or not the relative proportions of cash, accounts, and stock compare favor- ably with those of the most successful concerns in the same line of business. This thought is admirably expressed by the eminent banker, Joseph B. Martindale, President of the Chemical National Bank of New York, who said at a recent Bankers' Convention: I have always claimed that under normal business conditions a stated amount of capital (borrowed as well as invested) should allow a concern in any line of business to carry a certain amount of mer- chandise. This merchandise later is converted into bills and accounts receivable; later on into cash; and upon these transactions, subject to the charges of conducting the business, there should be realized a certain amount of net profit. All of these items in a well-organized and well-conducted business should be in relative proportion one to the other. And if the best results are to be attained, the management of any concern will see to it that each dollar of its capital carries its proportion of merchandise, and will also see to it that the merchandise is moved rapidly and converted into a bill or account receivable, and that its outstanding debts are promptly collected, and that its cash is used to reduce materially, or entirely liquidate, its indebtedness, thereby saving interest and expense. We have in a number of instances fol- lowed this natural sequence in business and have found any number of instances where each dollar of capital (invested or borrowed) was not performing its full duty, and following the matter still further, we found it due to either extraordinary expenses, or losses, or due to indolence and a lack of an aggressive policy in handling the affairs of the concern. These are "earmarks" which will denote a condition of 66 AUDITING this kind, and we believe that it is our duty to examine these conditions thoroughly. As an illustration of this, some years ago, a certain firm reported in their statement an invested capital almost equal to the amount of their annual sales. At the same time their statement showed a substantial liability for borrowed money. It seemed incredible that a working capital invested and borrowed of more than the amount of the annual sales could be correct, but that is what this report showed. Upon closer analysis and further information, it was found that in the accounts receivable of the firm there were many old accounts running years back, which they were carrying as good accounts, and also sub- stantial sums due the firm from the partners, which were, in other words, overdrafts. When the statement was all boiled down, it was found that their actual capital was less than one-half that reported in their statement. These are the "earmarks" which, upon close observation and the knowledge of credit, prove invaluable to one's institution. It is vitally important in examining and passing upon a statement that one should be thoroughly familiar with the conditions surrounding the business during the year. Conditions may have made it impossible for any concern to make money, and where a concern reports a gain in its capital, one owes it to himself and to his institution to inquire thoroughly and closely as to the causes which produced such a result when all the conditions were adverse. As an example, we have the accounts of a number of houses in the same interior city in identically the same line of business, and while the amount of their capital varies (and, consequently, their volume of business), we can each year, by working out the percentages, see which concern is obtaining the best results upon its volume of business and the amount of its capital. From the standpoint of good banking it is not in the province of any bank to furnish permanent working capital for any one of its depositors. A bank whose liabilities are all payable on demand should observe closely the well-established rule that its borrowers should at some time during each twelve months liquidate their indebtedness to the bank for a reasonable period of time. In my opinion, this is neither unjust nor arbitrary, and is dictated by well-demonstrated and sound banking and business logic. I have always believed that an independent audit by a firm of certified public accountants is desirable. And from the standpoints both of the borrower and the lender, it is wise at least once a year to have the affairs of a firm or corporation examined and audited by a high- class firm of auditors. BALANCE SHEET AUDIT— ASSETS 67 It is obvious that no concern can have a "dean up" annually or oftener unless its current assets are susceptible of being turned into cash within a reasonable time. There- fore, before the auditor commences his verification of the current assets, he should ascertain as accurately as pos- sible the normal proportion of each class of such assets in the average concern in the same line of business as that under audit. With this as a starting point he will be able to deter- mine, as his work progresses, how far from normal the concern may be, and an opinion so formed should be of the greatest possible value to his client. CASH Cash in Bank If no notice has been given txD the client's stafif, the cash should be balanced immediately, the bank balances being verified by independent confirmation. The cash transactions since the date of the balance sheet should be scrutinized and the footings proved in order that the balance on hand as stated therein may be shown to be correct. When the audit occurs a considerable time after the date of the balance sheet, it is customary to secure certifi- cates from the banks covering the balances as of the clos- ing date. These are reconciled with the books, accepting as a basis the schedule of outstanding cheques shown by the books. Many auditors accept bank pass-books as conclusive evidence, but the author has encountered several cases of fictitious pass-books and two cases where the genuine pass-books were very cleverly altered. Therefore, to be safe the auditor should have one of his own staff secure the pass-books or statements from the bank, or preferably 68 AUDITING have the confirmation of the balances mailed direct to him Jby the banks. The auditor should satisfy himself that the cash in banks is free from any liens or offsets and may be with- drawn on demand. The auditor may very properly inquire into the average balance carried, as it is possible that the concern is overconservative and maintains a cash balance in excess of its requirements. If all purchases are discounted and nothing is borrowed, it may not be worth while to criti- cize, but instances are known where large borrowers have carried cash balances considerably in excess of the require- ments of sound business financing. The cost in such cases is large enough to attract attention, and the auditor should tactfully investigate the circumstances leading up to the custom. It may be found that those in charge of the finances are ignorant of the general usage, in which case the auditor can suggest what, in his opinion, would represent an adequate average balance to be maintained throughout a given period. Auditors of broad experience frequently suggest that where the balances in" commercial banks are larger than necessary to secure the maximum line of credit, some funds be transferred to trust companies Where interest is allowed on inactive accounts. Some of the largest trust companies now accept active commercial accounts and even allow interest on daily balances. The rule with national and state banks is by no means uniform, but many of them allow interest to desirable depositors. Cash on Hand Where the petty cash balance or fund called for by the balance sheet is small, it may be unnecessary to- attempt to account for it, as it might require considerable BALANCE SHEET AUDIT— ASSETS 69 time to inspect and prove all of the entries between the closing date and the time of the audit. Usually a scrutiny of the subsequent entries will be sufficient. If the balance is, say, over $100, it had better be veri- fied by actual count and proof. In an English case an auditor who failed to verify a petty cash balance of nearly $4,000 was held to have committed a breach of duty. The actual balance was $150. The balance should consist of actual cash, not memo- randa or "cash items." A cashier who is carrying ques- tionable items as a part of his cash balance may borrow money enough on the closing date to enable him to pay the entire balance into bank, or to exhibit the cash to an executive; after doing so the cashier will immediately put the items back into the cash drawer and again with- draw the cash. If there is any suspicion that this is being done, a second count of the cash on hand should be made toward the close of the audit. It depends on the auditor whether this part of the work proves pleasant and satisfactory. It is quite possible that an auditor will, in his desire to jump in without notice, really upset a cashier who has certain routine methods of handling the cash and cash records. First impressions are very important, and it never pays to dis- arrange the work of a single person in a client's office unless a definite reason exists for proceeding ofifhand and without giving notice. Where the client does not inform his staff that the accounts are about to be audited, it is, of course, desirable for the auditor to take advantage of the chance to surprise the man in charge of the cash. Probably more petty frauds are disclosed in this manner than in any other, for too many men are unable to dis- tinguish between their personal funds and those of their employers. Many of these discrepancies are under one JO AUDITING hundred dollars, and if the cashier were given time to put his cash drawer in order, the shortage would disappear. It may be argued that in such a case no great harm would ensue, as there would be no actual rnoney loss to the client. No greater mistake could be made, however, for a man whose moral sense is so blunted that he will pilfer a few dollars is on the highway to further frauds and needs only a good chance to misappropriate anything of larger value on which he can lay his hands. In practice the auditor's appearance is usually ex- pected. If the audit is a periodical one, an approximate time of commencing is known in advance, and if it is a special engagement, in most cases the negotiations with the auditor are known to all in the client's office. Here the auditor can exercise a little tact or diplomacy. The cashier may, for instance, balance his cash late in the day, and if it is much of a task he will be anxious to hurry oflf home upon the striking of a balance. The wise auditor will make it a point to tackle him first thing in the morn- ing at a time when the memoranda of the day have not commenced to accumulate and when the cash book is written up and the footings shown. Very often slips of paper, tickets, and so-called vouch- ers will make up a large portion of the ''cash" in the drawer. In all cases count the actual money first and then list the memoranda. This record should be full and complete, for there may be some delay before it is used again, and cases have been known where unauthorized tickets carried as cash have mysteriously disappeared immediately after an auditor's count of the drawer. If there is a difference between the amount on hand and the balance called for by the cash book or the round sum carried in the ledger as a petty cash fund, it is not wise to assume at once that there is something wrong. BALANCE SHEET AUDIT— ASSETS 71 The auditor should note the cash book footings, and with this information in his possession, together with his count of the cash drawer, he can afford to give the cashier a chance to hunt for the difference. If the cashier bal- anced the night before, the error may be in the auditor's own figures. If a shortage exists, it should develop at this point. When the cash balance consists of several bank ac- counts or funds, care must be taken to see that the entire balance is verified simultaneously. Instances are known where auditors have been deceived through one balance, after being inspected, having been transferred and used on a later day in connection with another balance. ACCOUNTS RECEIVABLE Trade Debtors In a long-established business where the sales are fairly constant, the accounts can be valued on a basis of past results. Ascertain the percentage of bad accounts in past years and apply this percentage to all sales up to the closing date. The sales, for, say, the last month, should be scrutinized (not footed) in order to ascertain whether or not there is any evidence of predating, billing to fictitious customers, or including consigned goods or goods sent on approval as sales at full prices. Consigned goods may be included among the current sales in good faith, if it has been the custom of the con- cern to do so, but this, of course, does not justify the practice, which results in anticipating profits that have not been earned. Accounts current should be obtained for all consign- ment accounts, and any unsold goods at time of closing should be added to the inventory and priced at cost or market, whichever is the lower. If the goods are salable 72 AUDITING and practically sure to be sold, accrued charges thereon may be added to the inventory prices. If past experience is not available the outstandings will have to be valued on their merits, because the auditor cannot hope to have reliable statistics of other concerns or for a series of years upon which to base his conclusions. The auditor of experience will have a general familiarity with the normal volume of outstandings which various classes of business may be expected to carry, and he should, for his own information, compare the relative outstandings of each business to the gross sales, and of different con- cerns in the same line of business. The value of such a comparison may be apparent at a glance, and negligence and laxity may stand revealed which might not be ap- parent in a routine audit. The best method of collating such data is to compile statistics covering gross and net figures and the percentages produced thereby, at the close of each audit. In the course of time a vast quantity of information will be at hand and available at a moment's notice'for comparative purposes. When the list of open balances is compared with the sales ledgers it should be noted 'that the balances are represented by specific invoices of a recent date; other- wise the balances should be analyzed. An old item in a running account or a bill partly paid, followed by others fully paid, usually means that an allowance has been or will be made, or that a defalcation exists. Schedules should be made of all overdue accounts classified according to age. Those quite old cannot be considered as worth anything unless a very strong argu- ment is presented, supported by documentary evidence. . It is a rule of law that assent to the correctness of a balance may be inferred from retaining an account ren- dered without objection within a reasonable time, and BALANCE SHEET AUDIT— ASSETS 73 the burden of impeaching the accuracy of the account, for fraud or mistake, is cast upon the party complaining of the balance, but the only proper test of ability to pay is payment, and where this is delayed an unreasonable length of time, the inference is that "ability to pay" is lacking. Accounts ranging from long overdue to those just over the ''net" pei-iod should be depreciated as may be determined after proper inquiry has been made. The auditor must ascertain whether any accounts have been pledged or assigned. This is frequently done with- out any record being made in the books. The following suggestions will be found useful in fix- kig a valuation upon trade accounts which are overdue: 1. Have the terms of credit been habitually ignored? Even so, the debtors may be perfectly good, but such accounts should have special attention from the credit manager. 2. If payments on account are being made, is the bal- ance being increased or decreased? If the former, this is prhna facie evidence that debtor is approaching the time when all payments will stop. This is a class of account which deserves more attention than it receives. The auditor should keep this point in mind, and a word of advice from him may save ultimate loss. Salesmen relin- quish these accounts very reluctantly, but they are not the best authorities on the ability of a debtor to pay. 3. If credit has been stopped and no recent collections appear, ascertain if account has been placed with attor- neys for collection. 4. If in hands of attorneys, ask for correspondence. Accounts are frequently placed with lawyers who are not equipped for collection business and who do not keep after the debtors. Unless frequently checked up, the debtor will not pay. So long as his money lasts, or he 74 AUDITING desires to preserve his credit, a debtor will pay those who press him the hardest. 5. If a debtor who has paid cash commences to give notes, ascertain if a sound reason therefor has been offered and whether the change has been approved by some one in authority. In all except the rarest cases, those in charge of the outstandings will be found to be optimistic to an unrea- sonable and undependable degree. Nevertheless, their knowledge must be utilized by the auditor, who can dis- count their estimates as much as seems necessary and finally draw his own conclusions. A certificate as to outstandings ought not to be given unless the schedules of accounts have been compared in detail with the customers ledgers, and the footings of the schedules verified. The procedure in this case should be the same whether or not a controlling account is kept, except that this rule may be modified in the case of a concern having a very large number of open accounts which are subject to internal check. Discounts which will be deducted by customers and which, while called cash discounts, are greater than a con- cern would pay for the use of money, must be allowed for. In a stable business it is usually possible to deduct a fixed percentage from all the outstandings. Where special discounts are given, it may be necessary to classify the balances before determining the deductions to be made. If freight allowances are permitted, care must be taken to see that adequate provision is made therefor. Miscellaneous Receivables The foregoing comments refer to what are known as trade debtors and apply chiefly to mercantile and manu- facturing concerns. The same principles govern the veri- BALANCE SHEET AUDIT— ASSETS 7- fication of the outstandings in enterprises which are not generally classified as mercantile or manufacturing. For instance, real estate agents, as well as manufac- turing establishments, may show on their balance sheets large items which represent real estate rentals uncollected. Likewise, stock-brokers carry very large items of assets which represent balances due by customers. The balance sheets of financial institutions, and of enterprises where investment securities are owned, will contain items of interest and dividends due, but not collected. The bal- ance sheets of commission houses will show commission and other charges as accounts receivable. In all cases the auditor must satisfy himself: (a) That the items constituting the balances are bona fide, and (b) That the balances have not been liquidated in part or in whole. The means of verifying these requiremen5VI, "The Detailed Audit — Purchases and Expenses." There are, however, some accounts which do not arise out of cash transactions and others about which more can be said. These accounts will now have our attention. Reserves We have discussed on other pages the following reserve accounts : Bad accounts, page 371. Accrued expenses, page 225. C Depreciation, exhaustion, etc.. Chapter XVIIlJT Obsolescence, page 224. )f^ Contingencies, page 168. ^ ^ ^ Sinking fund accounts, pages 128) 194.} The question now arises as to how and when these charges should appear in a current profit and loss account. The fact is that they do not as a rule appear in the current profit and loss account at all. A fair proportion of the 10 per cent of the business enterprises of this country who do consult professional ac- countants heed the advice given and include among their expenses, or deductions from income, all of the costs of doing business, and the words "net profit" are not used 219 220 AUDITING except after full allowance has been made for keeping the capital intact. Most of the remaining 90 per cent, and those who consult but who do not heed the professional auditor, however, include among their earnings every dollar of pos- sible income, but from such earnings are deducted only such costs and expenses as are apparent and easily ascer- tained, the balance being designated as ''net profit." This balance is carried to surplus and is thereafter referred to as the profit earned during the period stated. Subsequently (but only if the period has been a prosperous one) various deductions are made from surplus, covering depreciation, adjustment of inventories, writing off of accounts re- ceivable, etc. This practice seems hopeless to the auditor who is familiar with actual conditions and who knows that about 99 per cent of such deductions were direct charges against earnings and that most of the items could have been in- cluded in the current profit and loss statements. But busi- ness men will fool themselves, and corporation officers and directors will fool their stockholders, and attempt to fool the public. However, a slight, but perceptible, progress is being made, and it is inevitable that some day the words "net profit" will have the same meaning as the word "sterling" on silver. Laws and custom w^ill decree that the issuing of false statements such as are now spread broad- cast will be a punishable offense. It is regrettable but true that many financial writers of ability who should, and perhaps do, know better, are re- sponsible for much of the present unsatisfactory state of affairs in this respect. Just as surely as a corporation does issue a carefully prepared balance sheet and profit and loss statement, probably one certified to by reputable auditors, in which proper deductions are made to cover the items here- tofore referred' to, one or more of these writers will learnedly PROFIT AND LOSS ACCOUNT 221 analyze its contents for the edification of the investing public. Almost invariably they will ignore the deductions for depre- ciation, etc., and solemnly state that during the period the corporation "earned" a given per cent on the capital — carrying out the rate to several decimal places. They may mention incidentally that from the profits there were certain deductions, thus emphasizing their own opinion that the actual profit was the one used as a basis for calculating the rate earned, and that the deductions were purely voluntary. When legislative investigations are instituted, these figures are also the ones used, and the fallacy has been car- ried so far that some corporations that have not and never can earn a dividend on their common stocks are cited as having realized large earnings. In the case of the United States Steel Corporation nearly all of the financial writers, and certainly all of the statesmen (?), who have investi- gated its affairs state its net earnings over a period of years as many millions of dollars greater than the accounts of the corporation itself show. What is the real trouble ? Surely accurate accounts are desired. Is it because the tendency to overstate profits and understate losses is so general among business men that no standard exists ? Perhaps public accountants are themselves somewhat to blame for present conditions. Have they always been keen to make all the deductions of which they have any knowledge from earnings before designating any one sum as ''net profit"? The fact is that, because some of the reserves for de- preciation, etc., are more or less difficult to ascertain, it has been fairly general to omit them entirely, or qualify the account by stating that the profits are so and so exclusive of some very large costs and expenses. Is it not peculiar that this action on the part of the auditor exactly fits in with 222 AUDITING the wishes of the client who knowingly overstates his profits ? Candidly, is it not possible to estimate more closely on an allowance for depreciation than on the valuations of fixed assets or current inventories to which the auditor so cheerfully certifies ? Depreciation The question of depreciation is important enough to require an entire chapter for its discussion (see Chapter XVIII), but at this point it is in order to consider whether or not depreciation is to be included among the cost and expense items in the current profit and loss account. In the preceding section attention was called to the gen- eral practice of omitting this and other items from ordinary operating accounts. Accountants of experience defend this practice on the ground that where depreciation has not been calculated at all, or where an arbitrary amount has been set aside, the task of determining a fair allowance — one that can be included among operating costs without detracting from the value of the entire statement — is too onerous to handle, with the result that costs are compiled without any allowance for depreciation. It is, of course, assumed that mention is made of the omission before any final figures are certified to. It will always be admitted that wear and tear, and per- haps obsolescence, is going on all the time. If not admitted in so many words, the repairs and maintenance accounts speak for themselves. The usual and time-worn argument against provision for deterioration is that constant attention is given to the upkeep of the plant and renewals and repairs are looked after as soon as, or before, occasion demands. Disregarding for the moment the fact that there is always a considerable amount of accrued wear and tear not apparent enough to necessitate immediate attention, there PROFIT AND LOSS ACCOUNT 223 is to be considered the question whether the renewals and repairs which will be imperative, and which are always in- cluded among the expenses or costs, recur regularly enough to be charged up as incurred without upsetting the equilib- rium of the accounts, or whether in the ordinary course of affairs the amounts fluctuate so greatly that factory man- agers are justified in leaving the items out of consideration in self-defense, as otherwise their costs would vary to such an extent that comparative records would be ludicrous. In the case of fuel, for example, no such difficulty arises. Purchases and consumption run along regularly and no one would think of omitting the cost thereof. Now wherein lies the essential difference between the cost of fuel con- sumed under a boiler and the accruing loss on the purchase price of the boiler itself? Both are consumed in the process of manufacturing. The cost of both must be reimbursed from the proceeds of the sale of the product manufactured, or the capital of the concern will be depleted. Capital de- pletion is exactly what happens in thousands of cases. The cost of fuel is made a part of the cost of the product, but for some mysterious reason the cost of the boilers is pro- vided in some other way, or at least that is the effect of the accounting system followed. The most flagrant fallacy is found in connection with the accounts of the first year's operations of a new plant. The management, if sane, must know that the buildings and machinery will not last forever and that into every unit of production there has gone some part of the entire cost of the plant. It would be ridiculous to charge the total cost of buildings and machinery into the operations of the first year, but is it not equally unsound to make no charge whatever thereto merely because the exact amount of the charge is somewhat difficult to ascertain? Accounting difficulties are comparative only, and accurate 224 AUDITING accounts always require careful and intelligent attention. If the same thought were given to calculating the proper proportion of the cost of a boiler, which forms a part of the cost of operation, as is given to determining the basic costs of other elements which enter into the manufacturing operations of a modern plant, the amount arrived at would be quite close enough to form a dependable item of prime cost. Professional auditors fail in their duty whenever they allow an opportunity to pass which might permit them to elucidate the foregoing principle. Thousands of enterprises have gone into bankruptcy solely because their accounts never exhibited the full cost of their product. As soon as ac- counting practice and procedure and commercial common sense are developed to the point where an allowance for depreciation is made just as much a part of prime cost as labor or materials, a considerable number of business failures Vv^ill be prevented. Obsolescence The author is not prepared at this time to support the contention that an allowance for obsolescence is an item of prime cost as is the case with depreciation. The latter is certain and cannot be avoided any more than taxes or death. Obsolescence is never certain. It is true that most of our modern machinery has superseded other machinery which was not worn out, and the plant of ten years ago which counted on a twenty-year life for its equipment and set up a depreciation reserve on that basis has not been able to renew that machinery out of the reserve. Take the case of a machine costing $1,000 in 1908 with an estimated life of fifteen years and a scrap value of $100. There would have been $900 to charge to operations and a PROFIT AND LOSS ACCOUNT 225 depreciation reserve based on the expected life would be conservative accounting. In 1915 it is found that the machine is obsolete and a new one costing $1,500 is pur- chased, but the new one has twice the capacity of the old. Here we find our answer to a large extent. An old machine will not be superseded by a new one unless the latter has greater efficiency or capacity, and this supplies authority for capitalizing part of the cost of the new machine. It is obvious that obsolescence cannot be foreseen, and any attempt to reduce the contingency to a definite allow- ance to form part of current operating costs would defeat its own purpose. In view of the rapid strides in all of the mechanical sciences, obsolescence is likely to continue to be a serious factor in the ultimate cost of producing manu- factured goods. Therefore, wherever possible, a reserve should be created to meet the possibility, but the reserve should be provided for out of profits before stating the surplus applicable to dividends and never as an item of prime cost. Accrued Expenses, etc. It is perhaps superfluous to mention that the items of expenses in a profit and loss account embrace those which have accrued during the period, whether paid for or not. At the closing date all accrued expenses, rents, taxes, in- terest, and similar items should be ascertained and entered as liabilities on one side and charged to their respective^ expense accounts on the other. As many of these expenses are more or less unusual in their nature, it seems unavoidable that some are omitted. The question then arises in subsequent audits as to whether the items applying to prior periods should be charged to surplus or included among the current expenses of the period in which paid. There are two reasons in favor of 226 AUDITING the latter practice and no good reason in favor of the former. In the first place, where charges are made against an old book surplus it simply means that so far as pub- lished accounts go they are never in evidence. That is, the items were not known at the time and were therefore omitted from the period in which they belonged, and being eliminated from the period in which paid they practically disappear. The most valuable records compiled are comparative schedules of earnings and expenses, and where these are carried along from year to year it is practically impossible to adjust reports which are perhaps a year old and of which frequent use has been made. Therefore proper accounting practice permits the inclusion of such items in the current profit and loss account, without calling special attention to the matter, unless the items are large enough to alter materially the results, in which case the items are deducted from the net profit of the current year before a transfer to surplus is made. Where the items are comparatively small it may be assumed that corresponding items are omitted from the current accounts and will have to be taken care of in the subsequent period. This must not be construed as an excuse for closing ac- counts before every known liability is taken into considera- tion. The auditor who does not satisfy himself that all known liabilities and those which should be known are in- cluded in a balance sheet is guilty of negligence and de- serves any consequence which may ensue. Cash Discounts Where it is customary to permit trade debtors to de- duct a discount for cash within a limited period these deductions are entered in a separate column of the cash book. The discount allowed up to the date of the closing will, of PROFIT AND LOSS ACCOUNT 227 course, appear in the books, preferably in a separate ledger account. The aggregate of such allowances should be entered among the expenses of the business and not as a direct de- duction from gross earnings. The theory is that the dis- count allowed represents a premium paid for prompt atten- tion and for the use of the money at an earlier date than it w^ould be received if no inducement were made for pre- payment. Where the items are strictly cash discounts, and are not permitted if the debtor does not pay within the limit, then the total allowance is clearly an expense and should not be charged against sales as if it represented an abate- ment of the purchase price of the goods. Trade Discounts The author, in common with most practitioners, has al- ways stated that trade discounts were direct deductions from invoices and should not appear in the books of account of the seller or the purchaser. It is true, however, that in some trades considerable importance is placed upon the variations in trade dis- counts, and it would seem to be in order that the accountancy student should be given an opportunity to decide for him- self whether trade discounts have any place in books of account. This point assumes importance in auditing be- cause the auditor cannot very well report the amount of trade discounts given or received unless the items have been separated throughout the period covered by the profit and loss account. At the request of the author the "case" for trade dis- counts was stated by John R. Wildman, C.P.A., as follows : The general practice is to deduct trade discounts from the face of the purchase and sales invoices. It is claimed, however, that in large organizations, where the fixing of prices is delegated by the administra- 228 AUDITING tive officers to the respective heads of purchasing and sales depart- ments, the recording of the data in question facilitates the compilation of statistics which will show the average discounts and thus serve some- what as an index to the efficiency of the heads of the respective depart- ments as well as to serve as a guide to the administrative officers in reaching conclusions and formulating policies concerning these phases of the business. Theoretically, it appears to have some scientific foundation. Prac- tically, it is questionable whether the amount of work involved is war- ranted by the purpose for which the data are used. Accounting instruction, in my opinion, should be as broad as pos- sible. Every phase of a subject should be discussed. All the facts should be presented. The relative advantages and disadvantages of various methods should be explained. After discussion the instructor should state the preference dictated by the general practice so far as it can be ascertained. Further, the relation of trade discounts to cash discounts, and the relation of both to the purchase and sales prices, seem worthy of discussion. DISPOSITION OF PROFIT When an auditor has determined the amount which he is wiHing to certify represents "net profit," the difficult part of his task is completed. Probably he will not be asked whether the amount shown should be paid out in dividends or transferred to surplus, and as a matter of principle he is not concerned. It may be, however, that his opinion will be asked, in which event he may be able to suggest such a disposition of the profit as will conserve the best interests of the concern. Whether to declare a cash or a stock dividend is a ques- tion which may very properly be referred to the auditor. There should be no transfer of profits to general surplus account unless the entire amount is applicable to dividends when and if declared. The net profit for the period is first shown, then any transfers which have been authorized by the board are deducted, the balance being carried to surplus. This practice has been followed by- some of our best- managed corporations for a number of years, and has the PROFIT AND LOSS ACCOUNT 22g sanction of law in that the courts have repeatedly held that the directors of a corporation need not declare dividends unless they so desire, provided they can show that the funds which would be required for dividend disbursements can be used to better advantage in the business. It is carrying this discretion to an extreme which stock- holders never contemplate when they purchase stock, for the directors to invest the surplus in securities the control of which is not a necessary incident to the carrying on of the business for which the corporation was organized. In England the law is as follows : English Companies (Consolidation) Act 1908. Table A. Section 99. The directors may, before recommending any dividend, set aside out of the profits of the company such sums as they think proper as a reserve or 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 application, may, at the like discretion, either be employed in the business of the company or be invested in such investments (other than shares of the company) as the directors may from time to time think fit. An auditor will recommend the setting aside of reserves for contingencies or for the equalization of dividends or other reasonable purposes so long as the financial condition of a corporation demands conservative financing, but when it finds itself so well off that it can not only pay all of its debts, but has cash enough to purchase investment securities, then the auditor had better allow the board itself to take all the responsibility. The practice savors too much of paternal- ism. Stockholders are said to forget dividends quickly, and it is therefore not thought safe to pay out big dividends in good years and small or no dividends in poor years. But some stockholders are quite as well qualified as the directors to invest their earnings and prefer some variation in the dividend rate to an attempt to build up a big surplus and 230 AUDITING indefinitely postpone the distribution of the earnings of a particularly prosperous period. PRINCIPAL AND INCOME It has been pointed out in other chapters of this book that the distinction between principal and income (or capital and revenue) must ever be in the auditor's mind. It affects the balance sheet as well as the profit and loss account and is a fact to be faced rather than a theory to be played with. As the matter is discussed fully under various headings, it is not necessary here to review the attitude of the auditor with respect to determining whether a given item belongs to principal or to income, because by reason of his training and experience he will decide each question according to its merits, with sound accounting principles to guide him. It is at present doubtful, however, whether the courts can be depended upon to decide as equitably. Dividends Must Not be Paid from Capital While questions with respect to capital and revenue " arise in every branch of accounts, many of them are not met squarely, but are passed over undecided. Issue is not usually joined until the question of a dividend arises. Directors and managers who will not admit that depreciation is an operating expense will nevertheless hesitate before voting for or advocating the payment of a dividend before there have been set aside sufficient reserves to maintain the capital intact. Section 23 of the New York Stock Corporation Law 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 PROFIT AND LOSS ACCOUNT 231 its capital stock, except as authorized by law. In case of any violation of the provisions of this section, the directors under whose administra- tion 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 corporation so divided, withdrawn, paid out, or reduced. The English Companies (Consolidation) Act, 1908, con- tains the following provisions relative to dividends : Table A. Section 95. The company in general meeting may declare dividends, but no dividend shall exceed the amount recommended by the directors. Section 96. The directors may from time to time pay to the 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. There is no practical difference between this law and that of New York State. In neither jurisdiction is it per- missible to pay a dividend unless the capital is unimpaired. Where the assets have depreciated in value and the depre- ciation is not provided for out of earnings, the capital is impaired. In the case of the Interborough-Metropolitan Company, of New York, its losses in respect of holdings in the Metro- politan Street Railway were so great as to cause a very large deficit. In some states it has been held that yearly profits may be distributed irrespective of shrinkage in capital assets, but in New York the question has not been judicially de- termined. Recent earnings of the Interborough-Metropol- itan Company arising out of its holdings of profitable subsidiaries have been large enough to justify dividends; but it was considered unwise to pay dividends so long as the large deficit remained. Thereupon the Interborough- Metropolitan Company consolidated with a new company 232 AUDITING which had a much smaller capitalization, and upon the ex- change of the stock of the old company for the new the latter immediately commenced the payment of dividends. There are undoubtedly many corporations in existence today whose dividends are being or have been paid out of capital. If stockholders appreciated their rights, many di- rectors would be called to account for this. The most notable case in the United States wherein it was shown that dividends were paid out of capital instead of net profits or surplus is the American Malting case. If an auditor finds himself in disagreement with a board of directors over the allocation of items to capital or revenue he may find it salutary to request them to read extracts from this case. Decedents' Estates The distinction between principal and income assumes more importance in some trust estates than in ordinary com- mercial practice, because while with the latter the result of a misapplication of an item may affect the ultimate solvency of an enterprise, in respect to an estate the decision of a court as to a dividend being principal or income may actually deprive a dependent of the necessities of life. Wasting Assets It is permissible for a mining company to pay out in dividends all realizations from its operations, but its stock- holders are on notice that the capital of the company is being dissipated. On the other hand, if a steel company owns ore lands it must not treat the entire net income from ore sales as profit, but is obliged to allocate the realizations into principal and income. The principal must Idc kept intact in order that the capital may not be depleted. The income may be distributed in dividends. PROFIT AND LOSS ACCOUNT 233 In an estate the practice (in the absence of testamentary or statutory provisions to the contrary) is similar to that of mining companies, that is, the tenant for life may work a mine or a quarry or cut down timber and is not required to make good the depletion. In the case of buildings, etc., the rule is different; they must be maintained, ordinary wear and tear excepted. Interest Interest and similar income is said to accrue from day to day so that the full amount accrued to the date of the dece- dent's death becomes principal. It has been held in at least one state that where the in- terest is represented by a coupon the amount thereof is not apportionable, but represents a separate contract to pay a definite amount at a certain time. The distinction between such a contract and a registered bond, where the interest is paid by check and is not represented by coupons, is a fine one, rather beyond the comprehension of a layman. Dividends The date of the declaration of a dividend fixes its standing as principal or income; if declared before the dece- dent's death it is principal, even though it is payable after the date of death. It accrues wholly on the date of declara- tion, i.e., there is no apportionment based on the period it covers. Stock, and Extraordinary Cash Dividends The foregoing rule does not always apply to dividends which are declared out of the regular order. It is rather popular for corporations and banks to accumulate their excess earnings for a long period of years and then make an extraordinary distribution at one time, in cash or in stock. 234 AUDITING In most cases, and in all cases where full and correct ac- counts have been published periodically, these hoarded earn- ings become identified with the capital of the undertaking, and furthermore are reflected in the market price of the stock. From an accountant's point of view it seems absurd that a life tenant, to whom there is devised the income for life on, say, ten shares of stock, should receive as income, say, ninety shares of the same stock, thus vitally depreciating the estate left for the remainderman. But the courts have so held in spite of the injustice of the result. In some juris- dictions, however, the decisions have been to the effect that extraordinary dividends are distributions of principal. Space does not permit a lengthy discussion of this sub- ject. Any one interested and seeking further particulars is referred to a very able and interesting paper on the subject by William F. Weiss, C.P.A., of New York. CHAPTER XII CERTIFICATES AND REPORTS What shall it benefit an auditor if he perform the highest grade of professional work and be unable to present his re- sults in a form acceptable to and understandable by his client? Yet this happens every day, chiefly because some auditors apparently prepare reports for themselves rather than for those they are supposed to enlighten. An engineer builds a bridge for others to use. It is useless unless it is safe and convenient. The man who rides across it does not care how many difficult problems were encountered in the building, nor how they were solved ; he is content to judge the engineer by results. So with a banker or a busi- ness man. He employs an auditor because he wants re- sults, and he wants results which he can use without having to follow in the auditor's footsteps and traverse the same jungles of figures and grapple with the same problems through which the results were accomplished. As pointed out in Chapter III, the auditor should pre- pare for the termination before he starts, and as the con- summation of an audit must include a report on his work, this fact must be kept in view during the progress of the work. If feasible, the auditor should picture himself in his client's position and reason out what he would want if the other man were doing the work. The examination may have started under most favorable auspices; it may have 235 236 AUDITING been executed in an unexcelled manner, but if it is not delivered properly the first two factors will go for naught. It hardly seems necessary to state that reports should be typewritten and an office copy preserved, yet auditors are frequently induced to submit manuscripts of which no copy has been retained. Subsequent embarrassment has followed this unwise practice, through loss of the original, unauthorized alterations therein, etc. It is better to keep a client waiting than to run such a risk. Promises to return for rewriting are not kept, as a rule, and the auditor who relies on these and similar promises ignores a precaution which experience has demonstrated to be valuable. Something More Than Figures Are Wanted in a Report A prominent banker recently said to the author that most of the reports submitted to him were lacking in information which the auditor was peculiarly able to fur- nish. He said that auditors who are retained to investi- gate earnings, expenses, assets, and liabilities, frequently going back over a long series of years, have an unusually good opportunity, for instance, to size up the personnel of an organization, particularly the office staff, but also to a certain extent the other departments. A banker is obliged to vouch for an enterprise as a whole when he offers its securities to his customers. He wants the assets and liabilities and net profits stated in proper form for publication, and requires a certificate attached which reads well, but he wants a supplemental report for his own use expressing the auditor's opinions on just as many points as the latter can comment on intelligently. He does not want trial balances and lists of debtors and creditors and memoranda of errors in post- CERTIFICATES AND REPORTS 237 ings and similar bookkeeping data. He will read only what is of interest to him and these things are not. The same principle applies to the client whose own accounts are being reported upon by an auditor. The auditor secures access to records which the usual execu- tive does not see, and has a chance to observe the staff under conditions which do not exist when the boss is around. This does not contemplate that the auditor will report trivial matters which will make the staff hostile without being of any real benefit to the client. Elsewhere in this book it has been pointed out that the successful auditor must secure and retain the hearty co-operation of the of^ce staff, and this fact is here reit- erated as a reminder that a report should be a constructive document and helpful to the client's staff as well as to the client. Occasions may arise where the auditor cannot prevent his report from arousing hostility on the part of the staff. If this must be, let it be because vital defects are criticized and not trivial ones. Terminology It is most important that an auditor express his find- ings and opinions in good simple English. His aim must be to write so clearly that his report cannot possibly be misunderstood. He will not err if he follows the simple language of the Bible or of Lincoln rather than the involved style of Henry James. It has been said that accounts are the language in which business transactions are written. It is incumbent on the auditor to exemplify the fact that this language is a simple one, and readily understood. Classics may be read in dead languages, but commonplace business history is better understood if written in a live tongue. Figures in themselves are of no value, but correctly 238 AUDITING arranged and properly interpreted, the accounts of a busi- ness organization furnish a basis for knowledge which is indispensable in the successful conduct of any enterprise. The truth may exist in a report poorly written, but if it is not evident to any interested party, then the lan- guage used is not well chosen. The following memorandum is submitted as suggestive only, but it is more than hkely that it would be read through to the end by every man or woman who might have an interest in the enterprise in question. Statement of Financial Condition of A and B At the Close of Business, December 31, 1915 The total assets of the firm on this date amounted to $213,333, con- sisting of the following items : Cash in bank, $9,465. This is somewhat less than is usually carried, but a number of bills were paid on Decem- ber 31, which reduced the bank balance accordingly. Bills Receivable, $8,450. These are notes not yet due, and are all believed to be good. They can, if necessary, be discounted at the bank and furnish additional funds. Accounts Receivable, $29,416. These were gone over carefully on December 31, and an amount equal to all accounts long overdue was charged to Profit and Loss and carried to Reserve for Bad Debts ac- count. They are also carried in a separate ledger and are being care- fully looked after, and a fair amount will no doubt be realized there- from. The sales for the month of December were nearly $20,000, and, as practically all sales are at thirty days' time, it is evident that collec- tions are in fine shape. Stock was taken on December 31 and amounted to $39,460. The market was somewhat lower on that date than when most of the goods were purchased, so, in order to be conservative, the inventory was priced at market. All obsolete and damaged stock was inventoried, but was not valued. It is proposed to dispose of all this dead stuflF as soon as possible, as it is in the way, and is the source of constant expense and annoyance. The inventory sheets have been securely bound and placed in the safe. The insurance on stock aggregates $45,000, which is about 10 per cent in excess of the inventory. The rate, however, is only about forty cents since the installation of the sprinkler plant, and, as the amount CERTIFICATES AND REPORTS 239 fluctuates from day to day, it is considered advisable to cover a small margin above the estimated stock. The insurance question comes up automatically once a week so that we cannot be caught unawares, as was the case recently with the X Y Z Company. In November, we paid the insurance for an entire year in advance, so that on December 31 the proportion prepaid amounted to $762, which is carried as an asset, because it should be charged against the opera- tions of 1916. We also paid the discount on the notes at bank in ad- vance to the extent of $412, and this is carried as an asset in the same way as the insurance. On a conservative basis, the furniture and fixtures on hand on De- cember 31 were worth over $6,000, but as liberal depreciation hns been written oflf each year, this item now stands at $3,418. We are carrying insurance for $6,500, however, and in case of a fire there would be no trouble about adjusting the loss and proving our claim, as a carefully prepared schedule of each article, with date of purchase and cost price, is kept in the safe. Our land and buildings are now carried at a net valuation of $84,710, made up as follows: Cost of land in 1901, $50,000; cost of buildings, $49,862. We have carried to our reserve account annual depreciation at the rate of 4 per cent per annum, reducing the accounts to $34,710. This rate is probably too high, as 2^ per cent per annum is stated to be the proper rate of depreciation on buildings like ours, but, as the depreciation is charged into the expenses every year, it keeps us on the safe side when figuring our costs, and, if it should ever be considered advisable to tear down some of our older buildings, the rate of de- preciation charged will be justified. The machinery account now stands on our books at a net valuation of $37,240. The original cost of the machinery now installed in the plant was over $60,000, but depreciation at rates varying from 10 to 20 per cent per annum has been charged on the same theory as with buildings. Much of our machinery is of a type which is subject to improvements and new inventions, and, as has been the case in the past, some so-called modern machines may become obsolete over night. If our machinery account were carried on our books at cost or nearly so, as is done by some of our competitors, we would no doubt be afraid to abandon it for fear of the resulting shrinkage in our assets, but the liberal depreciation charged and the consequent margin in this account permit us to keep absolutely up to date with our entire equipment. Unquestionably a fair share of our continued success as manufacturers is due to this policy. Our auditors tell us that they have never examined the affairs of a single bankrupt concern where the machinery account was not inflated by reason of insufficient depreciation being written off, and they point out that the moral is obvious. 240 AUDITING The depreciation on buildings and machinery is not deducted directly from the respective accounts, but is carried separately as a reserve. The reason for this is that in case of fire we can submit the cost of all the buildings and machinery to the adjusters and show them the accounts in the books. We have a subsidiary building and machin- ery ledger, which shows each building and each machine separately with cost of installation, etc. The aggregates of the detailed items in this ledger agree exactly with the totals in the general ledger. If a fire occurred it would be a matter of negotiation as to the deductions for wear and tear, and, as the adjusters would be obliged to make their calculations on a basis of the life of the buildings and machines or their replacement cost, we ought to realize a much larger amount than that shown in the balance sheet. This conservative valua- tion not only means that we are not fooling ourselves, but our banks realize that we are not fooling them and compliment us on our method every time it is explained to them. The President of the National Bank told us a short time ago that he believes we can borrow a larger amount on our statement as it is made up than some concerns whose plants may have cost far more, but whose methods are not as conservative. The distrust occasioned by lack of conservatism leads a banker to discount all the assets ruthlessly, while with us they feel perfectly safe in relying on our figures and "go the limit" when we ask for credit. The assets referred to above aggregate at their reduced valuation $213,333. The total liabilities on December 31 amount to $74,493. leav- ing net capital invested in the business $138,840, of which there stands to the credit of Mr. A $74,910, and to the credit of Mr. B $63,930. The liabilities in detail are as follows : Bills payable, $18,500, consisting of three notes for $5,000 each, and one for $3,500. The former were discounted at the National Bank and are due January 25, February 25, and March 25. The $3,500 note was discounted at the Citizens Bank and is due February 25. As our purchases are increasing, due to the approach of the busy season, these notes will have to be renewed and additional funds secured. Our line at the National Bank is now $40,000, and at the Citizens Bank $25,000. This is more than sufficient to carry us through the season and will enable us to discount all our bills. The unpaid accounts pay- able for purchases on December 31 amounted to $24,218. No bills are overdue, and all invoices carrying cash discounts have been paid. The collections which are sure, are not sufficient to meet all of our bills on our regular pay day (the 20th), so $10,000 should be bor- rowed, say on the 18th. The accrued wages up to the night of the 31st amounted to $1,340. The taxes accrued to the same date amounted to $435. This repre- CERTIFICATES AND REPORTS 24 1 sents a tax rate of 2 per cent, which is a decided advance over last year. We are unable to discern any additional benefits arising out of the increase, and it might be in order to suggest to the municipal authorities that it is up to them to establish efficiency and cost records and justify the enormous sums they are expending annually in an apparently aimless manner. The only remaining liability is the mortgage for $30,000 on the real estate. As the interest rate is 5 per cent and as it is not due for three years, no action with respect to this debt is suggested. The foregoing narrative is necessarily colorless and lacks the local flavor which might easily be woven about the balance sheet of a going business, so that as read solely by those connected with the particular undertaking, one item after another would awaken interest and stimu- late action with respect to those figures which might appear to be unfavorable. It is not hard to imagine a state of afifairs different from that described, and it is quite within reason to prophesy that a cleverly written description of balance sheets in the manner described would excite decisive action on the part of an executive with respect to unfavor- able items where previous efforts along routine lines had failed. In any event, it is well worth trying, particularly in connection with a profit and loss or trading statement where comparisons are important and instructive. An occasional witticism or business ''story" would not be out of place, assuming always that a proper diagnosis has been made of the executive to whom the report is addressed. Scope of Report Certificates and reports, if true, must be founded on the work which has been done. A report should be a nar- rative of facts. It may include a short history of the enterprise under audit, particularly where it is intended for the perusal of those whose information on this point is limited. 242 AUDITING A certificate should be brief and to the point and embody conclusions based solely on the auditor's investigations. A report is for the edification of others, and it is the duty of the auditor to make it interesting. The most successful auditors pay much attention to this aspect of their work, so that clients are glad to get their reports and read them. How much space should be given to the detailed work done by the auditor? The average client does not care how the auditor arrived at his results — all he wants is information. He asks: ''Are the accounts correct, or, if not correct, wherein are they inaccurate, and how shall they be improved?" Some auditors who have not verified every item on the books think that they escape responsibility by detail- ing all of the ground covered. If work is omitted which should have been performed, a carefully worded report pointing out that other work was done and omitting any mention of the work in question cannot be used to escape liability. Reports must be founded on facts discovered, verified, or compiled by the auditor, but it is neither desirable nor necessary to comment on immaterial matters and furnish superfluous schedules. The purpose for which the report is to be used must in every case be carefully considered before it is written. For instance, a prospective borrower does not want an auditor to submit a balance sheet which is accompanied by comments on th'e system of accounts, nor does he want long schedules of clerical errors. On the other hand, it is quite in order to submit a balance sheet accompanied by qualifying comments, provided the changes which the auditor thinks should be made in the balance sheet figures CERTIFICATES AND REPORTS 243 are not permissible in the books, or where balance sheet items are not sufficiently self-explanatory. It is usually desirable and convenient to comment on balance sheet items in the same order in which they appear on the balance sheet. Where balance sheets are not designed for publication the most satisfactory report consists of the following: Certificate of audit. Comments on audit and on balance sheet. Balance sheet, supported by detailed schedules wher- ever they are necessary or deemed to be of prac- tical use. Profit and loss statement, divided into sections or groups and supported by schedules if required. Special schedules. Certificate of Audit The certificate should be as short and concise as possible. Attempts to qualify a certificate are not looked on with favor, and unless an auditor has been greatly restricted in the scope of the audit, it is his duty to conform as nearly as possible to the "audited and found correct" style. Of course, where qualifications are necessary they must go in without fear or favor, but the point the author has in mind is the evident fear of many accountants that their certifi- cates will be taken seriously and acted upon, and in this fear they hedge them about with all sorts of ambiguous qualifications. Sometimes they sound like arguments, i.e., the certificate will read in effect that if so and so were done, so and so would be the result. Most business men will listen to sound arguments before the report is written, and the changes recommended might as well be made in the balance sheet and thus permit the giving of an unqualified certificate, which is always the most desirable. 244 AUDITING A form, variations of which are used by leading audit- ors, is as follows: The Board of Directors, ABC Company. We have audited the accounts of the A B C Company for the year ended December 31, 1915. We verified the Cash, the Inventories of Raw Materials and Sup- plies. Work in Progress, and Finished Product, and the other current assets as of December 31, 1915. The Raw Materials and Supplies on hand and in process of manu- facture were priced at cost, except that where market values at Decem- ber 31, 1915, were less than cost, the inventories were reduced to market values. Sufficient reserves have been made for probable losses on notes and accounts receivable. We examined the charges to capital accounts and find them to represent actual additions to the Company's property. Ample allow- ances have been made for depreciation of plants. All known liabilities have been included in the accounts. We Hereby Certify that in our opinion the accompanying balance sheet and profit and loss statement correctly present the financial con- dition of the Company as of December 31, 1915, and its operations for the year ended with that date. (Signed) X Y Z, Certified Public Accountants. If qualifications are necessary, the above form can be used as a basis and the qualifications mentioned in their proper place. As mentioned heretofore, some certificates may require as much analysis as the figures themselves. In such cases it might be better to omit the certificate in the annual report of a corporation, as its wide publication, chiefly to those who need simple rather than complicated reports, is likely to do more harm than good. The following auditor's certificate (with slight changes) was circulated in July, 1915, to many thousands of stockholders of a large corporation. The balance sheet contairied many details, yet the certificate itself was about as complicated. The certificate was substantially as follows: CERTIFICATES AND REPORTS 245 We have audited the head office books and accounts of the A, B, and C companies at , and of the two independently operated companies at and , and of D company at , for the year ending May 31, 1915, and, accepting the financial reports and balance sheets submitted to us for all other subsidiary companies, district offices and branches, whose books we have not audited, we find that the above Consolidated Balance Sheet is correctly prepared there- from. We have scrutinized the expenditures added to property accounts, and are satisfied that the respective items are of the nature of actual additions or permanent improvements, and are properly chargeable to capital account. All expenditures during the year for replacements and maintenance aggregating $ have been charged against operations, but, as in previous years, no further provision has been made for depreciation. The inventories of raw materials and manufactured products on hand are valued at cost or market price, whichever was the lower. The quantities of all inventories shown by the system of cost accounting have been confirmed by actual count or measurement as at May 31, 1915, made by responsible officials. The head office cash, notes and other securities have been verified by actual inspection or certificates from depositaries and due provision has been made for all outstanding liabilities. Owing to the exceptional business conditions prevailing during the past year, an unusual propor- tion of notes and accounts receivable have not been paid when due (against which the company held collateral valued at approximately $ ) and further provision against losses thereon may be re- quired. Upon the basis above indicated, we certify that in our opinion the above Consolidated Balance Sheet is a full and fair statement, and is properly drawn up so as to show the true financial position of A Com- pany and its subsidiary companies at May 31, 1915. (Signed) J K L, Certified Public Accountants. In support of the argument for a short form of certifi^ cate, the president of a large bank wrote to the author recently and said, mter alia, '*We frequently observe cer- tificates which require as close an analysis as the figures themselves. Some standardized form of audit ^yhich would carry with it all that the word implies, would be most acceptable, I think, to bankers generally." 246 AUDITING Where a shorter form is wanted for a certificate which is to be appended to the condensed balance sheet used by note brokers and others, the following is acceptable: We have audited the accounts of the D E F Company for the year ended November 30, 1915, and We Certify that the above balance sheet and statement of profit and loss agree with the books and in our opinion correctly set forth the financial condition of the Company as of November 30, 1915. (Signed) R S T, Certified Public Accountants. The question sometimes arises as to how to submit a balance sheet and report thereon when the audit is made so long after the balance sheet that adjustments cannot be made as of that date, and the auditor cannot certify that the balance sheet ''agrees with the books and is correct." The best way is to have the entries journalized before the report is written, and no matter how long after the date, the entries should read ''as of" the date of the balance sheet, and when posted to the ledger the items should be connected with the closing date by a star, or asterisk. Subsequent trial balances and any subsequent references will then find the accounts in order, and there can be no difficulty if the necessity arises for their being reconciled with the balance sheet. Wherever the auditor's recommendations as to adjust- ments of asset or liability items are not or cannot be adopted and recorded "as of" the date of the balance sheet, the most satisfactory form of report thereon is to submit the balance sheet as shown by the books and pre- cede this with comments which will be bound with and permanently attached to the balance sheet, so that im- proper use cannot be made of the balance sheet by remov- ing the qualifying comments. CERTIFICATES AND REPORTS 247 Clients do not always appreciate the position of an auditor with respect to the use of balance sheets. Experi- ence has shown that they frequently hope for a more favorable statement than they receive, and as the audit may be for the purpose of securing credit, an unfavorable statement places the client in an embarrassing position. Auditors must always be on their guard, therefore, that balance sheets made up by them and subject to qualifica- tion are not submitted in such form as will admit of their being separated from the qualifications. Based on long experience of his own and other firms, the author believes that the only safe method of reporting is to use paper bearing one's own watermark. This is not very expensive when a considerable quantity of paper is used. Where an auditor is able to construct his own balance sheet and can certify thereon that it is correct, it does not make any difference whether or not it is separated from the comments. In fact, it is usually preferable to submit such a balance sheet complete in itself. Form of Balance Sheet Many tiresome pages have been written explaining, or trying to explain, why it is that universal American custom decrees that assets shall be placed on the left-hand side of the balance sheet and liabilities on the right-hand side. The explanation is no more satisfactory than the reasons advanced by English authorities to support their custom of placing the liabilities on the left and the assets on the right. The author ventures the following: The English practice is purely the outcome of custom. A long time ago some one started that way and every one since has followed, until now the form has the sanction 248 AUDITING of law. (See forms prescribed under the English Com- panies Act.) The only sound reason the author can think of for the custom is that a conservative Englishman looks for his liabilities first and then looks to see if he has enough assets to discharge them. In the United States, accountancy has developed more scientifically than in England. If a short cut is logical we take it. When it was found that loose leaves were far more convenient and economical to handle than leaves bound permanently together, we adopted them. So with balance sheets. It was observed by accountants that the average American looks for his assets first and subse- quently glances at his liabilities in order to assure himself that his excess of assets is as much as he believes it to be. Furthermore, it is common sense for a man who decides to record his financial condition to place his possessions first. Frequently a man has few or no liabilities, so that the practice of stating the assets first, then the liabilities, if any, as a deduction therefrom, thus arriving at the surplus, is the logical presentation applicable to the great majority of business enterprises in the United States. What may be styled the account form of balance sheet is one with the assets on the left and the liabilities and net worth on the right, this permitting an agreement between the totals of the two sides. Sometimes a deficit exists and the bookkeeper's passion for making things balance is so strong that the deficit is included among the assets! The almost incredible result is that practically all pub- lished balance sheets consist of a confusion of figures on both sides which exactly agree in total. The reader thereof who is not trained in accounts does not compre- hend the details, but he is reassured in some mysterious CERTIFICATES AND REPORTS 249 way when he finally discovers that the liabilities at least do not exceed the assets. The author's conception of an ideal balance sheet is one which will set forth: 1. The assets, properly valued and grouped, and arranged in the order of their availability. English law and custom may be against this form, but nevertheless it is the most readable and the most under- standable to the average business man. Furthermore, it has the sanction of the bankers and credit men of this country, who use balance sheets oftener than any other class. (See official forms, pages 253-267.) 2. The liabilities also properly grouped and arranged in the order they will, or should, be discharged. 3. If possible the excess of the assets or the liabilities should now be shown in order that there may be clearly apparent to anyone interested, the net worth, or capital and surplus, of the enterprise. 4. A statement showing to whom the excess belongs or by whom it is due. That is, if a corporation, there should be shown the capital stock issued, the addition thereto if a surplus of assets exists, or the deduction there- from if there is a deficiency. Current Assets: Cash Notes and Accounts Receivable . Inventories Deferred Charges to Operation: Prepaid Insurance, etc Plant Assets: Real Estate Machinery, Fixtures, etc. . . Good-Will, Patents, etc ' $.... . . . $.... 250 Notes Payable . Accounts Payable Accrued Wages . Bonded Debt Reserves Capital Stock Surplus (or Deficit) AUDITING Liabilities $.... Excess of Assets (Or Net Worth) $. The most popular form among large industrial cor- porations which publish their balance sheets is as follows : Assets Plant Assets: ( Including Real Estate, Machinery, Patents, Good-Will, etc.) . . $. Deferred Charges to Opera- tions : Insurance, Interest, etc., Prepaid . . . . Current Assets: Inventories . . . . Accounts and Notes Re- ceivable Cash $.... Liabilities Capital Stock Bonded Debt Current Liabilities: Notes Payable . $. Accounts Payable Accrued Wages, etc. . .$.... Reserves Surplus .... $.... But the above arrangement is not easy reading for one unaccustomed to accounts, and it presupposes that the reader can discriminate between actual liabilities and surplus. So long as it is unnecessary, it is unfortunate that the surplus must be included under a caption which is misleading. CERTIFICATES AND REPORTS The following form is preferable: 251 Assets Liabilities and Capital Current Assets : Current Liabilities: Cash . . . $.... Notes and Accounts Pay- Notes and Account* > able . . . .$.... Receivable .... $.... Bonded Debt Reserves Inventories Deferred Charges to Opera- tion . . ... - Total Liabilities . . $ Excess of Assets, made up Plant Assets: as follows: Real Estate, etc. Capital Stock . $.... Surplus (or Deficit) Good- Will, etc. . Total Liabilities Total Assets . .$.... and Capital . . $ It is asserted that there is a demand for the form of balance sheet given on page 250 from those whose chief desire is to see the relation of the fixed assets to the cap- ital stock. But this information could be more readily secured from the above form, because where fixed items appear first it is usual to place the capital stock first among the liabilities and the surplus last. As the sur- plus may be as large as or larger than the capital, it is very necessary to have these figures nearer together, as provided in the second form. It is, of course, impossible to mention by name the assets and liabilities which are found in different enter- prises, therefore these outline forms must be suggestive only. It is hoped that other chapters of this book in which is pointed out the importance of the auditor's plac- ing himself as far as possible in the position of the one who is to use the accounts will be more helpful in framing a balance sheet than a set form which might apply in a 252 AUDITING few cases, but which would be restrictive and therefore of little value in others. One general principle which should be observed in all balance sheets is that the matter of the arrangement of the groups is not of so much importance as the relation of one to the other. That is, it does not greatly matter whether the fixed assets are first or last, but it is impor- tant that the balance sheet shall indicate, if at all possible, the relation of the fixed assets to the other assets and to the liabilities. For instance, a concern owning a million dollars of fixed assets should have a capital and surplus, or funded debt, of at least as much, otherwise the current liabilities would be excessive. Statement Required by Banks For some years bankers have required borrowers to furnish statements of their assets and liabilities. At first a uniform statement was not insisted on, but it was found that some borrowers were disinclined to submit full reports and others did not know what details the banker wanted. Individual banks thereupon compiled their own forms and furnished blanks to their customers. These blanks were by no means uniform, and as many borrowers used more than one bank, the diversity became a nuisance to both banks and borrowers. The former, in exchanging credit information with other banks, found comparisons difficult, and the latter were put to unnecessary trouble in arranging and rearranging their statements. Finally an attempt was made through the various bankers' associations to formulate a uniform or standard blank which would embody the information most useful to banks. This plan was entirely successful and resulted in the present standard form of borrowers' statement. The form which is reproduced herewith is that officially adopted by the New York State Bankers' Association: CERTIFICATES AND REPORTS 253 STANDARD FORM OF BORROWERS' STATEMENT To THE Bank : For the purpose of procuring credit from time to time with you for our negotiable paper or otherwise, we furnish the following as a true and accurate statement of our financial condition on 191..., which we may hereafter be considered as representing to be a true statement of our financial condition unless notice of change is given you. ASSETS ■ Cash on hand and in bank Notes Receivable of customers (not transferred) . Accounts Receivable of customers (not transferred) Notes and Accounts Receivable of officers (not transferred) Merchandise finished (how valued ) . " unfinished (how valued ) . " raw material (how valued ) . Land owned by corporation, used for this business . Buildings owned by corporation, used for this busi- ness Machinery owned by corporation, used for this busi- ness TOTAL LIABILITIES Notes Payable given for merchandise Notes Payable negotiated to own banks Notes Payable otherwise disposed of Accounts Payable .... Deposits of Money with Us Bonded Debt (when due) Mortgage Debt Chattel Mortgages Total Liabilities Capital . ' Surplus including Undivided Profits TOTAL 254 AUDITING Standard Form of Borrowers' Statement — Continued CONTINGENT LIABILITY: Notes Receivable of customers Dis- counted 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 191.. or from 191. .to 191.. Gross Profits on Sales for the same period $ Expense of Conducting Business " " " *' Net Profit " " " " Other Income including investments " " " " Combined Profit " " " " DIVIDENDS PAID for the period 191.. to 191..$ BAD DEBTS for the period 191 . .to 191 . .$ CAPITAL: Authorized $ Issued $ 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 CUSTOMERS, 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 Accountant? if so, Name and Date of Audit (Sign corporation name) Date Signed 191 . . CERTIFICATES AND REPORTS 255 This form is more explicit and desirable than that offi- cially recommended by the American Bankers' Associa- tion. In the New York State form the matter of hypothe- cations is brought prominently to the attention of the prospective borrower. In the light of many unfortunate experiences where liens on accounts and stock-in-trade have been concealed, the importance of this possibility is unquestioned. Furthermore, in the American Bankers' form there is danger in the arrangement of the assets and liabilities in that reserves are not deducted from the former nor included among the latter, thus permitting the inference that by deducting the liabilities as shown from the assets as shoivn the net worth of the corporation may be ascertained. It is true that reserves are not liabilities, but where they are created in order to provide for depreciation, bad debts, etc., the aggregate thereof is a direct deduction from the assets, and borrowers should not be encouraged in the belief that a banker considers that the "total" assets and the "total" liabilities may be stated before con- sideration is given to items which are in fact directly re- lated thereto. The following is the "short form" recommended by the American Bankers' Association; 256 AUDITING ASSETS H LIABILITIES Caih NOTBB PlYABLB TOTAL TOTAL ~~* Bills Rbccivable fwETl Accounts Rkc«iv«blb (n«t) MlBCHANDMB l.AMD BuiLDIMOa MaCHINBBY— FiXTUBBS .... :*::: :::: Dsposin UoNDKD Debt mobtoaqbs Capital Surplus— PmoriTB Keskbvbs .'.'.'.'.'. !!'.! :::::: .... TOTAL 1 . 1 1 1 \ CONTINGENT LIABILITIES. On bills receivEble discoonted Other CASH. On hand and in bank, | ....Kamei of banks i BILLS RECEIVABLE. Any OTerdna or doobttnl t Any from offlcers, dirsctOrs, 8ab<«oini>aniei, or itisllar aoarces ACCOUNTS RECEIVABf.K. State Mnonnt donblful, not from nstomsrsor in any way not reaUi«ble within lmmediat« fntars. . . . MERCHANDISE. Finished Unfinished Raw Valued at cost or market 1 ball salable t ^. LAND. DescribObHsfly ~ Assessed Talne Market Talus BUTLPmOS. CortI f.AC* DeprwHatlon MACHINERY AND FIXTURES. Cort • Depreciation CondlUott OTHER ASSETS . Areany of assets nnsTallable for paying debts! LoMes INSURANCE. State what kind and NOTES PAYABLE. To own banks.... Through brokers... Othsrwist ACCOUNTS PAYABLE. Terms of purchase ? Do you discount and anticipate I DEPOSITS. Time or demand ! ;... From whom* Interest , BONDED DEBT AND MORTOAOE-S. Due! Rate On what assete a Uen t ACCRUED LIABILITIES. Itemlie ^ «■ CAPITAL. Preferred Authorised | Issued $ Wrldendi Common Aothorlied $ Issued i Dlridends | . RF.SERVES. Itemizs , • NET SALES. Cost of sales • 1 Gross profit ,'.... iBtifNst. taxes, depreciation, sic. DiTidends paid Surplus for year • Hare the books been audited by a CcrUfled Public Aoeountent t.. ..If so, glre 1 of firm and date of audit. CORPORATE NAME. Date signed Office addreu ^mitioo of plante and branch ofllcea. . By. .Mature «t Bwlness.. (SUte officer's tlUe) CERTIFICATES AND REPORTS 257 To a professional auditor the question, ''Have the books been audited by a Certified PubHc Accountant?" is of particular interest. This question was suggested by James G. Cannon, of New York City, who has for many years advised bankers to use professional auditors more generally. Unfortunately for both bankers and auditors, the for- mer have not had the nerve to take this advice except to a limited extent. There have, however, been some ''horrible examples" where the calling in of auditors pre- vious to making loans would have saved the banks mil- lions of dollars. It will be noticed that the bankers wish to read the statements just reproduced, along the lines advocated on page 249 hereof; that is, they want to know about the assets«in the order of their availability, and want to ascer- tain the liabilities in the order they must be discharged. A more recent form, prepared by the credit manager of one of the largest national banks in the United States, is shown in detail on pages 258 to 263 inclusive. This form follows the rules laid down by the Federal Reserve Board and is the best one to which the author's attention has been drawn. It was prepared by Abraham E. Van Doren, of the Irving National Bank of New York. A desirable innovation in this form is found in the pro- vision for a notary's certificate. Together with other features, which are designed to put the borrower squarely on record as to his actual assets and liabilities, this form is expected to furnish legal evidence suf^cient to convict the borrower of fraud if it is shown subsequently that any material discrepancy existed between the statement and his books. 258 AUDITING ^1 < < "A O eg H - < §6 ■• C V M O C <; u .S W -0 2 Q Uh W w H O H rt 3 c o 1/3 la N 3 W s* m « u (L> > O Ix 15 Si 2 < PQ iH 4) •O (U l^ "•?, 2 L. c 2^ CO 3 U) OC/J 3 a -I o ^ o is Uh-l £1 ^ BPu P4 C/3 .« "rt _ to "3 3 u a rt 3 C/3 Uco » u J5 bC H "S V e s ^§.H^c2 CO 3 C _^J5J3 « O « .y rt rt o o a •s < Q 3.5 « 13 tn 3 M w (O u bOC u «3« « -oars Q CERTIFICATES AND REPORTS 259 .2 « ON •OS u 1^ <" o c *°2 t« J ^« »ttO " '-' Si c .^ rt fJ cj: « ir,'-' J' £ Ml fj U a> i^ aj ^ ti u c-a aS) S 3 o.« cS « « MpLiOOaOrt Q W < >^ < u C/3 g O U <: P •J ID CO > c (h '3 H C ««. u M CO « ^«2 a> 3-n 3 b «*« 3 j: o^ 3 C I O w-^ " 3 ,2-- « y t« QQOt/3j 6 3 • in - : > to C/3U 26o AUDITING Schedule A — Depositary Banks and Other Sources OF Credit Depositary Banks Cash Balance at Date of Statement Line of Credit Received from Each Amount Owing at Date of Statement Security Indorse- ments or Guarantees Other Sources of Credit Branch Borrowing Included Total as per Balance Sheet . Schedule B — Notes and Accounts Receivable Notes Accounts Description Receivable Receivable Due from Trade Debtors only — upon usual terms . Due from Trade Debtors — over six months old Due from Officers, Directors, Stockholders, or Employees Due from Own Selling Houses or Branches . Due from Subsidiary Corporations .... Due from Allied or Controlled Interests Due from Capital Stock Sold Amount of Consignment Accounts — included herein $ Amount Discounted, or Pledged, or Assigned — included herein $ Notes Receivable — Past Due Notes Receivable — Renewals of Notes Previously Taken Other Accounts or Notes Receivable Total . . . Less Reserve created to cover possible discount and losses Total as per Balance Sheet Schedule C— Inventory (The within Statement is based upon an (estimated) Actual Physical Inventory taken , 19. ., By ) Description Insurance Amount Finished Merchandise . (How priced?* ) Merchandise in Process . ( " " ) •Inventory should be taken at cost or market price, whichever is lowei. CERTIFICATES AND REPORTS Raw Material . . . (How priced? ) Supplies, etc. . . . ( " " % . ) Total Less Amount of Merchandise of Obsolete Pattern or other- wise not readily salable Total as per Balance Sheet .... Other items included in inventory What amount is held under trust receipt by you? . What amount do you hold on consignment (included in in- ventory) ? What amount has been pledged as collateral for loans or advances? Total 261 Schedule D — Real Estate {Please give particulars of each parcel.) Description Location Title in Name of Value Mortgages Equity Is any Good- Will included in Plant Account? What provision is made to cover depreciation on Buildings, Machinery, and Fixtures, Real Estate, and Plant Account ? Listed at cost, appraisement, or market value ? Schedule E — Investments — Any pledged? Description of Security Number of Shares Held Number of Bonds Held Par Value Market Value Income or Div. Received Last ^ ;ar Schedule F — Deposits of Money Name of Depositor Amount Security Maturity Rate of Interest 262 AUDITING Schedule G — Bonded Debt Amount Authorized Amount Issued and Outstanding Amount Issued and Held in Treasury Amount Pledged as Collateral to Loans Maturity Date Rate of Interest Trustee of Mortgage On what assets are the above described bonds a lien?. Provision for retirement Form Fire Credit .//...//..'.'.. .',...'.'. Liability or Casualty Life (in favor of Company). Other Kinds Insurance Assets Covered Merchandise ... Buildings and Eauipment . Accounts and Bills Receiv- able . . . i , Employees Indorsers or Executives Amount Verification : If your books have been audited by a certified public accountant, state his name and date of audit. Name Date Maximum and Minimum Requirements: When did your liabilities reach their maximum last year and what was the amount ? Month When did your liabilities reach their minimum last year and what was the amount ? Month Character of Business (Federal Reserve Requirement) : Describe briefly the character of business you conduct. Contingent Liability (Federal Reserve Requirement) Form Amount Upon customers' notes dis- counted, sold or other- wise transferred Upon drafts negotiated For accommodation in- dorsements For guarantees given Upon leases Form Amount Upon bonds or other obli- gations of subsidiary companies Under contracts or pur- chase arrangements Under agreements Under pending lawsuits . CERTIFICATES AND REPORTS 263 This company is not a guarantor or indorser of any liabilities or obligations of any individual, firm, or corporation, and it is not liable under any contracts, bonds, or profit-sharing arrangements, or any other agreements, and there are no lawsuits pending except as set forth above. Sign Company's name here By N. B. — It is most essential that each question be fully answered. Federal Reserve Board Requirements The Federal Reserve Board, whose regulations should in time become the controlling authority with respect to financial statements, has issued model forms, the one for corporations being reproduced on page 264. The board suggests that the credit files of member banks should include information concerning the follow- ing matters: 1. The nature of the business or occupation of the borrower. 2. If an individual, information as to his indebtedness and his financial responsibility. 3. If a firm or corporation, a balance sheet showing quick assets, slow assets, permanent or fixed assets, current liabilities and accounts, short- term loans, long-term loans, capital and surplus. 4. All contingent liabiUties, such as indorsements, guarantees, etc. 6. Particulars respecting any mortgage debt and whether there is any lien on current assets. 6. Such other information as may be necessary to determine whether the borrower is entitled to credit in the form of short-term loans. The credit files, it is expected, will be generally adopted, although it is to be noted that the regulations of the board do not absolutely require their adoption. It will be noted that care has been taken to separate "slow'* from "quick" assets, and "short-term" from 264 AUDITING *'long-term" loans. As this separation merely follows long time practice of professional auditors, no further comment is required thereon. The form of statement reproduced below embodies these recommendations. To Bank OF We make the following uacement of all the atiaets and liabilities of this companv at the close of t give other material information for the purpose of obtaining advances on notes and billt bearing our signature < ASSETS Cash 00 Hand and ia Banks. . Accounts Receivabie Notes Receivable Merchandise , Other Quick Assets (ItemizeX- ■ LIABILITIES Accounts Payable Notes Payable to Banks Notes Payable to Othe* Depoaiu Other Current LiabiUtiM (Itemixe) . Land and Buildings Machinery and Fixtures. Other Asseu Otenuse).. Bonded Debt Other LiabiUtiea atemize). TOTAL Cmmit anil Deferred LlaMUtlaa Capital Stock Pieferred Capital Stock Common Surplus and Undivided Profits TOTAL MerchandUe . On what basis valued, cost or market?... Finished! Unfinished* Raw*. If any goods are on 1 Contfnaent Liability. Asindorserf As guarantor $ .. Xo or aaogned except as follows:. , aceounu have been sold AecoHnta and Notea Payable . If any are past due sate «nioiuit Sales and Prcata Last Fiscal Yaar . Netnlesf Net pro&U % Dividends paid ( Accoania and Notea Receivable. If any are past due or aUte amount and circumstances During last fisod year current liabilities » ....)on „ and at a minimum (I ) on... Mortgagee nnd Bonds. Sute due dates of If any amounta are doe 60m tfrectors^ oSoen, employees, subsidiaries, State due date of bonds and oa what assets a Ueo . Are mortgages or bonds a lien on any carrent assets?. I f any other liens 00 assets, state amount and drconistaaces .... , ■ oofttaiocO ^rboth suM Signed this. CERTIFICATES AND REPORTS 265 U whM (Mte incorpontad? U An book* audited by > certified public aocoantant?, ■.,..,: Give d>t« rf lut audit. In order that there may here be a full presentation of the forms in general use throughout the United States, we will next consider the ones issued by the mercantile agencies. These forms are supplied to practically every business concern in existence, and are therefore more familiar to the average business man than any other. The arrangement is not ideal by any means and the informa- tion which may be gathered from it falls far short of that supplied by the bankers' and credit men's associations. It is possible that the agencies do not feel at liberty to request as full a statement as the others, but it is obvious that their forms might be improved without seriously affecting their chances of securing information. The cor- poration forms in use by the two large agencies are as follows: 266 AUDITING (First Form) . STATEMENT OF FINANCIAL CONDITION Name Engaged in the business of Located at From Inventory of 19. . Dated 19.. Under what state laws incorporated ? When ? Authorized capital Subscribed capital ? Preferred stock ? Common stock ? Bonded debt Bearing interest at per cent. ASSETS Stock on hand, raw and finished , . . . $ Amount of book accounts considered good . . Amount of notes considered good . . . Cash in bank Cash on hand Machinery and fixtures Any other assets, exclusive of patent rights REAL ESTATE, consisting of. Total Assets LIABILITIES For merchandise . . . $ For machinery and fixtures For borrowed money For mortgage on real estate For all other liabilities Total Liabilities , Total Assets over Liabilities . Is the surplus at the risk of the business? r. . Do you keep books of account of the business?. If so, what books ? Do you borrow on accounts receivable? Date last dividend declared How much. , . . INSURANCE ON STOCK, $ ON BUILDINGS, Annual rent, $ Annual business, $ CERTIFICATES AND REPORTS 267 (Second Form) STATEMENT OF FINANCIAL CONDITION ASSETS 19 Cash in banks Cash on hand Notes receivable, actual value Accounts receivable, actual value Merchandise (finished and unfinished) Raw material Machinery and fixtures Real estate Other investments (not including patents, trade-marks patterns, etc.) Total Assets How much, if any, of above accounts receivable have been assigned or pledged for loans . . $ LIABILITIES 19 Capital stock paid in Surplus and undivided profits Bills payable .... Accounts payable Bonded debt . . . Mortgage on real estate (not included as bonded debt) .Chattel mortgage on all kinds of property . Borrowed money from banks (not included above) . " " " individuals (not included above) All other liabilities Total Liabilities How much, if any, of the above indebtedness is past due $ CAPITAL Authorized Common stock . Preferred stock. How PAID in: In cash . Patents, trade-marks. In other property Subscribed Paid in $ $ $ $ patterns, etc. $ $ $ $. Give particulars and the value of each kind of property. Amount of annual business $ Amount of annual expense $...., Annual dividend , Surplus (not including undivided profits) . . . .$...., Indebtedness of company to stockholders included in liabilities... Amount of insurance on merchandise . . . .$.... Amount of insurance on buildings and plant . . . $ Ever had a fire ; if so, give particulars Other interests of principal directors CHAPTER XIII CERTIFICATES AND REPORTS (Continued) Statements Requested by Credit Managers The scientific granting of credit requires a high degree of ability, and this is possessed by the modern credit man- ager, or he would not occupy the important position which he fills today. Nevertheless, he does not depend solely on the data he can secure from the mercantile agencies and similar sources, and many concerns have adopted their own system of credit reports from customers and pros- pective customers. The form recommended and indorsed by the National Association of Credit Men does not differ materially from that used by bankers, but it is believed that the exact form will be of interest to those who are anxious to ascer- tain the point of view of men to tvhom reports are fre- quently addressed. As stated elsewhere, the auditor who prepares his reports in a form easily read and easily under- stood by those for whom they are intended will be the most successful. Preceding the form is the following pertinent observa- tion: Large assets are not always necessary to the creation of credit. What is most desirable is, that credit be in relative proportion to the actual assets. The giver of credit is a contributor of capital, and be- comes, in a certain sense, a partner of the debtor, and, as such, has a perfect right to complete information of the debtor's condition at all times. 268 CERTIFICATES AND REPORTS 269 Those accountants who call a deficit an asset and classify capital stock and surplus as liabilities will be shocked to see the informality of the form on pages 270-272. It brings out in strong relief, almost brutally, the "total active business assets," and the "total business liabiUties"; and it is evident from the spaces provided that the differ- ence between the two must be the "net worth." It is a corporation blank, but the intelligent mind that devised the form was not hampered by the fetish of trying to make the two sides balance, but went straight to the point and asked for the information which a credit man- ager, or a business man, or a banker wants. Too much emphasis cannot be placed upon this. Clients assume that their own bookkeepers can prepare trial balances; that is, if they think about the matter of balancing at all. Pro- fessional auditors must get away from the delusion that every item in a trial balance must be transferred to a bal- ance sheet. The author does not advocate a change in the present system merely because it has been demonstrated time and time again that bankers and business men want some other form of statement than that which has been thrust upon them by accountants who are still only bookkeepers, but because the scientific manner of presentation is that which reduces figures to readable form and which dis- closes facts rather than book balances. This form of statement may be considered crude by the technical auditor, but the author ventures the opinion that if it is presented to one hundred business men, side by side with the usual debit and credit form of balance sheet, ninety-nine will express an immediate and emphatic preference for the one tiow shown. There are several unsound features about the form which will be noted by the professional auditor. For ex- 270 ' AUDITING ample, the question ''Value of merchandise on hand at cost" is practically an invitation to overvalue the mer- chandise, as most concerns hold goods which should be inventoried at less than cost. A much better form appears on pages 258-263. CREDIT STATEMENT RECOMMENDED BY NATIONAL ASSOCIATION OF CREDIT MEN To For the purpose of obtaining credit now and hereafter for goods purchased, we herewith submit to you the following statement of our resources and liabilities, and will immediately notify you of any material change in our financial condition. In consideration of your granting credit to the undersigned, we agree that in case of our failure or insolvency, or in case we shall make any assignment for the benefit of creditors, bill of sale, mortgage, or other transfer of our property, or shall have our stock or plant attached, receiver appointed, or should any judgment be entered against us, then all and every of the claims which you have against us shall at your option become immediately due and payable, even though the term of credit has not expired. All goods hereafter purchased from you shall be taken to be purchased subject to the foregoing con- ditions as a part of the terms of sale. CERTIFICATES AND REPORTS 271 Active Business Assets Value of merchandise on hand at cost If manufacturing, raw material, $ , finished, $ '. unfinished, $ Notes and accounts, cash value Cash in hand Cash in bank Bills or accounts receivable, due from officers. Patents and patterns Fixtures and machinery Total real estate, cash value $ Total encumbrances on real estate, $ , Equity , Total Active Business Assets. Business Liabilities Owe for merchandise, open acct., of which $ is past due Owe for notes for merchandise Owe banks Owe for bills for paper sold. . . Owe others for borrowed money Owe taxes and rent Mortgages on fixtures & mach'y Dollars Cts. Total Business Liabilities Net Worth .in Business Name in Full OFFICERS President Vice-President Secretary Treasurer ... Dollars Cts. Address DIRECTORS . f Accommodation Indorsements Contmgent J indorsed Bills Receivable and Outstanding. Liability j Authorized Capital Subscribed Paid in . How paid in : Cash, $ Other property 2J2 AUDITING Incorporated in what State and under what General Laws or Special Act? Nature of business ? Date of charter ?. Suits pending, and of what nature ? Are any merchandise creditors secured in any way? Amount of annual business Annual expenses Annual dividends When was last dividend declared ? Rate Insurance carried on merchandise. On fixtures and machinery On real estate. Regular time of taking inventory Keep bank account with Keep the following books of account. If you have pledged or transferred outstanding accounts or property remaining under your control, state amount thereof and amount re- ceived, or to be received, on account of such pledge or transfer Remarks The above statement, both printed and written, has been carefully read by the undersigned, and is a full and correct statement of our financial condition as of 191 . . . Dated 191 . . Corporation Signature Town State By Liens and Hypothecations Instances have been known where certified balance sheets have gone out wherein accounts receivable and merchandise inventories, included among the assets with- out any qualification, have, as a matter of fact, been pledged as security for loans, and thus were not assets in the sense which anyone making use of the balance sheets had a right to assume. A concern might have accounts receivable of $10,000 and stock-in-trade of $10,000, with accounts and bills payable of $15,000. If the latter were entirely unsecured, a prospective creditor might extend further credit if the CERTIFICATES AND REPORTS 273 concern's standing were good, on the theory that in the event of bankruptcy there could be a shrinkage in the assets of 25 per cent before a creditor would lose anything. But suppose it were found that all of the accounts receivable had been assigned to, and a chattel mortgage on the stock taken by, a creditor for $10,000. This would mean that in bankruptcy the unsecured creditors would probably receive nothing. The professional auditor must never certify to a balance sheet zmthout fully considering the possibilities of liens upon the assets, and if any are discovered, such liens must be plainly indicated on the face of the balance sheet or men- tioned in the certificate, otherwise he is guilty of suppressing material information and -can probably be held responsible in damages to anyone relying thereon zvho suffers loss in consequence. If there is any difficulty in securing information of this nature, the auditor may have to ask the question shown in the credit men's standard form. If he finds no trace of liens, and the of^cers or partners state in writing that there are none, then he could not be held guilty of negli- gence. It would not do, however, to rely on not finding any evidence; there should be af^rmative proof that no liens exist. PROFIT AND LOSS STATEMENT A profit and loss statement is one which assembles all of the income and expenses, or gains and losses, for a stated period. It is synonymous with the ^'Revenue" statement sometimes presented, but as the term ''Revenue" is more frequently used to designate one side only of a profit and loss account, the term is not properly applicable to a statement which includes expenses as well as income. 274 AUDITING The profit and loss statement may be divided into as many sections as are desirable or necessary. The stu- dent of accountancy is usually taught to prepare the profit and loss statement in two sections, the first being a trad- ing or a manufacturing account, the second section being called the general profit and loss account. This illustrates the principles of grouping and enables percentages to be calculated which are extremely valuable for comparative purposes. The trading or manufacturing account usually shows on one side net sales, and on the other prime costs of sales; i.e., materials used, labor, and other direct expenses. In some cases other expenses are included, such as rent, interest, taxes, etc. In modern practice it is not customary to submit a trading or a manufacturing account under these captions. The experienced auditor or accountant compiles a profit and loss account suited to the requirements of each enter- prise upon which he is reporting, and in a form under- standable to those who are to use the report. The following condensed form of profit and loss state- ment was submitted to the St. Louis Congress of Ac- countants in 1904 by A. Lowes Dickinson, C.P.A.: Gross Earnings (whether sales of products, transportation earnings, professional earnings, etc.) . . . . $.... Deduct — Cost of Manufacture or Operation : ^a) Manufacture (for a manufacturing concern) Labor $ Material General Manufacturing Expenses (b) Cost of Operation (for concerns not manufacturing) : (Under suitable headings according to the nature of the business) Gross Profits . Other Earnings CERTIFICATES AND REPORTS 275 Deduct : Expenses of Sale (manufacturing business only) $ Expenses of Management (if distinct from operation) Net Profits from operations $ Deduct : Interest on Bonds $ Other Fixed Charges Surplus for the year $ Extraordinary Profits (detailed) Surplus brought forward from preceding year Deduct: ^ Extraordinary Charges not applicable to the operations of the year . . . $ Interest and Dividend on Stocks Surplus carried forward $ Where further information is required the condensed statement is supported by schedules or exhibits which go into as much detail as may be necessary. The auditor should strive so to arrange the accounts as to show a comparison with previous periods; also, wherever the nature of the business permits, unit costs or earnings should be shown. For instance, the accounts of a taxicab company, if properly set up, will show the average gross earnings of cabs per day. They will also show the operating cost per mile. Perhaps the simplest illustration is a blast furnace. Here it is relatively easy to determine the cost of producing a ton of pig iron, but the figures would be of little value unless the output were shown with the average cost. The production for one week might be 10,000 tons and the average cost $8 per ton; the next week if the production were 15,000 tons and the cost $8 per ton, the natural inquiry would be: 276 AUDITING Why is the cost not proportionately less upon the greater output? If the cost per ton were reported separately from the production, attention might not be called to the possi- bility of lower costs being in order. The relation which each class of expense bears to the total volume of business is always interesting. In dull times it may be expected that certain so-called fixed charges will not vary, but there are other classes of expenses which should fluctuate ratably with the volume of business. The auditor who states the accounts of a number of concerns in the same line of business can readily acquire a knowledge of income and costs which he may impart for the benefit of all at the expense of none. He must not divulge to one client the afTairs of another, but if he ascertains that the office staff of one wholesale grocer costs 1 per cent per annum of the sales, while another costs one-half of 1 per cent and is equally or more efficient, he certainly is justified in making a special investigation into the matter, and cannot be criticized for reporting that 1 per cent is excessive. Use of Charts and Graphs The use of charts by engineers probably dates back to the early days of that profession; likewise, the use of charts by, accountants can be traced back many years. Their use, however, is by no means general, although there are occasions when a chart can portray a situation far more graphically than columns of figures, particularly to a man who is more used to blue prints than to accounts. In such cases the effectiveness of a report is greatly increased by thus picturing the figures. Sales Charts An effective use of charts can be made in a wholesale or retail trading concern where the question of compari- CERTIFICATES AND REPORTS 277 sons IS of great importance. A chart can be prepared at the commencement of a fiscal year showing the compara- tive sales by months and the cumulative totals for the preceding year, e.g.: 28 ? e I I ri~~rgi 280 nOQ MONTHLY 5ALES CURVES, USE SCALE ON THE LEPT. FOa. ACCUMULATED SALES CURVES, USE SC^LE ON THE RIGHT It will be noted from the above that during the pre- ceding year the monthly sales in February were $14,000, going up to $18,000 in June, down to $16,000 in Septem- ber, up to $19,000 in December, and down to $17,000 in 278 AUDITING January. These figures are shown by the dotted black line. The new year (solid line) commences with $16,000, a gain over the previous year, as clearly shown by the chart. In May the increase is not only maintained, but the rate of gain is increased. In other words, a chart will show a trend which col- umns of figures fail to emphasize. The best place for a chart of this kind is on the wall of an office or on a map holder. It may be kept private by having a cover over it, or it may be rolled up. The auditor may submit a sample chart, based on past experience, which will indicate the possibilities of the plan. Gross and Net Profit Charts It is sometimes difficult for a business man to calcu- late how much gross profit he must make to cover his general expenses. The use of a chart will assist him to solve his problem. The chart opposite illustrates the fact that in any business there is a point above which increases in sales return a net profit greater proportionately than the in- crease in sales. In other words, above a certain point any increase in sales occasions an increase in direct cost, but does not necessarily increase the overhead or indirect expense at all. The result is that the percentage of profit is greater. The chart shows that from January to June cost and expenses were increasing, and that when the slump in sales came in July and August, the expenses were not reduced in proportion. The result was that in September the sales were just enough to cover cost and expenses. Had the expenses been kept down to the point at which they started in January, the reduction in direct cost due to the decrease in sales would have kept the total cost CERTIFICATES AND REPORTS The lower well below the low point reached by the sales, line represents the net profit realized. It will be noticed from the chart on this page that whenever the gross sales are above $10,000 per month, the net profit increases rapidly, and below $10,000, the net profit drops at once. After a little experience the business man will be able to see the danger mark. 12 n K> 9 38 7 L A 3 2 1 / \, i • SAV.tS '^ \ \. / "*"*"> / -^ND fi \ \ -^ C^ ^ J^ ^ ^Rt/y, ai. / -^ lAf^ ^f' ^V \ k \ .-^ 2 i FEB MAR APR MAY JUN. JUL AUG 5ER OCT. NOV 28o AUDITING Combined Purchase and Sales Charts If business is not good purchases may represent an unnecessary risk as compared with sales. A chart would show the sales and purchases month by month, thus giving instant expression to an expansion of one against a con- traction of the other, as shown below. 170 160 . |- d ^ fe 13C |l20 fllO 100 to / / \ —5^ -ES / . ' ^ / ,^-^^' rrr ^ / 90 .tj-/' ^-^ .^^' r J 1 1 1 1 r ■ • PER MAR. APR. MAY JUK JUL. SEP OCT. NOV. i It will be noted that in June the sales fell off, but that the purchases kept up the regular advance, and that by November the sales were actually less than the purchases, indicating an enormous increase in the inventory. If the chart had been kept up to date the proprietor would have noticed the trend in July and purchases might have been cut down at once. It may be objected that a good business man always CERTIFICATES AND REPORTS 281 keeps in touch with such important matters and that while such a chart might be of interest to him it would have no practical value. This is true of many men, but it is not true of the many who have such a poor clerical staff that they cannot depend on their results, or those who ignore book figures because they are not able to understand the monthly "trial balances" which they receive. Charts like the above can be kept up day by day so far as sales are concerned. As to purchases, all depends on the method of entering invoices. If compiled monthly only, of course the chart can be posted only once a month, but if it is looked after, say, by the 10th of each month, it will then be sufficiently up-to-date to be of substantial value. Preparation of Charts As a result of invitations extended by The American Society of Mechanical Engineers, a number of associations of national scope appointed representatives on a "Joint Com- mittee on Standards for Graphic Presentation." The com- mittee made a study of the methods used in the different fields of endeavor for presenting population statistical and quantitative data in graphic form, and recommended the following simple and convenient standards to be used in the prepara- tion of charts : 1. The general arrangement of a diagram should proceed from left to right. ioo.000.000 80.000.000 60.000.000 40,000.000 20.000.000 I S S S 8 8 8 2 Fig. 1 282 AUDITING 2. Where possible, represent quantities by linear mag- nitudes, as areas or volumes are more likely to be misinterpreted. Year Tons 1900. 270,588 HB I 1 nU DO 1914. 555.031 U Fig. 2 3. For a curve, the vertical scale, whenever practicable, should be so selected that the zero line will appear on the diagram. 4. If the zero line of the vertical scale will not nor- mally appear on the curve diagram, the zero line should be shown by the use of a horizontal break in the diagram. Sales $ 1000 900 f too ■" y 98 97 96 ^ y y-A «.- — ' ' 95 rj — 1 — rn — r^ 1 E c L C 1 1 2 3 4 5 6 7 8 9 \0 H U Months Fig. 3 E 3 4 5 6 7 Hours Fig. 4 5. The zero lines of the scales for a curve should be sharply distinguished from the other co-ordinate lines. y / y s. X ^ ■^ "^ T A i-^ 5.? 3 y 3.S fea 5 c r 5 .c s.< 3 Fig 5c CERTIFICATES AND REPORTS 283 6. For curves having a scale representing percentages, it is usually desirable to emphasize in some distinctive way %SSl "" ~" ^ ^ ^ ^ ^ /^ ^ ^ 1' i?i Y sar n *l? Relative Cost 104 IDS 102 K)l 100 99 96 97 :==;;!eU ^ Fig. 6a -■'Year' ' Fig. 6b Percent of People too 90 eo 70 60 50 40 30 20 10 r ~ " " - ■; ? ? / / J / / / - ? ^ ^ /^ - - 7 / / i / i ^ Pep Cent of Income Fig. 6c the 100 per cent line or other line used as a basis of comparison. 7. When the scale of a diagram refers to dates, and the period represented is not a complete unit, it is better not to emphasize the first and last ordinates, since such a diagram does not represent the beginning or end of time. 8. When curves are drawn on logarithmic co- ordinates, the Hmiting lines of the diagram should each be at some power of ten on the logarithmic scales. Population I a 8 e 8 .» I 2 Year ' Fig. 7 Population 100,000,000 t.000,000 Year Fig. 8 284 AUDITING 9. It is advisable not to show any more co-ordinate lines than necessary to guide the eye in reading the diagram. Population too.ooo.ooo \ I 8 s F s S5 i ^ Year Fig. 9a Population "* — yi .- 60.000.000 A * I ■ mn I I J |SS?SS?82 Fig. 9b =^ 8 2^8882 ■ Year * Fig. 10 10. The curve lines of a diagram should be sharply distinguished from the rul- ing. 11. In curves represent- ing a series of observations, it is advisable, whenever pos- sible, to indicate clearly on the diagram all the points representing the separate observations. Population ao.(»D.oao - 60.000.000 - «)AX>.OQO - 20.000.00 > L I » S ? .8 9 8 .2 Year " Fig. 11a Days Fig. lib 20 2% 30 ^ t S S R S8S Speed RPM Fig. lie CERTIFICATES AND REPORTS 285 12. The horizontal scale for curves should usually read from left to right, and the vertical scale from bottom to top. 13. Figures for the scales of a diagram should be placed at the left and at the bottom, or along the respective axes. Population tnn fwn iwm ^ 80,000.000 ^ / / / 20,000.to .^ ^ ^ Fig. 12 Population 100.000.000 80.000.000 60.QCO.a0O ;:*: wss $2,000 1,500 1,000 soo 500 1.000 1,500 ^.,,^.,i.= ri > /^ < V. y T 1 i-^ 5 J S.J 3; if r 3 i 3.S Fig. 13a Fig. 13b L Fig. 13c 14. It is often desirable to include in the diagram the numerical data or formulae represented. .5 £ a K 8 s 100.0Q0.000 60.000.000 60.000.000 40,000.000 20.000.000 / / / / X ^ g c I-" H i 8 / r fi i 1° Fig. 14a r 2!::'8SS ^ s .^ ^. ^-^ / % 12345678910 II 12 Month Fig 14b fi 12 3 4 5 6 7 X Fig. 14c 286 AUDITING 15. If numerical data are not included in the diagram it is desirable to give the data in tabular form accompanying the diagram. Population r lUU.UUU.UUU fiOOOQQQQ / €0^000.000 20.000,000 / / / ^ y ^ ^ S S ^ S 8 8 2 - - - - - ^ , Yean Population 1840 1850 1860 <870 1880 1 1890 1900 1910 17,069,453 23,191 876 31,443.321 38,556;371 50,155,783 62,622,150 75,994,575 91,972,266 Year Fig. 15 16. All lettering and all figures on a diagram should be placed so as to be easily read from the base as the bottom, or from the right-hand edge of the diagram as the bottom. lY. The title of a diagram should be made as clear and complete as possible. Subtitles or descriptions should be added if necessary to insure clearness. .o^ part of a machine may be renewable, and it is quite conceivable that at the end of five or six years a machine may be largely renewed and be about as good as new. If in the meantime depreciation at the rate of 10 per cent per annum has been reserved without any adjustment for new parts supplied it is evident that the reserve is too large. It is not intended to advocate any reduction in or- dinary depreciation rates, but it is suggested that the care- ful auditor should study the relation between the deprecia- tion reserve and the physical condition of the machine. Reference to Professor Cooley's description on page 404 herein will remind us that machinery to serve its purpose 424 AUDITING properly must be maintained at from 75 per cent to 85 per cent of its original condition, therefore there is no necessity for providing the cost of maintenance plus the wear and tear element of depreciation if the latter is fully covered by the former. The following tables compiled by George A. Cravens and published in the Electrical Review, April 23, 1910, are of interest. Rates of depreciation on various kinds of equipment as estimated in connection with litigation and by recognized authorities are shown. Table II indicates the variation caused by light or heavy use. Table I Items c cd o ■Hc3 3 >, S6 1 c W V G 1 .2* K U g^ it ^2 > < > < C o in o % Boilers 3.5-10 6.6 7.5 6.6-8.5 5 8-10 2.5-3.3 4-6.6 7.5 Steam Piping 3.5 6.6 7.5 5 5 8-10 2.5-3.3 5-8 5 Auxiliaries 5-10 6.6 5 6.6-8.5 5 8-10 4-6.6 3-5 7.5 Steam Engines.. . . 3-10 6.6 5 5-6.6 5 5 4-6 2.5-5 4-6.6 5 Steam Turbines. .. 5 5 7-9 2.5-5 4 4 Belted Generators. . 5-10 6.6 7.5 5 5 5-10 6.6 3.3-4 7.5 Wires and Cables. 2 6.6 5 2 5 3-5 4-6.6 5 5 Switchboard, etc... 2 6.6 5 2 7.5 8-10 2-5 5 Motors ..... 5-10 6.6 66 5 10 5 5 5 5-8 9-11 4-6.6 5-10 5 6.6 S Storage Batteries.. 10 Shop Equipment. . 3-10 5 7.5 3.3-10 7.5 7.5 12-15 5 4-10 7.5 Table II Items of Equipment Boilers, Water Tube Boilers, Fire Tube Piping, Steam and Water , Auxiliaries, Steam Engines, Steam , Turbines, Steam Generators, Belted , Wires and Cables Switchboards and Instruments, Motors (A. C. and D. C.) Storage Batteries Shop Equipment, Tools, etc... Light or Intermittent Service 4-6.6 5-6.6 4-5.5 3-5 4-5 3-4 4-6.6 3-5 2-5 4-6.6 5-6.6 5^10 Heavy or Continuous Service 5-8.3 6.6-10 5.5-8.3 4-6.6 5-6.6 4-5 5-8.3 4-6.6 5-8.3 5-8.3 6.6-10 7.5-15 DEPRECIATION 425 Small Tools Small tools should be revalued periodically, thus fix- ing accurately the rate of depreciation. If this plan is followed for several years and a dependable rate is secured, it may be feasible to omit the revaluation for a year or two, applying the rate previously ascertained. Furniture and Fixtures Many concerns write down this item to $1, and the practice is to be commended unless stockholders, partners, or other interested parties are being deceived. Where the asset is a large one such a course is not so feasible, but there is no doubt that this item is usually overvalued so far as any possibility of realization is concerned. Usually in a going business, assets are not treated on the basis of realization values, but in the case of furniture and fixtures so many changes are made to suit the con- venience and whims of executives and clerks, and ofifices are moved so often from one place to another, that furni- ture and fixtures have a most uncertain value. Office partitions are frequently built at the expense of tenants and are worthless at the end of the lease. In the meantime changes are often made, and if the auditor is careful he may find duplications in the account. If it is important to write off actual depreciation only, it will be found that 15 per cent per annum will represent a fair average allowance. Landlord's Fixtures Leaving out of consideration the complex question as to what are and what are not landlord's fixtures, it may be laid down as a general rule that the minimum rate of depreciation upon machinery and fittings erected upon leasehold property should be written off at a rate at least 426 AUDITING sufficient to wipe off the book value before the expiration of the lease. In the case of machinery, etc., which will not become landlord's fixtures, a less rate may be permitted, but it is imperative that in such a case it should be clearly under- stood and agreed what are to be the landlord's fixtures, and what are not. Horses It will be readily seen that the depreciation of horses and other animah is rapid and inevitable. The rate of allowance may be from 1.^ to 25 per cent of the cost. By means of revaluation, which can be more accurately done in the case of horses than with most other assets, it should soon become possible to determine the actual rate of depreciation. These revaluations should be fairly frequent. Wagons, Automobiles, etc. In the case of wagons it will be found that 8 to 10 per cent per annum is an ample allowance, provided that all repairs, renewals of parts and maintenance are charged to operating expenses. As with wagons, most of the parts of an automobile can be replaced. Under ordinary conditions the rate of depreciation on automobiles should be fixed aL from 15 to 20 per cent per annum. The most expensive parts, such as tires, motors, and bodies, may be easily replaced, and if charged to operating will leave unprovided for only accrued depreciation and obsolescence. Ships Although the depreciation of ships is invariably great and must be the subject of allowance, it is a difficult mat- DEPRECIATION 427 ter to lay down any fixed rate to be written off. The amount of depreciation should be certified by an engineer, and unless there appears to be some reason to doubt the correctness of his report, the auditor is not responsible. The auditor's certificate should state clearly that inade- quate allowance for depreciation has been made unless an amount has been provided which in his opinion is ample. Patents Although it is true that some value may attach to a patented article even though the patent has run out, it is generally conceded that it is well to write ofT the entire cost of a patent ' during the period of protection. The patent derives its value in great measure from the fact that it is a monopoly, and the moment the monopoly has ceased by the termination of patent rights, the value is seriously affected, if not entirely wiped out. In the case of a patent which has been leased and not purchased, the item should not be treated as an asset except to the extent of its actual cost in fees, etc. To capitalize a patent lease at any sum in excess thereof would be as incorrect as to capitalize good-will, although both are latent assets in every paying concern. Copyrights may be treated in a similar manner, except that their commercial value generally expires long before the termination of the copyright. The original life of a patent is seventeen years, and renewals are dependent upon the introduction of some essential novelty. Good-Will While good-will does not depreciate, it is constantly liable to fluctuations. Good-will is not usually written off, and the question of the amount at which it shall 428 AUDITING stand in the balance sheet was not formerly deemed to be within the scope of the auditor's work, but the present range of an auditors duties compels him to give serious thought to this item. The various points connected with the valuation of good-will are fully discussed on pages 123- 128 and should be referred to in case a question arises as to writing off all or any part of the amount at which good- will is carried. WASTING ASSETS Mines Depreciation of mines is equivalent to a depletion of mineral wealth. The value of the mine to the owner or lessee has decreased at the end of a year by exactly the amount of ore extracted. But on account of the uncer- tainty in the total amount of ore, its quality and grade and the expense which may be involved in mining, it is a difficult matter to set such a rate of depreciation as will represent the average depletion during the life of the mine or the term of the lease, as the case may be. The only way in which this can be done is by estimation, which is naturally inaccurate and may be misleading. Under most state laws a mining company is not com- pelled to write off any depreciation before declaring a dividend, but it is generally considered better finance to write off annually such proportion of the total cost less residual value of plant as the output bears to the estimated content of the mine, or, in case of a leased mine, such pro- portion of the total cost as the output bears to the output estimated for the duration of the lease. On account of the great uncertainty of mining, and the fact that stockholders object to the accumulation of large reserve funds, which would earn only a low rate of interest and might just as well be distributed as dividends, DEPRECIATION 429 it may be better policy that mines should be regarded as non-permanent undertakings in which excesses of cur- rent revenue might be distributed without regard to the value of the remaining assets in their relation to the amount of paid-up capital. Timber Lands In just the same way that the removal of a ton of ore or coal reduces by so much the value of the mine, so the cutting of each thousand feet of timber likewise re- duces the value of the land on which it stood. It is obvi- ous that there should be written off from year to year such proportion of the cost of the lands as the quantity of timber cut during the year bears to the quantity stand- ing on the entire tract at the time of its purchase. In some cases allowance for the value of the cut-over lands may be made in determining the amount which should be charged off for depletion of the timber. Very frequently, however, the cut-over land has but little value. Inasmuch as the total quantity of timber standing on a tract of land can be determined with m.uch greater cer- tainty than is the case with the contents of a mine, it follows that the depletion charge per thousand feet of timber cut can be more accurately fixed than is true of the depletion charges for mining operations. CHAPTER XIX INVESTIGATIONS Part of the work of the professional auditor is desig- nated, not as an audit, but as an investigation. There is here an actual distinction, just as the work of the account- ant may be differentiated from that of an auditor. For the purposes of this book, audits and investiga- tions are separated only as to the special points to be ob- served in the latter, it being assumed that in many investi- gations a complete detailed audit will be required, and that in others a balance sheet audit is essential. Investigations are usually undertaken in connection with the sale of a business to a corporation or other pur- chaser for the purpose of obtaining special information relative to finances or general affairs, or with respect to alleged fraudulent transactions, or into the profits derived from the manufacture of infringing articles, etc. A curious feature connected with investigations, which rarely arises with respect to audits, is the attempt on the part of disreputable promoters, or of those with no repu- tation at all, to retain the services of reputable auditors. Usually the enterprise to be investigated lacks books of account and promises little in this respect for the future, or a company has been formed with a large capital stock on one side, and mining claims or some equally uncertain asset on the other. A certificate is desired for pubUcation, or for private exhibition to prospective investors. In the hands of an honest man, an auditor's certificate 430 INVESTIGATIONS 43 1 in the ordinary form might be unobjectionable, but if the certificate is in the possession of an unscrupulous pro- moter, it may be represented to be an unqualified indorse- ment of the enterprise and its promoters, and there are enough ignorant investors to believe these or stronger statements. The wise auditor will never permit his certifi- cate to be so used, for a single mistake of this kind in sizing up a client may mean the loss of one's reputation. Successful auditors can take no chances at all in this respect; they must be more particular about their clients than a bank is about its customers. The various classes of investigations and the special features of each class will be discussed in the following order: 1. Upon the sale or purchase of a business. 2. To ascertain information required by: (a) Creditors, prospective creditors, or stock- holders. (b) Parties to litigation or disputes. 3. Investigation of suspected fraud. SCOPE OF THE WORK Instructions from Clients The title of this chapter may convey the impression that the work to be done is more or less restricted in its scope, and that the auditor who undertakes an investiga- tion for a special purpose may expect to receive special instructions, differing from the circumstances under which he would be wilHng to make an audit. It is not claimed that an auditor would insist on proceeding with any pro- fessional work, including audits, which appeared to be even remotely in opposition to his clients' wishes. He could withdraw, and this would be the only proper course 432 AUDITING if he found himself unable to comply with the directions of those for whom his work was intended. As a member of a profession with high ideals, he can insist, or in the exercise of his full prerogatives he can demand, that instructions outlining the scope of his work, or the form of his certificate and report, shall accord with honorable motives and straightforward dealing. Other- wise, he cannot proceed without forfeiture of his self- respect. If the instructions are incomplete and the auditor fails to interpret them broadly, so as to include all of the results which are called for by the nature of the case, he should not attempt to excuse his deficient results by falling back on his instructions. Therefore, at the commencement of an investigation it is most important that specific instruc- tions be issued by the client, or prepared by the auditor and confirmed by the client. Working Papers to be Preserved Following up his instructions from the client, the auditor will issue special directions to his own staff. The remarks on working papers (page 42) apply with full force, and, in addition, special care must be taken to pre- serve all data bearing on the adjustment of the accounts. In few investigations will the auditor's report show ac- counts and amounts as they appear on the books. Even if net results are not altered, an analysis will have been made resulting in a different arrangement and presentation. It is of the utmost importance that working sheets be prepared and retained which will show in absolute detail the reconciliation of the original book figures with those appearing in the final report. Neglect of this precaution may subsequently result in censure for neglect, coupled INVESTIGATIONS 433 with the necessity of dupHcate work, for which a charge cannot, or should not, be made. In some cases the working papers of an audit have to be referred to after the report is submitted, but in nearly all investigations, questions arise after the work is com- pleted which require reference to the data compiled during the progress of the work. Detail Which May be Omitted If "investigation" were simply another name for an audit, this chapter would not have been written. In general it may be stated that as an investigation is not an audit, but an inquiry into specific matters, the routine requirements of an audit as outlined in this book may be omitted. Later on, the features which must not be omitted will be discussed. Previous Audits It has also been mentioned that in an ordinary engage- ment the auditor will often find himself to be the first professional auditor who has been consulted. But with investigations, which are frequently called for in connec- tion with consolidations of prosperous enterprises, it will be found that many of the latter have had their accounts audited. If the auditor can secure the reports of such examinations, he will have a basis upon which to deter- mine what use he can make thereof. Obviously this basis will depend on the standing of the other auditors and the nature of their reports. If access to previous reports cannot be had, the auditor should secure permission to consult with the previous auditors for the purpose of securing any information pos- sible. If this is not feasible, he will have to proceed as if the accounts had never been audited. 434 AUDITING Where Assets Are Appraised It is becoming fairly general in an investigation to employ appraisers as well as auditors. The former must take the responsibility for physical valuations of fixed assets items, and while this is of great assistance to the auditor, he should never incorporate their valuations in his accounts without considering their relation to the profit and loss account. The auditor should steadfastly maintain that he cannot state the net profits of a business irrespective of an examination of the assets and Uabilities. If the book assets must be adjusted to an appraisal, the profit and loss account may require adjustment also. The word "may" is used advisedly, as some appraisal companies are inclined to overvalue physical assets. It is pleasing to proprietors (which may explain why it is done), but it does not always afiFord a reasonable basis for a writing up of book values and a consequent adjustment of the profits. On the other hand, in view of this tendency, any in- sufficiency of assets shown by an appraisal should be reflected in the profit and loss account. Definite Report Wanted In order that there may be no misunderstanding, it should be understood that the author does not advocate submitting suggestions and criticisms based on mere hearsay, or on incomplete information. The point to be emphasized is that all facts pertinent to the inquiry are permissible and may be of more value than a mass of figures. Certain adjustments are necessary in practically all investigations, but the auditor must be firm in arranging the results and in wording his report, or it may be found that the final conclusions are far from representing INVESTIGATIONS 435 a well-thought-out opinion of the standing of the busi- ness. Auditors have been very properly warned that if there is nothing definite for them to report, they should not be led into stating that if the expectations of the promoter are reaUzed his estimates of the profits are correct. Handling Books and Records Before making a single mark of any description in a record which is the property of another, the auditor should ask himself the question: "Is there any possibility of these records being falsified, and might it embarrass me later if it were shown that I had made marks herein?" In every case the question should act as a reminder that if marks are warranted they should be small, neat, and so made as to be readily and positively identified on any subsequent occasion. If fraud is suspected, it is always desirable, and some- times necessary, that no marks at all should be made. In such a case the entries which are falsified should be rewritten on loose sheets, paged the same as the original records, and the correct amounts shown in an adjoining column. This will permit a summary of the fictitious entries being made up at ^any time. It involves an immense amount of work, however, and the auditor should advise his cHents of its possible cost. False Entries Sometimes Forgeries The entry of an incorrect amount in a book of record, if made with intent to defraud, is forgery, and therefore a serious crime. Frequently false entries are found in books which indicate that the one responsible therefor has misappro- priated an equivalent sum of money, but it may be difficult 436 AUDITING to produce satisfactory evidence as to when and how the defaulter actually took the cash. It is well known that a verdict of guilty is diflficult to secure from a jury v hen the evidence consists largely of complicated and manipulated accounts. The defaulter's plea that his books were unfortunately mixed up, but that he never stole anything, appeals to the sympathy of the average man. If it can be shown conclusively, however, that certain entries are fraudulent on their face, it may be possible to prove a charge of forgery. An auditor should always be familiar with the law of his own state on this subject. Books as Evidence Aside from the question of fraud, it is always desirable that books and records be kept neatly and accurately, and that they be complete and co-ordinate. In other words, there can be no possible argument against accurate and creditable books of account, but serious loss may result from inaccurate and incomplete records. In the course of time a considerable number of business enter- prises are compelled to engage in litigation, either as plaintiffs or defendants, in which the books of account must be produced and offered in evidence, and many cases are lost through lack of evidence on some vital point on account of insufficient or discreditable data. The auditor will have many opportunities of dealing with the wrong kind of books, which experiences will serve as examples when he tells his clients what not to do. Loose-Leaf Records It was formerly held that loose-leaf records were not proper and sui^cient evidence, by reason of the supposed danger of substitution, but business custom and con- INVESTIGATIONS 437 venience forced a change, so that today these records, when bearing on their face all the signs of regularity, are admitted without question. The chief point to bear in mind in any event is the effect on a jury. Carelessly kept bound books may have an adverse effect, while neatly kept loose-leaf records, in binders, may impress the jury as containing complete and dependable records of the transactions in question. Erasures The matter of erasures is one to which the auditor should give some attention. It directly affects the neat- looking pages which some bookkeepers love, but it may be laid down as a general rule that an incorrect figure ruled out, and with the correct amount inserted above, always stands for itself, while an erasure or alteration is sometimes hard to understand. If it should develop at some later day that the altered figure is one required to base an action or defense upon, the position of the clerk responsible therefor is not an enviable one. The one great factor is accuracy, and to this beauty must, if there is need, be subordinated. Original Records Necessary The foregoing remarks lead up to a consideration of the value of records which are merely transcripts of others, or to which the entries in other books have been posted. In England it is customary to keep certain original records in more or less "rough" form, and subsequently transfer the entries to "fair" books. In such a case the moment it is shown that a certain book is merely a copy of another, and was written subsequently, it loses most of its value and the original record is called for. If destroyed, the entire case might be lost. 438 AUDITING This possibility contains a twofold lesson: It em- phasizes the desirability of making all original records part of the double-entry system of accounts without rewriting, and in addition insures the preservation of records which may be called for when least expected. The Auditor as an Expert Witness Few professional auditors escape their day in court as expert witnesses. The necessity usually arises out of investigations where fraud or disputes are known to exist, but experience teaches that fraud may be discovered in any audit, and in cases where it is least expected. There- fore, the auditor must look upon himself at all times as a potential witness. Neglect to give proper weight to this possibility has caused considerable embarrassment on more than one occasion where an auditor has placed someone in charge of an audit who is not qualified to make a creditable witness. Sometimes assistants, thoroughly equipped in other respects, are constitutionally unfitted to appear as expert witnesses. Part of the program of an audit, consequently, is a provision for the substitution of an experienced senior or principal as soon as the work has gone far enough to warrant the assumption that an appearance as a witness is probable. The author has testified as an expert witness scores of times, and submits the following suggestions based entirely on practical experience: I. Preparation Is Always Essential The average lawyer does not prepare his cases properly, because the majority are settled without suit, or when called are so frequently continued from time to time that he finds it fairly safe to take a chance of waiting INVESTIGATIONS 439 until the trial or reference is on before going into the details of the accounts upon which he purposes to examine the accountant. This makes it all the more necessary for the accountant to be ready. Unfortunately, the lawyer's excuses are received with less annoyance than the accountant's, and the latter must be ready to go into any or all phases of the matter on a moment's notice, or the lawyer, and through him the client, becomes impatient. The section on working papers (page 38) should be read at this point. Failure to make full and proper memoranda during the examination is as annoying subsequently as the failure to find data required, either because it is not properly arranged or filed, or because the query raised was not foreseen. 2. A Witness Can Testify to His Own Work Only While an expert witness is permitted to present synopses and summaries prepared from records offered in evidence, and is thus not compelled to produce his re- sults item by item, yet he must testify that the results to which he testifies are his own preparation and not the work of others. The state of mind of the presiding judge usually decides this point where there is any dispute. The author has found it valuable to have ready for inspection certain of the working papers written in his own handwriting. The attorney for the other side almost invariably raises this point when he thinks there is any likelihood of any of the work having been performed by others, and where the witness has a large practice, and is thought to be dependent largely on the work of assistants, or where the report indicates that one man could not possibly have compiled all of the data within a limited 440 AUDITING period of time. It is of the utmost importance, therefore, that the witness should be ready to state that the results to which he is testifying are his own work; that he brought the figures together; that if he did not perform all of the detail work, it was done under his supervision, and that he presents it as his work. 3. Information Should Not Be Volunteered As an accountant is supposed to testify to facts only, he will make the best impression when he answers questions explicitly and stops when he thinks the question has been answered. If the attorney is not fully conversant with the details of the case, the accountant should, before the hearing or trial commences, prepare for the attorney written ques- tions designed to bring out all of the matter favorable to his client's side of the case. The auditor should never be asked to suppress facts within his knowledge, and cannot honestly do so, no matter how much pressure is brought to bear, but no code of ethics recommends, or as a matter of fact permits, a professional man to volunteer to outsiders, or to the opposing side in litigation, facts which would injure his client. The accountant having, as a part of his duty, provided the means whereby favorable facts will be disclosed, must in every legitimate way guard against the disclosure of unfavorable facts. As intimated above, he must answer any pertinent question, no matter how much the answer may hurt his client, but if there is any possibility of such a question, in cross-examination, being irrelevant, or improper, he should give his own attorney plenty of time to object before replying, and if he is instructed to answer, his duty lies solely in telling the truth, and there should INVESTIGATIONS 441 be no volunteering of information for which the question does not specifically call. 4. Conclusions and Opinions Practitioners differ as to how far an accountant is justified in testifying as to his opinions where the facts at hand may not be conclusive enough for him to state posi- tively that his testimony is founded on conclusions based solely on facts and figures contained in the records offered in evidence. Frequently the records are incomplete, but enough data may have been compiled to warrant a definite opinion as to certain results. Where the witness is acting in good faith, and is interested only in seeing that, as far as he is concerned, substantial justice is being done, it may be urged that his duty to his client requires the presentation of all the evidence possible, and that the other side can be depended upon to object to anything going in unless the ground work of relevancy has been laid. On the other hand, it is contended that an accountant, as a witness, should be absolutely impartial and dis- interested, that he should state the bare truth and be oblivious of which side it might affect. The author has heard this argument for many years, but in the course of his experience, which has brought him into contact, on one side or the other, with the leading accountants in this country, he has invariably found that the accountants are more or less interested in their side and the presentation of the facts favorable to their side, and he has failed to detect any signs of pure disinterestedness on the part of any one of them. Furthermore, he has found in many instances that the accountants have been better advocates for their clients than the attorneys themselves, this being demonstrated 442 AUDITING not only by their testimony under oath, but by their skill in suggesting questions to the attorneys, and these ques- tions have been directed to all witnesses, and not to tliose only who are examined on the accounts. To sum up: the present practice seems to be for accountants to promote in all legitimate ways the success of the side of Htigation on which they are retained, and they are not found to be unconcerned and oblivious of results; that the attorneys and parties to the cases know that this is the practice; that they are relying more and more on professional auditors to assist in the preparation of matters in litigation; and that the attorneys and others who have a first-hand knowledge of the present practice do not see any impropriety in it. The author has no criticism to make of this procedure, but on the contrary believes that the accountants who have in many cases signally helped their clients by extra zeal would have fallen short of their full duty if they had maintained the attitude of a machine which shows final results, but which cannot make suggestions as to how those results may be used. 1. ON SALE OR PURCHASE OF A BUSINESS The professional auditor is now being consulted frequently by the man who wishes to sell as well as the man who wishes to buy. The former realizes that the services of an independent auditor are of the utmost value to him in stating the ramifications of his business so clearly that he will not omit any favorable aspects in dealing with a prospective purchaser. Likewise, the buyer feels that he cannot afTord to depend on the repre- sentations of the seller nor on his own judgment. One may pay too high a price and the other may sell at too low INVESTIGATIONS 443 a price unless the professional auditor passes upon the proposition. It is generally recognized by leading accountants that when an auditor represents a prospective purchaser, much that is necessary in an ordinary audit may be omitted. It is safe and legitimate to assume that the seller will not underestimate his profits, nor his assets, and that he will not overstate his liabilities. Briefly stated, if the auditor finds actual net earnings and assets equaling the representations, and no more liabilities than are claimed, he need not spend unnecessary time on an inspection of the expense vouchers and similar work. The chief points of difference which may arise between an investigation of this kind and an audit, are the following: (a) Something more than figures are wanted. (b) Period covered. (c) Analysis of earnings and expenses. (d) Future requirements and economies. (e) System of accounts. (f) Elimination of unusual items. (g) Adjustments and qualifications, (h) Errors in the books. (i) Investigation on behalf of a retiring partner when the business is being sold to a continuing partner. (j) Investigation for those in charge of reorganiza- tions. (a) Requirements Something More Than Figures Wanted The prospective purchaser of a business wants to know as much of its past history as a man does of his prospective 444 AUDITING bride. He usually contemplates joining fortunes for an indefinite period, and his associations must represent more than mere financial gain. Who is better equipped to pass on the enterprise from almost every point of view than an experienced auditor? Most accountants feel that their full duty has been discharged when they submit a balance sheet and a profit and loss statement, together with such comments thereon as modify the figures submitted. Outside of these figures they will not go, on the theory that to do so would mean a departure from facts into the realm of theory. Nothing could be more inconsistent! The figures shown are, with very few exceptions, estimates only. The stock-in-trade is always worth something more or less than the inventory valuation. The fixed assets vary in value to such an extent that book valuations are usually shown because actual values are unknown. The accounts receivable are valued on past experience, which may be deceptive. There may be contingent liabilities of large amount unknown and not provided for. Therefore, certain conclusions as to the conduct of the business, the trend of prices, and other general information may be compiled by the auditor and reported upon with about as much dependability as the accounts. What does a prospective purchaser want? It is not enough that the report of the auditor, the appraiser, or the engineer show that the assets, as represented, are in existence or that the earnings equal the guaranteed esti- mates. It is of quite as much importance to be assured that the management as it existed at the time of the examination was all that could be desired. Assets are sometimes accumulated and earnings realized through cumulative circumstances which are no longer a factor, INVESTIGATIONS 445 or under the administration of men no longer connected with the enterprise. In the United States, new industries or special and ingenious processes may have been responsible for large profits which subsequently become reduced through the natural economic law of competition and imitation. Capi- tal flows to unusually profitable enterprises as surely as water finds its level. Suppose the business under investigation has shown unusual profits up to the date of the last balance sheet. Is the auditor charged with the duty of forecasting a probable change? Perhaps not, but many enterprises have failed to maintain past profits, although the latter have been actual, and the auditor's certificates thereto true in all respects. In some cases bankruptcy has resulted within a year after the flotation of a stock or bond issue, due entirely to a drop in gross profits caused by competi- tion, the removal of tariff protection, compulsory reduction in rates by public authority or private demand, or reckless or fraudulent practices. The auditor is not and would not be held responsible for losses arising out of these contingencies, but if the downward movement were starting during the course of his examination, should he not convey his impressions to his client? It may be said that a prospective purchaser should think of these things himself. Perhaps he should, but he doesn't. The author has followed this line of suggestion more or less for some years, and has found that the comments are well received and always appreciated, even though his advice may not always be followed. An auditor who expects to perform a considerable amount of investigating in the course of his practice will find it very useful to compile statistics of various busi- 446 AUDITING nesses. This may seem to be a formidable undertaking, but it may not be. It so happens that the proprietors of a business will hear that a certain auditor has just completed an examination of the books of some one in the same line as themselves. They feel that he has acquired special knowledge relative to methods, etc., which may be beneficial to them. It should be remarked in passing that only in the rarest cases has an auditor been asked to reveal any confidential information which he has secured from a competitor. But the auditor may for his own information compile statistics as to what a certain kind of business should earn, and what its expenses and costs should be. Without revealing the source of his information, he may be able to ofifer constructive suggestions or in the case of a purchase or sale, or other investigation, he may be able to comment more intelligently on the accounts than if he were dependent entirely on the data compiled in each particular case. There is another line of investigation which is not often reflected in a report: Are the accounts to which the auditor will certify, prepared directly from the current books of account, or are they the result of special compila- tion? If the latter, is the actual state of the books an indication of neglect or ignorance? Have the proprietors kept themselves informed as to the results of operations through monthly or other frequent periodical statements, or have they waited for definite results until the end of their fiscal year, when an inventory is taken? Have they, therefore, been dependent entirely upon intuitive knowledge, which is possessed more or less (chiefly less) by executives who scorn theory and accounts, and who boast of the value of practical experience? Are the departments co-ordinated, or do they run independ- INVESTIGATIONS 447 ently to such an extent that one does not know what the other is doing? Is it a fact that certain departments are a law unto themselves, that they run along and write up copious records which are never used by those to whom they might be supposed to be of value? All of these queries and many more might be answered offhand by an auditor who had completed an investigation into assets, liabilities, and earnings, but he could not properly report thereon unless he had been in contact with every department of the business. Having this infor- mation, why should he not report thereon verbally or in writing? All these suggestions have a bearing on the two thoughts which are uppermost in the mind of a prospec- tive purchaser, viz., ''Taking everything into considera- tion, is the business a desirable acquisition?" and "How much is it worth?" The auditor may not wish to give a definite answer to either question, but he can furnish figures and other information which will be of the utmost interest. (b) Period Covered As stated at the commencement of this chapter, the auditor should require definite instructions before starting an investigation. These instructions usually specify the period to be covered. As a prospective purchaser wishes to know absolutely all that is possible about the past, it is usual to verify the earnings for as many years back- as time will permit. Three years would be a minimum, while ten years would not be too long a period for those who expect to make a permanent investment. As will be pointed out later, it is not necessary to audit the accounts in the usual sense. An analysis is all that is required. Therefore, it is very little more work to cover 448 AUDITING six years than three, unless, of course, the records for past years are incomplete or inaccurate. The longer the period, the more accurately will the trend of the busi- ness be shown. Most enterprises have good and poor years, and the respective recurrence of these is of great' interest. In no event should the results of two or more years be lumped. A big year and a small year might make a satis- factory average, but few wish to invest in a business where the small year is the last. Therefore, each year must be shown separately, and averages never used unless the actual results of the last year or two are substantially above the average. The auditor must not fail to inspect the results between the date of the balance sheet and the time of the examination. The most recent month should be com- pared with the same month for previous years, and if an unfavorable result is shown, the fact should be reported. (c) Analysis of Earnings and Expenses Gross Earnings In an audit it is always important to verify the gross earnings. In many investigations the prospective pur- chaser is greatly interested therein and is almost indififerent with respect to the net. He says that with his own appraisement of the physical property, and a personal knowledge of local conditions, he requires nothing additional except an accurate statement of the gross receipts or earnings of the enterprise in order to determine upon the price he is willing to pay for the property. The reason is that an experienced executive knows, or thinks he knows, the proper ratio of operating expenses which will be incurred under proper management, and it is of INVESTIGATIONS ^g little moment to him how much the old management has expended. This procedure is followed in connection with the sale of public utility companies oftener than with any other class. The sales or output of these companies is, of course, more nearly constant and dependable than with trading or manufacturing enterprises. But capable men in nearly all lines are found willing to invest in a business with which they are familiar, and if reasonably assured of a minimum of gross earnings, will undertake to guarantee a maximum of operating cost, irrespective of what the previous owner may have done. Recently a large and unsuccessful taxicab company was purchased by a competitor who was willing to guar- antee a satisfactory profit on the purchase price if operated separately and an additional saving if consolidated with his own company. He had managed a business with exactly the same problems as those of his competitor, and had been able to produce a large profit out of smaller gross earnings. He knew the competitor's shortcomings without seeing an analysis of its expenses. (Subsequently, however, he found that the problems were not all the same, and the expected results did not materialize.) This illustrates the importance of a thorough under- standing of the client's viewpoint before commencing an investigation. If a purchaser is chiefly interested in gross earnings, the auditor will take great care to state them properly, looking carefully into the sources of revenue, comparing one period with another, and noting any deductions therefrom in the shape of discounts, returns, allowances, etc. The latter should be deducted from the gross earnings and not included among the expenses. He will then state the expenses and costs as shown by the books and make such verification only as may be required. 450 AUDITING Net Earnings On the other hand, if a prospective purchaser does not have any preconceived ideas as to the proper relation between gross and net earnings, the auditor will make his examination exhaustive enough to enable him to prepare- and submit full and complete analyses of expenses as well as earnings. The comparative statements of earnings will afford profitable data relating to the progress of the enterprise. Of all businesses in which a purchaser is interested, the one with a stable earning power and small but sure earnings is preferred to the one which fluctuates violently. Many business men manufacturing a novelty, or working under patents, have an unusually prosperous year due to lack of competition or some similar cause. They immediately talk of incorporating or reincorporating on the basis of the one year's earnings, and commence to spend money as if it were an annuity instead of the returns from an exceptional year. The auditor who is consulted in such a case will do his client a kindness if he will point out the wisdom of waiting until he can show a good three or five-year average before he is justified in considering his business as on a stable basis, and one in which others will care to invest. Fluctuations must be noted and explained. Gross earnings depend largely on general business conditions, but costs and expenses do not, as a rule, vary to the same extent. It is necessary to obtain an analysis of the accounts and be able to report the various stages from gross earnings to net profits. In a trading business, for instance, the following form of statement brings out the information which a prospective purchaser requires: INVESTIGATIONS 451 A B COMPANY CompMlUve Statement of EARNINGS AND EXPENSES for 3 years ended May 31, 1913 Ykabb Endxo GsomSau^: Less AUowanoM and ReturoB . . Bs: res . UEz. 1013 May 31 Per Cent 1912 May 31 Per Ctot 1911 May 31 Ftt Cent = ~ NetSales ...... Inyentory. beginning of period . . . Puroha8es.net ........ Lees Inventory end of peiiod . . CostofSales Gross Profit Ratio to Sales Ratio to Cost Bbllwo Expekses: Salesmen's Salaries Salesmen's EspenSBs . . . . Commissions Advertising ..... Catalogs Delivery Expenses ::'::*: :::::::: ::''*:: Total Selling Expeoseft . . :::::: RaUo to Sales (UnHKISTRATIOK AND GlNEBiL EXPINBI Executive Salaries Office Salaries Stationery and Office'Supplies . '. Telephone and Telegraph . . . Postage Traveling Expenses , . . . Legal Expenses Rent Insurance Light, Heat, and Power Buiidmg Repairs, and Muntenance Depreciation on Furniture and Fixtu Miscellaneous :::::::: ::::::: :::::: Total Admmistration and Gener penses . . . . Ratio to Sales . # .- . Total Expenses , . . . i Net Earnings . , . . ttmrocnoNs: Interest on Loans, ete. •NetPtpfit It will be noted that the percentages shown are gross profit to sales, gross profit to cost, selling expenses to sales, administration and other expenses to sales. As an investigation implies a comparison of two or more years. 452 AUDITING these percentages are of more value, relatively, than the amounts. The net profit for each year being shown, the next most important thing is to know how it was made. If the sales were about the same for two successive years, the variation in the percentages of expenses would be most interesting, and to a prospective purchaser it might be a deciding factor to learn that while the selling expenses increased, the administration expenses decreased. Verification of Sales It will be assumed that all sales except of recent date will be verified otherwise than through the sales records. That is, after being charged to the personal accounts of customers, if overdue they will be handled as doubtful accounts. As it is customary to accept recent sales as collectable, it is necessary for the auditor to satisfy himself that they are bona fide and not manipulated to produce a good showing just before the date of the balance sheet. The more common forms of manipulation are: 1. Inclusion of goods sent on consignment and approval as completed sales. This practice may result from ignorance, rather than fraudulent intent. 2. Sales or earnings may have been unduly inflated by charging out wholly fictitious quantities and amounts. Where the earnings arise from cash sales, the amount by which the earnings are to be increased is arbitrarily added to the daily receipts. At least one instance is known of the improper increase of street railway fares by a promoter who planned ahead to sell out. He knew that the purchase price would be calculated on a certain number of times the net profit realized, or be based on the gross earnings of the most recent period. It will be seen that if the good-will of a property were INVESTIGATIONS 453 to be sold on a basis of four times the average net earnings for the last two years, any method of increasing such earnings would at least double the cost thereof, i.e., the addition to cash sales of each $100 would be divided by two to get the average for two years and then multi- plied by four to arrive at the purchase price, thus yield- ing a profit of at least 100 per cent for the fraudulent practice. A scheme of this nature must necessarily be planned ahead, which does not apply to most manipulations. This makes it extremely difficult to detect, and no general test can be devised which will surely uncover the fraud. The auditor who keeps constantly before him the pos- sibility of fraud designed to inflate the earnings will have the best chance of discovering it. Where the legitimate cash sales or receipts are small, no one would be bold enough to inflate them to any considerable extent. Therefore, the most feasible method is to enter among the bona fide sales fictitious names, quantities, and amounts. This fraud will be disclosed to the auditor who investigates the average number of new customers' accounts opened within a given period. Any unusual increase would be worth while looking into in any event. If legitimate, the question of a continuation thereof would be important; if not legitimate, it would be even more important to uncover the irregularity. If there has been an increase in prices shortly before the date of the balance sheet, the cause thereof should be investigated. Such increases are not always maintained, and it would be unsafe to depend thereon unless the most positive evidence could be secured of the propriety and wisdom of the change. It may also have been the case that special contracts have been undertaken which have realized large profits, 454 AUDITING but which may never be repeated. For instance, a small steam railway company reaped the advantage of a military encampment during a considerable part of one summer. The increase over its normal traffic was enormous. Yet a prospective purchaser would have no assurance whatever of a repetition of such earnings. The period after the closing date up to the time of the investigation must be scanned closely for rebates, allow- ances, and returns to see if they constitute deductions from prior sales. Likewise, the subsequent sales will be inspected, particularly if suspiciously small, as it might indicate that shipments after the closing date were carried back and charged under false dates. It will not be sufficient to be informed that the out- standings have been guaranteed by the vendors, making a valuation unnecessary. It might be that fictitious sales have been entered in order to make a good showing, the vendors calculating that they can well afford to stand the apparent losses arising out of the non-collection of such items. The auditor should keep this possibility in mind, and where the vendors or guarantors make good any considerable amount in this respect, the details of the accounts should be inquired into. The Turnover - Authorities difYer greatly as to what this term means. The dictionary definitions are: "A completed commercial transaction"; *'The money receipts of a business for a given period." The merchant who speaks of his ''turnover" usually refers to his gross sales, but if his answer were analyzed it would be found that his reference was rather to his stock of goods than to the sales value thereof. If he started his fiscal year with a certain inventory, he would INVESTIGATIONS 455 endeavor to "turn it over" several times during the year. In this case it would mean the cost of the sales, because his inventory and subsequent purchases are entered at cost, and it is this stock that he is endeavoring to turn over to the greatest possible advantage. The banker does not look with favor on the borrower whose gross sales are not several times as much as his starting inventory, and it is a fair inference that sales and cost of sales are here used interchangeably. Uniformity is desirable in accountancy terminology, so the author suggests this definition: The turnover of a merchant or manufacturer represents the number of times his capital in the form of stock in trade is reinvested in stock-in-trade during a given period. To ascertain the turnover, take the starting inventory, add the purchases or cost of manufactured goods, and deduct the inventory at the end; divide the total by the starting inventory. The calculations are based upon a normal inventory. The result will be the number of times the capital invested in stock-in-trade has been turned over during the period. The capital invested in the stock and the physical stock itself may be used synonymously in referring to the "turnover" of a business. Profits on Fluctuations Many enterprises using staple raw materials frequently buy their requirements in advance, and in numerous instances have found it more profitable to sell their entire stock on a rapidly advancing market than to operate their mills. This occurs oftener with cotton than with any other commodity, but the practice obtains in other lines, such as grain, pork, copper, etc. If such profits are actually realized, they should appear 456 AUDITING as a special item in the current profit and loss account. On the other hand, if the transactions have resulted in a net loss, the most conservative method will be to include the loss in the current accounts, on the theory that an extraordinary profit should not be counted as operating income, but that safety will not permit a loss to be ignored, inasmuch as it will have to be paid out of current earnings. Decrease in Expenses The expenses of all classes will be compared for a number of years. If there has been any considerable decrease during the period shortly before the balance sheet date, a careful analysis should be made to determine the possibility of the omission of liabilities which have been incurred, but the entry and payment thereof postponed. The auditor must look at all expense payments after the closing of the books; if unduly large, the vouchers should be examined and their dates noted, as some of them may be for expenses incurred prior to the close of the fiscal period. Advertising and Other Deferred Charges It will be found that excessive valuations are fre- quently placed upon the prospective earning power of advertising and other forms of exploitation. In the publishing business, for instance, it has been considered permissible to capitalize the expenses of establishing a magazine. There is no possibility nor expectation of recouping the preliminary expenses out of the earnings of the first year or two. If succcessful, the early advertising, etc., will have been justified and should bQ charged against the years w^hich reap the bcnefitj INVESTIGATIONS 457 In practice, however, the result is not ideal. Many periodicals have incurred large preliminary expenses, capitalized same, and have never been able to charge off any part thereof against earnings. Other publications which have shown a loss in their early years because no deferred charges were carried over have realized large enough profits in subsequent years to recoup all the pre- liminary expenses. It is a difficult matter to settle at best, but is doubly hard for a prospective purchaser. The best advice to give is to suggest that if the business has been running for some time, all such charges, unless very recent, should have been absorbed, and that if too recent to forecast the result, the purchase of the prospective profits arising therefrom is a pure gamble, modified perhaps by evidence, if available, of what similar advertising expenditure has produced in the past. An English prospectus contained the certificate of a chartered accountant as to profits realized over a period of years ''before charging interest, management salaries, and advertising." Leases If the concern under investigation does not own the land and buildings within which its business is transacted, the matter of the lease and renewals thereof is of the utmost importance. It is safe to estimate that out of one hundred leases for a long term, or which provide for extensions, more than Y5 per cent call for a higher rental during the later years than at the beginning of the term. Where the renewal rate is not fixed, it usually is to be based on an appraisal, and, in perhaps every case, it is contemplated by owner and lessee that the future rental to be fixed on such appraisal will be higher as a result thereof. 458 AUDITING Therefore, the prospective purchaser must ascertain definitely whether he can retain the same premises for a reasonable time if he so decides, and whether the prospects for an increased business or other equivalents will compen- sate for the increased expense if a long lease is desired. Conversely a prospective purchaser may not be willing to buy the business unless it can be removed economically to a new location. In such a case a long lease might in itself prevent the consummation of the deal. Strange as it may seem, prospective purchasers do not always think of these matters during the early stages of negotiations. The auditor should ascertain the precise state of afifairs with respect to the lease before he enters upon an investigation of earnings, the result of which has no interest for a purchaser w^ho may not have known that a long lease on an ascending scale could not be disposed of. In other cases, a purchaser may be negotiating for sevefal properties with the intention of consolidating them. It may be part of his plans to unite them all in one place. Obviously the terms of the leases, if any, are of extreme importance. Sometimes mergers are effected, and plants consoli- dated, leaving certain plants idle. If the plans of the promoters contemplate leasing the idle plants at a remu- nerative rate, or leave out of consideration the continuation of the payment of rentals which cannot be evaded, a serious difference between estimated and actual profits might ensue. In conclusion, it cannot be stated too strongly that the location of a business may determine its success or failure, and any facts or opinions relative thereto which the auditor can furnish will be of the greatest interest to his client. iNVESTIGAtiONS 45$ inventories In an investigation for a prospective purchaser the question of inventories is one of the most important. Little need be added to the discussion on this subject on pages 88-98 except that the distinction must be especially noted between valuations properly incident to a going business and those which apply in case of a purchase. Naturally and properly the purchaser wishes to buy as cheaply as possible, and the seller desires to realize as high a price as he can secure. But in representing one or the other, the auditor cannot allow any such considerations to afifect his mind in arriving at the earnings. The latter should be the same, whether prepared for a vendor or a vendee. Inventories vitally afifect the profit and loss account and the good-will of a business rests upon the profits reaHzed. The result is that inventories actually fix or materially control the purchase price of the business, because the overstatement of an inventory results in an overstatement of profits. An auditor need not, and, as a matter of fact he cannot, be entirely indifferent to the interests of his client. If he represents a purchaser, it is almost certain that the seller will have stated the inventories at the highest pos- sible price, so that he need not be particularly concerned about not doing justice to him. Obviously, a purchaser does not wish to acquire "souvenirs" illustrative of former unsuccessful sales cam- paigns, no matter how willing the vendor may be to part with them. With this thought in mind the auditor should be able to analyze the inventory for the purpose of disclosing unsalable goods. The experienced auditor will prepare a report the 460 AUDITING accuracy of which he can maintain before conflicting interests if misunderstandings arise, as is often the case when commercial enterprises change hands. Other Factors Which Affect Earnings Inasmuch as all of the items of assets and liabilities, as well as all sources of income and every class of expenses, enter into the final adjustment of the profit and loss account, the auditor should not pass finally upon the amount of net profit or net loss, to which he will certify, unless he has covered, or intentionally left untouched, all of the procedure required in a balance sheet audit. The practitioner who does not have his own program for an investigation is, therefore, referred to the chapters of this book describing a balance sheet audit. (d) Future Requirements and Economies An Auditor Should Not Prophesy The author has taken the position that an auditor is bound to furnish his client all of the information bearing on the investigation or audit which he believes to be reliable and relevant, and that he is by no means limited to the figures which any intelligent bookkeeper might compile. But it must be understood most positively that it is never permissible for an auditor, as such, to certify to future earnings or future results. An auditor can express his opinion as to the effect particular transactions will have if applied to a future date. For instance, an auditor would be justified in stating that if a million dollars of bonds were sold at par the bank account would be increased by the same amount. But an auditor would not be justified in stating over his signature that if a INVESTIGATIONS 461 million dollars of bonds were sold at par and invested in the business, savings would result sufficient to net an additional profit. This would.be pure surmise, for unex- pected losses or expenses might more than offset the savings, or the additional capital might be lost entirely through errors of judgment in its expenditure. Business men and financiers frequently ask their audit- ors to calculate the effect certain changes will have on the results of operations. For instance, an auditor will be asked to prepare a statement showing the probable outcome if gross sales are doubled, with no proportionate increase in fixed charges. This is proper, profitable, and pleasing work for a public accountant, and he should welcome the engagement, but it must be distinctly under- stood, before the work commences and after it is finished, that his work is performed in the capacity of an accoun- tant and not that of an auditor. He should refrain from submitting his estimates on paper which bears his name at the top or the bottom, otherwise there is a risk of the figures being put forth as if they were certified to. Great pressure is sometimes brought to bear on audit- ors to have them' certify to what are in reality only esti- mates. It is an astonishing fact that certificates have been issued which are so worded that the untrained mind reads therein that the auditor is satisfied that if certain additional capital is raised, or something of that kind, there will be sufficient earnings to pay a large return thereon. The auditor who lends his name to such near- fraud should be expelled from any accounting body to which he may belong. There are a number of matters which afYect the future upon which an auditor may and should give his opinion, and he may and should discuss the relation which such matters have to the past, but in no case should these be 462 AUDITING grouped in such a way that there can be read into the opinion a conclusion as to the future net profit or net loss of an enterprise. The author believes that this is the best test to apply when in doubt as to how far an auditor should go in furnishing information. InsufHcient Capital For instance, a business may have had insufBcient working capital, and discounts may not have been taken advantage of. A prospective purchaser may ask that a report be compiled which will assume adequate cash capital. An analysis of past purchases may definitely fix the saving which would have been made, but the point at issue is whether or not a like saving can be realized in the future. If an auditor is asked to prepare a statement setting forth the past results and then stating that in his opinion the following period will produce a given result, assuming the saving of discounts, he is going far beyond his prov- ince. But if in his opinion the discounts will continue, or some equivalent thereof, there can be no valid objection to his stating in a certificate that assuming ample capital and upon the same volume of business there will be one item of saving, mentioning the amount. There may be other undue expenses or losses due to insufficient capital, but most of the arguments advanced as to what would have been accomplished are fallacies. Naturally a prospective purchaser wants to know wherein economies can be effected or profits increased, and evidence may be available to prove the truth of the representations made. The most common claim is that the output has been too small, and that additional facili- ties would have meant greatly increased profits. Output, however, must be sold to produce a profit, and it is always INVESTIGATIONS 4O3 easier to talk about a big increase in sales than to secure actual orders. Men who are partially successful frequently overestimate the buying capacity for what they sell. The market may readily consume all that is offered, but if the offerings were to double, the sales price of the whole might be reduced to an unprofitable basis. Large capital is by no means a guarantee of financial success, and any investigation into the capital required for a particular business, the effect of a lack of it in the past, and the possible returns therefrom in the future, calls for more acumen and general business knowledge than most men possess. Nevertheless, there are times when an auditor can be of substantial value in such an investigation, and there can be no objection to his plac- ing at the disposal of his cHent the benefit of his experi- ence, but for his own sake he must not permit the pub- lication of a certificate which can be directly or indirectly interpreted as a statement of future results. Comments on future requirements should always be accompanied by a statement as to the average net capital employed in the old business. This will afford an oppor- tunity for a prospective purchaser to arrange for addi- tional capital if the old is inadequate. Economies Exaggerated One has but to read some of the glowing prospectuses issued a few years ago to appreciate the difference between expectation and realization. Fortunately not much of the responsibility for the failure of many large enterprisv-^s can be traced to auditors, but a part of the blame might not be improperly placed on their shoulders. It has been stated in these pages that an accountant should be available to make calculations and compile data, for which others would take the responsibility. This is 464 AUDITING true, but no public accountant should ever work in the capacity of a clerk. He may assist in the preparation of a statement which purports to show the economies to be effected by a merger of two or more concerns, but if, through ignorance or lack of experience, estimates are made which the accountant knows cannot be fulfilled, he should not hesitate to express his convictions, and if it appears that facts are to be ignored and the public de- ceived, he had better withdraw in order to avoid any possible connection with the enterprise. Almost without exception promoters have, or seem to have, visions of two or more plants being conducted on about the same expense ratio as the most economical of those merged. Economies in all departments are- prophesied, and, as a matter of fact, many are possible and are effected. But they are sorely needed to offset the extraordinary expenses and extravagances which seem to be a necessary element in the promotion and establish- ment of all such consolidations. To start with, vast sums are paid in cash or securities to promoters, attorneys, and insiders. Then engineers and accountants must receive large fees, although far less in proportion than those paid the lawyers. The bankers, lawyers, and others who become mem- bers of the board would not think of attending a board meeting at the dingy business offices of one of the old con- cerns, so a large and expensive suite of offices is secured "downtown." With expensive offices go expensive clerks, and so on down the line. How many poorly paid clerks and others must be dismissed at the works to pay a frac- tional part of the new and additional expenses which were not referred to in the prospectus? If anyone thinks this description is an exaggeration, let him examine a few of the popular consolidations. INVESnCATIONS 465 Former Owners' Attitude Except in rare cases the business which changes hands or consoHdates with others has been prosperous. It is conceded that the personal element is the most important factor in business life, so that if the personal attention of the former proprietor is not available after the sale takes place, it is absolutely essential that an equivalent be found, or the success of former years will not be dupHcated. This is another of the matters with which an auditor is not usually concerned, but no one has a better oppor- tunity to observe the relative position of each person responsible for the former prosperity than the auditor who investigates the finances of the business for a series of years. If the examination makes it apparent that one or more of the proprietors, rnanagers, or other officials were dominant in its afifairs, there can be no reasonable objection to this fact being communicated to the pros- pective purchaser. Many men think that ordinary ability, coupled with plenty of money, can win success in almost any Hne of business, but this is not true, as may be proved beyond •a doubt by examining for a while the bankruptcy an- nouncements. Many concerns which start in business with ample capital fail because they are not properly man- aged. Other concerns with less capital, doing precisely the same kind of business, during the same period of time, will realize large profits. One of the most striking instances is that of the whole- sale grocery business. Here conditions are nearly equal. The same kinds of goods are bought and sold. The same customers are available to all, yet in the same city one concern will earn large profits, while another doing a large business will not earn a dollar of net profit. It is due to the personnel of the management, and where success- ^^^ AUDITING ful executives can be retained, an auditor will not be exceeding his duty if he comments on the matter. Competition Some business men wish to expand, or consolidate, or do something else that sounds big just as soon as they have had one big year. It usually happens that the extraordinary profits earned have been due to a monopoly of a certain kind of product. Now economic laws will adjust an inordinate profit by stimulating competi- tion. Publicity which follows a sale or the publication of earnings will, of course, spread the knowledge of large profits. An exception may be noted in the case of patented articles, where the continuance of a monopoly is pro- tected by law. But where there are no patents of vital importance, the question of competition must be seriously considered. Another element which affects competition is the per- sonal attention referred to in the preceding section. If the business deals in any goods which are dependent upon the taste of the public, it must be borne in mind that the- public is very fickle. Popular demand may be increased by advertising or maintained more or less by fair dealing and courteous treatment, but no one can foretell what the future will develop in the way of competition, and for this reason a prospective purchaser must think deeply before he com- mits himself to a proposition, which, to yield a satisfactory return upon the purchase price, will have to continue to earn so' large a gross profit that there is an endeavor to keep the facts secret. How long an economic law can be arrested is for the purchaser to decide. INVESTIGATIONS 467 (e) System of Accounts Criticisms Should be Postponed In special investigations such as here discussed, the auditor should never express an opinion as to the condi- tion of the accounts, except in a confidential report to the prospective purchaser. During the course of the work he must accept things as he finds them, and in order to secure the sympathy or co-operation of the ofifice stafY, he must be careful to praise anything which deserves praise, and refrain as much as possible from criticizing accounts or methods which cannot be approved. When the purchase is consummated and the auditor is requested to submit suggestions and criticisms, then his working papers should disclose full information avail- able for use. Condition of Accounts an Index to Proprietors There are some particularly shrewd bankers who make frequent purchases of properties, and in other cases fur- nish capital, who consider that an auditor's report on the condition of the accounts reflects very accurately the kind of men who have been running the business. If profits have been large and no accounts worthy of the name have been kept, it is apparent that these men have depended upon their own ability to earn money, and as this cannot be sold and transferred very readily it is not a safe plan to continue such incomplete records. Preparation for New System Therefore, in their contracts the bankers sometimes insert stipulations along the following lines: 1. That within sixty days after the formation of the new company, public accountants satisfactory to the pur- chasers shall be employed to devise and install a modern 468 AUDITING system of accounts for the company which will permit of full and accurate reports of its operations and its financial condition being made at least monthly. (In many cases this provision is objected to, but bankers are anxious to have the accounts reorganized wherever dependable re- sults are not readily available, and therefore hesitate to finance a company whose accounts are unsatisfactory.) 2. That said accountants shall be furnished all requi- site information and facilities for carrying into effect such changes as may be necessary, and that the ofificers and employees of said new company shall co-operate wath the accountants in the installation and completion of the new system within a reasonable time, which in no event shall exceed twelve months from the date hereof. 3. That the reports contemplated by said proposed new system shall be delivered each month to the board of directors of the new company, one copy thereof to remain on file with the secretary of the company, subject to the inspection of any member of the board, and one copy thereof to be mailed each month to the purchasers, as long as the (preferred) stock is not retired. 4. That in the event of accountants being employed for the purposes heretofore stated, then the said account- ants shall be retained to audit the accounts of the new company at least annually. If the system in use is satis- factory and accountants are not required immediately, they shall in any event be retained to audit the accounts at least annually; copies of their report to be delivered and filed as set forth in paragraph 3. 5. If vendors do not name accountants satisfactory to purchasers, the latter may nominate and the vendors agree to employ accountants so nominated and to carry out the provisions referring to accountants with the same effect as if said accountants were appointed by the vendors. CHAPTER XX INVESTIGATIONS (Continued) ON SALE OR PURCHASE OF A BUSINESS (Continued) (f) Elimination of Unusual Items Earnings A purchaser profits from future business only. Large special profits may have been made in the past, but his interest lies in the possible profits of the future. Neces- sarily these are based largely on past experience, but if there are items which probably will not appear under subsequent conditions, they must be eliminated from that part of the report upon which his opinion whether or not to buy will be formed. Income from Assets Not Taken Over The auditor, in order to make an intelligent report, must have a copy of the purchase contract or option. In many cases there are items which appear on the books which are not included in the purchase price and which are to be retained by the vendor. It is important to ascer- tain whether any income from assets of this nature has been included in the current earnings. Interest on Deposits If the bank balances have been normal, any interest thereon should not be eliminated unless it is known that 469 470 AUDITING the future bank accounts are not to bear interest. Many trust companies carry active business accounts and allow interest, but are not in as good a position to extend loans as national and state banks. Some firms carry many hundreds of thousands of dol- lars on deposit all the time, earning, perhaps, 2 or 21/^ per cent, just because they always want to be ready for an emergency. It is not likely that anyone buying such a business would contemplate the same practice. Sale of Assets The analysis of earnings will disclose whether anything has been included which represents profit on the sale of a portion of the capital assets. For instance, an old build- ing or some land may be sold at an advance over the book value. This is clearly an extraordinary profit and must not be included among the earnings. The author was called upon to verify the earnings of a concern and found that among the current earnings were profits on the purchase and sale of the company's own preferred stock. Appreciation of Assets It is a common error to assume that an appreciation in the value of land or any other fixed asset can offset the depreciation of plant. If a statement of earnings has been prepared from the books, and an appraisal shows that the assets are equal to the book value, but that the land has appreciated in value $100,000 while the machinery has depreciated $100,000, then the amount of appreciation must be elimi- nated and treated as an extraordinary earning and the depreciation included among the expenses and deducted from earnings. INVESTIGATIONS 471 Insurance Profit Where a fire has occurred, it may be found that the books show that a profit has been realized. This usually occurs where book values have been written down to be conservative, but the insurance has been left undisturbed. As the assured is entitled to recover the sound or replace- able value of his property, he may be collecting for obso- lete or abandoned machinery, etc. In such case; as the prospective purchaser, in order to be conservative, will follow the same system of charging off, and cannot depend on a fire, the apparent profit cannot be included among the current earnings. Damages for Change of Grade, etc. Other extraordinary receipts may arise out of damages collected from compulsory change of grade, a portion of the premises being condemned for municipal or public utility use, etc. These are all unusual items and are not apt to recur in the same business, so they cannot be in- cluded among current earnings. Expenses There may have been special losses or expenses which the prospective purchaser can, or thinks he can, guard against. These, too, must be separately stated. Excessive Reserves Just as some men decline to allow for known losses, such as bad debts, depreciation, etc., others insist on writ- ing off all of their furniture and fixtures and create exces- sive reserves for other wasting assets. Since the passage of the Federal Income Tax Law, some corporations have entered excessive depreciation in their books. Upon a sale they would hardly admit that 472 AUDITING such charges were proper deductions from profits, and if the auditor finds that they are excessive, he will adjust the accounts accordingly. The auditor will endeavor to have the reserves repre- sent actual depreciation or prospective losses. When they go beyond this they are in reality part of the surplus and to be so treated. Embezzlements It is to be assumed that a prospective purchaser wise enough to employ a professional auditor to investigate the business he expects to buy, will, if he acquires the business, bond all employees and have the accounts audited periodically thereafter, so that any past loss through embezzlement can be eliminated from the expenses. Auditors should impress upon new executives the value of surety bonds for all employees. Many employers who have postponed action for many years never do get around to it, but a new proprietor can insist on this mat- ter without offending any sensitive employee. Failure to observe this precaution has entailed enormous losses to some concerns. Fire and Other Losses Not Insured Likewise, the purchaser will carry an ample line of all kinds of insurance, so that if there has been a fire loss not fully covered, or if an employee has been injured and no liability insurance has been carried, or if plate-glass win- dows be broken, etc., etc., the losses so sustained can be eliminated from the current expenses — which should in- clude, however, a sum equal to the premiums on such insurance as if it had been carried. Another form of protection which prudent busines§ INVESTIGATIONS 473 men carry is ''profit" insurance. This covers loss of the estimated profit which might have been earned had no fire occurred. The rate is about the same as for fire insur- ance, which in most manufacturing plants is extremely low. It cannot be held, however, that an auditor can cer- tify that the earnings of a certain business would have been a given sum if a fire had not occurred. If profit insurance had been carried, and the face of the policies collected, there could be no objection to stating the source of such receipts, but even then an auditor could not include the income so derived among current earnings. Actions at Law Where any considerable expenditure has been made by reason of a verdict or compromise arising out of a suit on contract or infringement, etc., it might be that part of such payment would be properly included among the current expenses, but that a part would be appUcable to prior periods. The auditor must deal with such items on their own merits. (g) Adjustments and Qualifications Partners' Salaries In stating the accounts of a business in connection with a sale, it is customary to eliminate from the expenses the amount charged on the books as partners' salaries. This may be misleading, particularly when the earnings are shown in support of an issue of bonds or preferred stock. For instance, the statement may be made that the net earnings of a partnership have averaged $48,000 per annum, this being four times the interest on an issue of $200,000 6 per cent preferred stock. In arriving at the ^74 AUDITING net profit, custom decrees that the partners' compensation may be omitted. It is true that unless mention is made of the amount it would be difficult for anyone without a knowledge of the facts to form an opinion on the matter. Partners frequently pay themselves large periodical sums carried on the books as salaries. Many others credit themselves with about the equivalent of the salary of a manager or a good salesman, while in many cases no salary at all is allowed for. In the case mentioned it may be expected that after the corporation is formed, the officers (former partners) will insist on salaries unless they have stipulated that none will be voted or drawn. Such stipulation is rare, so that it would not be unusual in a corporation of this size for salaries of $15,000 to $25,000 to be voted to the new officers. This becomes a charge to earnings, and thereby reduces the amount available for dividends on the pre- ferred stock. In other words, the future net earnings will be largely diminished, perhaps half, through the change of name from ''partners' withdrawals" (not an expense) to ''officers' salaries" (an expense). Therefore a charge should be inserted for management salaries. In cases of financing there is frequently some contract provision fix- ing the amount so to be paid. In any event an intelHgent estimate can and should be made. An auditor is never justified in signing a certificate omitting partners' compensation, unless the fact is clearly stated, and any reference to the bearing past earnings have on a bond or stock issue is quaHfied by this omission. Contracts If a business is of such a nature that contracts for pur- chases or sales to be received or delivered in the future are the custom, it will not be sufficient to stop with the results INVESTIGATIONS 475 of the last fiscal period unless the effect of the contracts outstanding at that time be considered. For instance, contracts may have been entered into for raw materials at a high figure, and at the time of the ex- amination the market may be much lower. The inventory may have been priced at the lower price, but it is not usual to anticipate a loss on purchase contracts not repre- sented by deliveries. If the contracts cannot be canceled, with the conse- quence that the new period is saddled with the necessity of buying materials at an inflated price, the auditor will have to adjust the accounts accordingly. It may be that the prospective purchaser has full knowledge of the un- favorable agreements, but the auditor must not assume this. If it is stated that unfavorable contracts for pur- chases or sales can be canceled, something more than the word of an interested party will be necessary to convince the auditor. Taxes While considering adjustments, the subject of taxes must be considered. It is becoming popular to levy taxes on v/hatever person or thing will stand it. In many localities real estate taxes are increasing steadily from year to year. At the time of the examination, if an assessment has been made for the following year, the auditor should inspect it and compare the amount payable thereunder with the previous year. As there may be an increase in the valuation as well as the rate, the increased taxes may be a sufficiently large factor to force a somewhat lower price from the seller. Royalties Where royalties have been paid under a license, and 476 AUDITING the financing provides for the purchase of the patents or copyrights, it may be permissible to eliminate from ex- penses the amounts paid in the past, so far as the possi- bilities of the future are concerned. But it may be unsafe to make the adjustment unless every detail of the acquisi- tion of the patents is available and it is found that a clear saving will result. Verbal statements of this nature, relied on by auditors, have led to unfortunate experiences in the past. The adjustment must include a periodical allowance for the extinguishment of the price paid for the patent or copyright. The capitalization, or proposed capitalization, in case of a purchase must not be confused with the treatment of royalties in the profit and loss statement. Royalties paid constitute an expense, and royalties received represent income. In the former case it is assumed that the patents (if it is out of patents that the royalties arise) are not owned, and in the latter case that they are owned. If the patents are owned the only income which can arise directly therefrom is from outsiders. The concern itself receives an equivalent in the form of reduced expenses by reason of not having to pay for the use of the patent. Orders of Public Service Commissions In making investigations of public service corporations operating within the jurisdiction of a public service com- mission, the auditor should not fail to make a thorough inquiry into the question of whether any orders issued by the commission have not yet been complied with by the corporation whose accounts are the subject of examina- tion. CompHance with such orders might require the expenditure of considerable sums of money — perhaps for purposes which will not result in a corresponding increase INVESTIGATIONS 4^y of revenue; instead of an increase in revenue, there may be only an increased expense for maintaining or operating appliances required to be installed. If the prospective purchaser had knowledge of the matter, he would be in a position to protect himself when conducting negotia- tions with the seller. In the absence of such knowl- edge, however, he would receive a severe shock on being required, after concluding the purchase, to make the entirely unexpected expenditures necessitated by the orders issued before his coming into possession of the property. (h) Errors in the Books As heretofore stated, an investigation is an audit for a special purpose. If the special purpose is the location of errors, then the auditor will proceed as in a regular audit and nothing additional need be said. But in other classes of investigations, the question frequently arises as to how far the auditor should, or must, go in order to satisfy him- self that the accounts are correct. For instance, in an inquiry into earnings, it is neces- sary that he should be satisfied that the income is at least as much as the aggregate to which he certifies. But sup- pose part of the income which should have been in- cluded has never been carried into the books, having been misappropriated, or lost through carelessness or neglect ? As to this, the opinions of professional accountants differ. Some say that in investigating the profits of a business with reference to a sale, an accountant is not ex- pected to check the books and entries for the purpose of detecting falsifications, there being a marked difference between an audit and an investigation with a view to profits, that some defalcations could not be discovered 478 AUDITING , without verifying footings, postings, and vouchers, arid that clients do not desire, and are unwilling to pay for, a detailed audit. On the other hand, it is contended that an auditor is not justified in certifying to a balance sheet and profit and loss account unless an audit has been made. In the author's opinion, the test of what should be done depends upon the nature of the result to be attained. If an auditor is requested to examine the accounts of a business for a period of years, to state and certify to the net earnings realized and to the financial condition as of a certain date, then it is proper to restrict oneself to the actual work necessary, and additional work is superfluous. If income or assets have been omitted, and the omission could not have been detected unless a complete audit were made, nevertheless the auditor has fulfilled his duty. If expenses or liabilities have been omitted, the auditor can- not be excused even if a detailed audit were necessary to discover the omissions. No examination along the lines indicated could be con- sidered as complete in any event unless intelligent analyses were made of the various income and expense accounts. Usually these analyses will disclose fraud or errors of prin- ciple if they exist. The final test of the sufficiency of the examination lies in the skill with which the work has been handled. If the auditor has brought to bear all of the care and skill which might reasonably be demanded of an experienced prac- titioner, then he cannot be held morally or professionally responsible for well concealed errors or omissions, but it must be remembered that the degree of care and skill called for is much greater than, is expected or legally demanded from an inexperienced person or one who does not hold himself out as a professional auditor. INVESTIGATIONS 479 (i) Investigation on Behalf of a Retiring Partner When the Business Is Being Sold to a Continuing Partner When the retirement of a partner is caused by his death or by physical disability, a ''continuing" partner may also be a ''Hquidating" partner. In such case the con- tinuing partner is charged with a greater degree of re- sponsibility than that to which the purchaser of a business under other circumstances would be held. The con- tinuing partner is in the best position to protect his own interests, and the auditor'3 connection with the liquidation of the old firm will most frequently be as representative of the retiring partner. The auditor will need to do all the work which is usually included in an investigation made for an intending purchaser, but there are, in addition, certain other phases of the situation which should receive consideration, and it is these of which mention will be made. It is only equita- ble that the assets should be valued on the basis of a going concern, and it is clearly the duty of the auditor to see that they are not undervalued. It would be most satis- factory to have independent appraisers employed to value such assets as plant and stock-in-trade, due consideration being given both to tHe circumstances of the case and the rights of each of the partners. Frequently, however, this is not done, and the business is liquidated by the con- tinuing partner, who himself values the various assets. While specific rules to be followed can hardly be laid down, it should be observed that in cases of doubt as to values the absent partner should have the benefit thereof. This is only fair, as the surviving or continuing partner is in a position to secure what he believes to be his rights, whereas the retiring partner, through death or absence, is not in the same position to urge the consideration of his rights. It is an estabHshed rule of law that a liquidating 48o AUDITING partner must not take advantage of his position, and this of itself is sufficient reason for his deciding all doubtful cases in favor of the absent partner. Accounts receivable and any other choses in action should be "worked out." The continuing partner is not entitled to any commission for his own services in this connection, though he should be reimbursed for the actual expenses incurred for clerical work entailed thereby. Dis- counts and other allowances credited to customers upon settlement of the outstanding accounts should be care- fully scrutinized. Goods returned by customers subse- quent to the date of dissolution would ordinarily be taken into the stock of the new business, and, unless particular attention is given to this class of transactions, the charge which should be made to the new business and credited to the liquidation of the old might very easily be overlooked. Unless the total amount involved is very small indeed, all credits to old customers other than for cash should be analyzed. Those which are for goods returned can then be made the subject of further investigation. The valuation of the stock on hand is Hkely to present considerable difficulty. The usual rule of valuing the stock at ''market or cost, whichever is lower," does not neces- sarily apply in such a case. The liquidating partner is under obligation to secure the largest return for all the assets of the business, and he has a right to sell the stock to himself, which he is in efifect doing, only if he is willing to pay as much, or more, for it than could have been secured from anyone else. This is not to be construed as meaning what could have been secured at a forced sale. The fairest valuation would probably be the cost of duplicating the stock as of the date of dissolution, due allowance being made for obsolete or imperfect stock. If INVEStlGATlONS 481 the inventory includes only staple goods, little difficulty will be encountered in ascertaining the present cost of duplicating them. If the goods, however, have been made to special order, or are otherwise difficult to value, estimates could be secured from manufacturers for making similar articles, or the actual sales of the goods in the in- ventory could be traced and the customary rates of gross profit applied to estimate the cost. These matters should be covered by an agreement. In drawing such a'greements the auditor should be consulted. If it be agreed to value the stock on the basis of cost, it is to be remembered that this would include not only the original purchase price of the goods, but also freight, cartage, and any other direct charges for handling and placing the goods in stock. It is sometimes urged that the term "cost" in such a case should include interest from the date of purchase to the date of the inventory. This does not seem logical, however, inasmuch as, if mar- ket prices were still the same as at the date the goods were bought, the fact that the goods had been in stock a number of months would not add to their value. On the contrary, the longer the goods had been on hand the greater the probability of their already being, or becoming at an early date, unsalable. Profits realized or losses sustained on the completion of contracts made prior to the dissolution of the partner- ship are to be apportioned between the retiring and con- tinuing partners. Inasmuch as the retiring partner shared in the expenses of securing the contracts and participated in the risk of undertaking them, it is only fair that he should participate in the profits derived therefrom. On the other hand, he should also help to bear the burden of any losses sustained in carrying out contracts which were made prior to the dissolution of the partnership. There is 4S2 AUDITING no reason why the continuing partner should be called on to bear the burden alone, unless a specific agreement is reached under which the continuing partner takes over the contracts at specific values and assumes all further risk in connection with their completion. To do this it would, of course, be necessary to secure the consent of all other parties to the contracts, so that the retiring partner or his estate be released from all liability for the execution of the contracts. Usually the most equitable method of valuing ma- chinery and fixtures would seem to be cost less proper depreciation allowances. If this differs materially from the cost of reproduction at the present time (also making allowance in this case for accrued depreciation), the valu- ation will probably have to be made the subject of com- promise between the parties. While the correctness of the balance sheet is of pre- eminent importance in an investigation such as the one under consideration, the correctness of the income ac- count is likewise of importance if the good-will is to be valued on the basis of past earnings. It is also necessary to review the expenses entering into the income account for a period prior to the date of dissolution so as to see that no prepaid expenses which would apply subsequent to the date of dissolution have been absorbed by the old business. The retiring partner will, in due course, be debited with his proportion of all expenses chargeable to the old firm, even though they may not have appeared among the liabilities stated on the books at the time of his retirement. Prepaid expenses applying to the new busi- ness would not, however, be so likely to be brought into the liquidation account if they were absorbed in the opera- tions of the old firm. There are still other questions, such as partners' salaries INVESTIGATIONS 483 and interest on partners' accounts, which will need to be carefully considered in the light of the partnership agree- ment. (j) Investigation for Those in Charge of Reorganizations There is an increasing demand for the services of ac- countants in connection with reorganizations. The special features of such examinations are admirably expressed by A. Lowes Dickinson, C.P.A., in his work "Accounting Practice and Procedure" (page 245) : The consideration of a plan for the reorganization of a property which has been reduced to a condition of insolvency requires a full and accurate knowledge of all the existing conditions with regard to the property and its past and probable future earning capacity. The elements to be investigated and determined will, therefore, be as follows : 1. The sources and nature of the gross earnings and the prospects of any increase therein without further expenditures for development. 2. The cost of operation, with particular reference to the effect thereon of bad management or bad organization, and to the possi- bility of remedying these conditions; and the proportion which the cost of operation has borne and may be expected to bear to the gross earnings. 3. A comparison of the gross and net earnings and capitaliza- tion of the property, with some actual or desirable standard, so as to determine the proportion which one should bear to the other if the reorganization is to prove successful. 4. Hence to arrive at the total interest-bearing and dividend- paying capital, which the reorganized property will stand on some fixed interest basis. 5. The rank of the different classes of obligations having re- gard to the property pledged as security therefor; the margin of security; the rate of interest; the date of maturity; the equivalent par value on the basis of the standard rate of interest adopted for all classes; and, if practicable, the extent to which the properties specifically mortgaged show sufficient earnings to meet interest on the indebtedness secured thereon. This class of information will probably require a report from an engineer or other expert on the value and the condition of the physical property. 6. Following upon the determination of these factors, a con- sideration of the various separately mortgaged divisions of the 484 AUDITING property, with a view to determining whether any should be aban- doned to the bondholders, rather than be included in a reor- ganization. And here it is important to observe that the contribu- tion of any specific piece of property to the general organization is not necessarily measured by its ability by itself to earn interest on the obligations secured thereon. Numerous other factors will enter into a consideration of this point, and it may easily appear that a property earning little or nothing toward payment of its obligations is sufficiently valuable to the organization, as a whole, to be retained, if possible. 7. Another important factor is the amount of new money re- quired to be introduced for the purpose of paying off the floating debt and rehabilitating the property, and the best method of raising such money, whether by the issue of new prior lien securities rank- ing in front of or on an equality with those issued in exchange for existing mortgages, or by assessments on junior classes of securi- ties. In the latter case it is important that sufficient inducement be given to the junior classes, in the proportion of new securities issued for old, to induce them to pay these assessments; while for the assessments themselves, the securities issued should represent the par value of the cash paid in on some reasonable market valuation. 2. INVESTIGATION FOR CREDITORS, ETC. Auditors are frequently called upon to make examina- tions the scope of which is practically limited to certain accounts about which the most complete detail is re- quired. For instance, a manufacturer may desire to ex- tend a large line of credit to a jobber or merchant, and before doing so wants to know the latter's capacity for handling his line, as well as to know that his financial con- dition and method of doing business are satisfactory. Investigation on Behalf of a Present or Prospective Creditor Examinations along these lines may be divided into two general classes: For bankers or note brokers who propose to loan on the promissory notes of the borrower, or for bank- ers who propose to bring out bond or preferred stock issues. INVESTIGATIONS 485 For individuals or business concerns who propose to make advances for various purposes, or who have extended or who expect to extend credit on open account. In the main, the points to be observed have been dis- cussed in the chapters on the conduct of a balance sheet audit, but there are certain special precautions which may, with propriety, be enlarged upon at this time. (a) Examinations for Bankers Extension of Business The most important line of examination, after ascer- taining the assets and liabilities and analyzing the profit and loss account, is an inquiry into the plans for the future which have been adopted or which are under considera- tion. The average business man is not content with a stationary business. He wishes to expand for the purpose of increasing his profits, decreasing his expense ratio, and perhaps the most compelling of all reasons is his ambition to outstrip his competitors. If his floating debt has been burdensome, he may have been obliged to keep within certain bounds as to capacity and production, but the moment he is financed it seems almost inevitable that new liabilities are incurred sufficient to use up the additional supply of credit almost before it is available. Accountants do not always feel concerned with this phase of business life, but as the lender should have some means of determining the use to which his money is to be put other than that supplied or promised by the borrower, he naturally looks to the professional auditor. True, he has looked in vain in many cases, and this may explain the reason why so many banks, bankers, and financiers hav§ 486 AUDITING secured the services of men who can secure and impart the information required, irrespective of the fact of whether or not they have the degree of Certified PubUc Accountant. Collateral v. Integrity Which is better, to loan money to a dishonest man on ample security, or to a perfectly honest man who wishes to borrow on his own name and who cannot furnish col- lateral? The former may seem to be more advisable, but there are disadvantages in doing any business whatever with a man who cannot be trusted. In a Federal investigation, the late J. P. Morgan testi- fied: Credit is personal. Money can't buy credit Men can borrow money who have most limited properties. The first thing they want is their record. Money is loaned on collateral, of course, but I would not lend a dollar to a man whom I could not trust, if he came to me with all the government bonds in Christendom. Therefore, no matter how good the collateral may be, the banker wants more information, and the auditor may be able to furnish it. Facts relative to previous business experiences, possible failures or embarrassments caused by speculation, etc., will be secured from the mercantile agen- cies, but inside information relative to the personnel of the organization can be furnished by the auditor. Experience has demonstrated that where partners quarrel, or where one does all the work, trouble will follow. Large concerns, solvent so far as finances go, have been placed in the hands of receivers because of internal dissen- sions. A banker does not want to make a loan which may be paid off eventually by a receiver, even if the assets are double the liabilities. Then one or more departments of the business may be weak. The sales force may be highly organized and ef^- cient, but if the manufacturing department is poorly man- INVESTIGATIONS ' 487 aged, or is not co-ordinated with the sales department, the results will not be satisfactory. If no criticism is justified and a man's honesty is un- questioned, a banker may prefer the risk to the apparent safety of a loan secured by collateral. It has been said that ''a crooked borrower is always a wise window- dresser," and this observation may be enlarged to remind the banker that crooked borrowers when negotiating a loan sometimes offer collateral to which they do not have title. Future Business During the progress of any audit which comprehends a balance sheet, there should be available full data with respect to future business and the means whereby it is proposed to finance it. Schedules of orders booked, the time estimated to complete same, the cost of the raw materials, labor, and other manufacturing expenses, the time within which the proceeds of sales will mature, the dates by which the lia- bilities for purchase will have to be discharged, and many other factors are all to be compiled and put into readable and dependable form. If funds are to be furnished to meet pressing obliga- tions, and if any increase in the business means the tying up of additional cash for a considerable period, then there may be a hesitancy about supplying the needs unless a stipulation is furnished that additional business will not be sought until the funds with which to finance it are in sight. The auditor who can secure information of this nature may be helpful to the banker and even more so to the borrower, for it is of no permanent advantage to the latter to be tided over one period of stringency merely to be plunged into another and more serious situation, 488 AUDITING Bank Loans to be Repaid The auditor must bear in mind that the banker whom he represents in these investigations is considering the investment of deposits which are chiefly payable on de- mand, therefore he is not contemplating the making of a permanent loan, but one which will be repaid within a comparatively short period of time. If a banker were looking purely for security, he would invest a large por- tion of his funds in real estate mortgages. The security might be better than commercial paper, but the maturities would be from one to three years, and hence entirely un- suitable for his purposes. If the auditor ascertains that the prospective borrower does not expect to "clean up" at least once a year, he should so report to his client. (b) Investigations After Bankruptcy Auditors are frequently called upon by creditors or other interested parties to make investigations of bank- rupt or insolvent concerns and to report upon their con- dition and the causes of insolvency. The detailed work of examinations of this class is, in the main, quite similar to that in connection with a regular audit. Certain features, however, call for special attention. These examinations fall into two general divisions : 1. To serve as a basis for intelligent action by a cred- itors' committee in connection with the filing of a petition, a possible extension of time, or prepara- tory to the liquidation of the business of the bank- rupt. 2. To furnish information and assistance incidental to a proper consideration of an offer of composition or other settlement. INVESTIGATIONS 489 In respect of the former, the auditor must guard against inflated assets, and understated and omitted liabili- ties, whereas in the latter case the reverse conditions must be looked for. The greatest care should be exercised in the verification of the assets and liabilities, and docu- mentary evidence in support thereof should be obtained wherever possible. A good plan is to secure, if possible, statements rendered by the bankrupt to credit agencies, say, a year or so prior to the date of examination. A com- parison thereof with the books might possibly indicate some assets which do not appear on the latter. The detailed examination should extend, at least, over the period during which preferential transfers or payments might have been made. These would consist of transfers of property while insolvent, with intent to hinder, delay, or defraud creditors; or with the intention to prefer one cred- itor over others of the same class. Transfers of property without compensation, or at unreasonably low valuations should be carefully investigated and scheduled, and special attention directed thereto in the report. The accounts should be carefully examined for pre- dated payments to creditors, chattel mortgages on mer- chandise, and payments to creditors charged to expense accounts, as preferences are sometimes effected in this manner. Wherever the identity of the merchandise can be es- tablished by numbers, trade-marks or other symbols, it would be advisable to trace the largest items in verifica- tion of the inventory totals. This might also disclose shortages of goods of such amounts as to support the inference that goods were shipped out to friends or rela- tives. Instances of this kind are of frequent occurrence. Where the examination is made in connection with a proposed settlement, inventory valuations should be very 490 AUDITING carefully verified. Instances are known where undervalu- ation was attempted by employing excessively low prices. Goods stated to be of no value because of alleged damage should be called for and inspected. If necessary the ser- vices of an expert appraiser should be had for this purpose. Misstatement of inventories is more frequently attempted than is the case with other assets, possibly because detec- tion thereof is more difficult. The auditor, therefore, must be especially vigilant in this regard. It is extremely important to vouch cash payments during the period selected for review. This is especially true of all large amounts. In a bankuptcy case of recent date it was found that cheques were drawn to the order of various employees who posed as creditors. The cheques were duly cashed and the proceeds eventually paid over to the partners of the concern in question. A critical scrutiny of the receipts and payments for unusual items may sometimes disclose the existence of a silent partner, as evidenced perhaps by interest payments or remittances for profits, etc. The accounts receivable should be analyzed, and pe- riodized, and set forth on the statements, classified as to good, doubtful, and bad. All the accounts should, if pos- sible, be confirmed by correspondence. Accounts with large balances, said to be uncollectable, should be regarded with suspicion and subjected to independent verification. Inquiry among other houses in the same line of business may result in the auditor's finding that some of the alleged doubtful accounts are good. Accounts with salesmen covering goods in hand, either as samples or for sale, also cash advances for expenses, commissions, etc., should receive careful attention. These accounts are frequently stated to be worthless in order to INVESttGAtlONS 491 make a poor showing and thereby to induce the creditors to accept an unfavorable settlement. Commissions due to salesmen should be verified by reference to the sales rec- ords, and by an inspection of the salesmen's contracts, if any exist. The auditor should satisfy himself that the commissions stated as due have accrued on actual sales and that the respective salesmen are entitled thereto. With reference to accounts payable, the auditor should be certain that all items are included and that the re- spective amounts recorded as due are actually owing. He should also, as far as possible, establish the propriety of claims presented and endeavor to provide for all possible claims not received at the time statements are submitted. The statements usually prepared consist of a statement of affairs, with supporting schedules, and a deficiency ac- count. If the auditor is still in charge, in cases where there is a final winding up of affairs, a statement of realiza- tion and Hquidation is prepared. It is essential in this class of examinations for the audi- tor to verify and account for all the assets and liabilities that appear on the books, and to estabUsh the possible existence of assets and liabilities not revealed in the ac- counts. He must be extremely conservative in estimating the realizable values, always keeping in mind that his re- port will, in all probability, be reHed upon by the creditors, and that a too optimistic report results in disappoint- ments that reflect on his accounting ability. (c) Investigation for Purely Credit Purposes The credit manager of a business concern or the repre- sentative of a capitalist who contemplates extending credit to a prospective borrower or debtor must proceed along somewhat different lines than the professional audi- tor, whose duty is to report upon actual conditions, and ^^^ AUDITING Upon whom the responsibiUty is not laid of having to de- termine immediate action, based more on the estimated outcome of the future than on present financial strength. For instance, an auditor might ascertain and report that a certain man had cash on hand of $100,000 and no debts. He would have no further responsibility there- after, unless it were shown subsequently that there were undisclosed liabilities. We will assume, however, that the facts were as reported. The credit manager might have an entirely different task before him. He should use the same means to ascer- tain that the $100,000 was actually on hand and free from Hens, and that there were no liabilities, but his work would then, in a sense, be merely beginning. He should ascer- tain the past and present moral and business reputation of the man; he should have an accurate and complete his- tory of his business career; he should question him in detail as to what he intends to do with the money; whether his proposed business venture calls for a capital of more than $100,000, and so on. It has been said that the credit manager must always look out for three essential elements in passing on a credit basis, viz., character, capital, and capacity, three "C's,'* and therefore easily remembered. The author feels that there are so many points of con- tact between a professional auditor and a credit manager that this opportunity should be taken to discuss the simi- larities of their work, with a view to standardizing as much of it as possible. It is not contended that the auditor should attempt all the manifold duties of the credit manager, nor that the latter should burden himself with the technical knowledge required to make a detailed audit. It is, however, urged, without fear of contradiction, that an auditor would be INVESTIGATIONS 493 able to render better service to his clients if he could ac- quire some of the instincts of the successful credit man- ager and keep constantly before him, when making inves- tigations involving proposed credits or investments, many of the requirements which the science of credits has found to be essential. Likewise, who will deny that the credit manager could perform his work more easily and scien- tifically if he were conversant with the principles, and could take advantage of the experience, underlying the practice of professional auditing? The National Association of Credit Men's bulletins contain this: The giver of credit is a contributor of capital, and becomes, in a certain sense, a partner of the debtor, and, as such, has a perfect right to complete information of the debtor's condition at all times. Credit is given a merchant because of the confidence reposed in him. Requesting a statement when credit is asked is not a reflection on one's character, honesty, or business ability, but is done to secure information to enable business to be conducted intelligently. When a statement is made it should be absolutely correct. To make it so necessitates the taking of at least an annual inventory and the keeping of an accurate set of books. Statement giving, therefore, will tend to make a debtor a better buyer, because more familiar with his stock, more careful in giving credit, more con- servative in incurring debt, and will result in a better knowledge of his business generally. A merchant who desires to serve his own best interests should recognize that his most valuable possession, apart from his actual assets, is a sound, substantial and unquestioned reputation as a credit risk, and that, under the prevailing conditions and demands of business, the most eflFective, and eminently the best way to prove his basis for credit is to be willing to submit a statement of his financial condition. The liabilities in business failures aggregate over $200,000,000 per annum, the loss to creditors being more than half that amount, and the number of failures is 494 AUDITING steadily increasing. In a very large proportion of these cases credit could not be secured if the debtor were obliged to submit his books to an examination by a professional auditor. Is it unreasonable to suppose that the general use of auditors to verify the accounts of concerns seeking credit would save ten per cent of this annual loss of over $100,000,000? If a saving of over ten millions of dollars could be effected by the expenditure of, say, one million, would it not be worth while to attempt to save another 10 per cent or more by compulsory audits of all concerns seek- ing credit ? It is a great surprise to credit managers when they realize losses from respected concerns — those concerns whose statements the bankers and credit men do not verify personally, nor cause to be verified by some independent means. It is because credit managers do not, as a rule, recog- nize the fact that most concerns cannot be depended upon to furnish a true statement of their financial condition. Aside from fraud, inaccuracies (which are just as expensive as fraud) arise from the following causes : 1. The fallibility of human nature, which, with respect to financial statements, leads to optimism, the mak- ing the best of things, which inevitably leads to the perhaps unconscious overstatement of assets, and understatement of liabilities. 2. The inevitable errors which arise in the use of esti- mates, honest errors, but errors which almost always result in an overstatement of net worth. 3. Ignorance of executives and clerks, inefficient meth- ods and systems, resulting in misleading statements of financial condition. Strange to say, such state- ments nearly always overstate net worth. INVESTIGATIONS 495 4. Consciousness of weak spots, but coupled with a mental reservation to adjust them later. If we can agree that the factors named are of sufficient importance to warrant an independent verification; if it is true that for his own sake, as well as for the benefit of the dispenser of credit, the seeker for credit should have his statement verified, how is it to be done? The answer to this question is simple. It may be ac- complished by proper recognition on the part of the credit manager of the value of verified financial statements and insistence upon the practice; and by a proper recogr nition on the part of the professional auditor of the point of view of the credit manager. The responsibility will then rest upon the auditor for audit certificates which can be depended upon. Unscientific Methods Such methods afifect business success quite as much as anything else. The auditor may find a satisfactory surplus of assets, but if carelessness or incompetence exists in the accounting and other departments, a day of reckoning will surely arrive. Signs of carelessness or incompetence may be found in lax collection methods. More than one failure has re- sulted from a policy of allowing collections to take care of themselves. The precise procedure followed should be ascertained and reduced to writing. The "follow-up" system must be examined very carefully. It may be that the system is good, but that it is not being followed. Then the relation between the departments must be looked into. Co-ordi- nation here is absolutely essential to success. Sometimes a credit department will claim that the salesmen arc so anxious to sell that a considerable part of the business 496 AUDITING must be refused. This brings up the question of co-ordi- nation among the various departments of a business. If it is lacking, one of the elements of failure is present. An investigation into the methods of doing business thus becomes a necessity where one is looking into the future probabilities of success or failure. Almost anyone can sell goods, but to insure financial success they must be sold at a price which will yield a satisfactory profit and to customers who will pay. Here again the methods of the prospective debtor are all-important, and the representa- tive of the lender or creditor not only has the right to know whether or not scientific methods are in force, but it is his positive duty to ascertain whether or not such is the case. Lack of Capital It is said that more failures result from lack of capital than from any other cause. It may seem superfluous to state that it is better to do a small but safe and profitable business than to attempt to trade beyond the limits of capital employed; but this overstretching is going on all the time. It is a point on which the auditor and credit manager can secure accurate information from the balance sheet, but this must be supplemented by an inquiry into plans for extensions to plant, commitments for large purchases for future delivery, and similar negotiations. Credit Risks The passion of a salesman is to sell; the dread of a credit manager is to pass a credit which will produce a loss. Between the two may He the secret of a successful business and large profits. The burden is upon the credit manager, and he cannot escape it by turning down every order about which any doubt exists. Investigations 497 The conclusions upon which he will base his final deci- sion in any case are dependent upon so many different circumstances that they cannot be enumerated here, but it may be mentioned that the margin between the cost and selling price of an article is one of the most important factors to be considered when the question of the accept- ance or rejection of an order is to be settled. If the gross profit is large, it is obvious that more risk may be taken than where the margin of profit is too small to admit of any material amount being set aside for bad debts. In some lines the gross profit is so large that it would be more economical to sell everybody than to maintain a credit department; in others it is equally unnecessary to maintain such a department, because all goods must be shipped sight draft against bill of lading. The point seems obvious, yet many accountants and credit managers do not differentiate between the rules to be observed, which makes their general advice of little or no value. Insurance A professional auditor does not always inquire into the sufficiency of insurance of all descriptions, but it is believed that the successful credit manager has this con- stantly in mind. Auditors now see the importance of this line of inquiry, and among certain firms it is an integral part of the audit program. Fire insurance is only one of the lines which should be investigated. If the personality of a partner or an em- ployee is of great value, life insurance might be desirable. Except in a very few lines of business, such as railway or taxicab, a reasonable amount of liability insurance, both public and employers', should always be carried. Profit insurance is frequently as important as fire insurance, especially where a seasonal 'business is con- 498 AUDITING ducted, and large preliminary expenses, such as advertis- ing, are incurred, and where a total loss would result if a factory were to be destroyed. Errors of Principle It is not enough that a concern's financial statement shall look well, for sometimes actual conditions are con- cealed through errors in bookkeeping. This state of things exists in more cases than is generally known. For instance, in a contracting business the book- keeper, in closing the accounts, closed all of the credit balances in individual contract accounts to profit and loss. He did not realize that all of them were not com- pleted and that a considerable liability existed in respect of the cost of completion. His balance sheet showed a much better financial position than the concern deserved, but the bookkeeper maintained that it was correct until he was shown how inaccurate it was. Errors may be honestly made, and yet they will bring ruin on a concern unless discovered and rectified. Failure to provide for depreciation is the most common derelic- tion, and excessive charges to asset accounts is a close second. The auditor is always on the lookout for such errors, whether intentional or unintentional, but few credit managers realize the importance of ascertaining whether or not the books of a prospective debtor have been regu- larly examined by a public accountant. Fraud Under this class the auditor will find far too many examples. The bankruptcy courts are full of cases in which creditors have been grossly deceived. Many of these are so flagrant that it seems impossible that the debtor should have been able to incur such large debts, INVESTIGATIONS ^gg yet the fact is obvious that credit managers by the hun- dred and business concerns by the thousand extended credit to these bankrupts to an aggregate of tens of mil- lions of dollars. The schedules of the bankrupts' debts speak for themselves. The most surprising feature of the whole situation is that in many cases the most cursory examination of the bankrupt's books would have revealed to the trained auditor that gross fraud was being prac- ticed. A more intimate relationship between professional auditors and credit managers would prove to the latter that the auditor can be of inestimable service in many ways. Character Last but not least is the element of character. In miQdern business it is almost concealed, owing to the im- possibiUty of continuing the personal relations between bankers and borrowers. The modern borrower's balance sheet may be submitted to hundreds of bankers. But the author would not like to see the audit program of the auditor or credit manager omit all consideration of character. The banker has to consider primarily the present abil- ity of the borrower to repay the loan, but further than this his business foresight will make it possible for the banker to size up his man and determine whether there is not some inherent lack of character in him, either moral or executive, which may at some future time make the risk more hazardous than if he were entirely normal. Some unprincipled business men pay all of their debts, but many are found in the bankruptcy courts being relieved of their obligations, and subsequent success does not incHne them to pay the debts thus discharged. The honest man may fail honestly, but if he can he ^QQ AUDITING will pay in time, and we may be thankful that there are many such. Therefore let the auditor and the credit manager study human nature and analyze the conditions presented to them not only from the financial standpoint but from a moral point of view as well. (d) Investigation in Patent Litigation An investigation to ascertain profits realized in the manufacture of patented articles, where infringement of patent rights is claimed, and the claim is sustained, or when an examination is ordered pending a decision, pre- sents several novel features, as compared with an ordinary statement of profits. It is not intended to discuss the matter from a legal point of view, and it may be that the principles hereinafter set forth might not be upheld by the courts in some juris- dictions. It is the author's experience, however, that most of these cases are settled out of court owing to the enormous expenses involved in the taking of testimony before masters, who are usually appointed where matters of account are involved. The following procedure, therefore, may be taken as the result of actual practice, following negotiations which usually involve concessions on both sides, rather than settled rules laid down in judicial decisions. General Accounting Principles Do Not Govern The preliminary conferences in a matter of this sort naturally bring out opinions which differ radically. The injured party will claim everything that can be imagined, and the defendant will produce a statement which shows that the manufacture of 'the infringing article has been attended with ruinous losses. From the beginning it is a question of gradually drawing the lines closer, until each INVESTIGATIONS 50T has stripped his case of redundant matters and the issue is joined. It will be found that ordinary accounting principles do not form the basis of the claim nor of the defense. The following are exceptions to accepted practice: There would seem to be no excuse whatever for appor- tioning any part of the general expenses as a part of the cost of the business. The infringers would have had these expenses to pay in any event in order to carry on their legitimate business. If the principal business of the defendants consists of manufacturing or dealing in infringing articles, then it may be proper to include a certain part of the general expenses, but items of a questionable nature should not be included. As defendants are not supposed to have pushed the 5ale of the article, it hardly seems proper that any credit should be claimed for special exhibitions. Where the same kind of materials are legitimately used in the manufacture of other goods handled by the defend- ants, and the purchases are not earmarked at the time for any particular department, it would seem improper that credit should be allowed for any materials not clearly iden- tified as having been used in the infringing product. Based on similar accountings, the defendants are not entitled to place a scrap valuation upon materials remain- ing on hand when they were compelled to stop the sale of the article, but they could be compelled to scrap the arti- cles on hand at that time, and would not be entitled to any credit whatever for the entire cost of the manufacture of said stock. It does not seem conceivable that the defendants would be permitted to make a profit out of their wrong- doing, and this would be the result if general expenses ^Q2 AUDITING and similar items were included, as the tendency would be to reduce the expenses of conducting their legitimate business. If they have been ordered to account for the profit made by them in the manufacture and sale of arti- cles, the court will undoubtedly hold that the word ''profit" as here used means the difiference between the proceeds from the sale of an article and the prime cost (that is, labor and material) of such sales, and that the cost of goods on hand at the end of the period should not be treated as an item of cost for which credit can be claimed. The courts, however, do not seem to accept the fore- going view. In the case of Rubber Company v. Goodyear, 76 U. S. 788, where a master's report was being com- mented upon, the court said : He refused to allow manufacturer's profits and interest on thp capital stock. This was correct. The profits made in violation of the rights of the complainants in this class of cases, within the meaning of the law, are to be computed and ascertained by finding the difference between cost and yield. In estimating the cost, the elements of price of materials, interest, expenses of manufacture and sale, and other necessary expenditures, if there be any, and bad debts, are to be taken into account, and usually nothing else. The calculation is to be made as a manufacturer calculates the profits of his business. In Am Ende v. Seabury, 43 Fed. Rep. 672, the court said: The master properly refused to allow the defendant, as an ele- ment of the "factory cost," .... interest on the capital of the corporation invested in the business. 3. FRAUD Following the discovery of an embezzlement may be heard expressions of surprise, based on the fact that the embezzler was a trusted employee. It does not seem to INVESTIGATIONS 503 occur to most people that, generally speaking, no one but a trusted employee has an opportunity to defraud others. Many trusted employees prove recreant to their trust every year, therefore mere business prudence demands some form of supervision over all those who have a chance to appropriate to their own use the property of others. In the preceding chapters an attempt has been made to outline the procedure required in audits of various natures, but the procedure there referred to was not intended to cover those cases where a particular person is under suspicion or where a particular form of fraud is suspected, or has been discovered, and where it is impor- tant to locate the guilty party or parties without delay. Then, again, it may be that an audit has been made along usual lines without developing anything wrong; but it is found that an employee is living beyond his means, or is constantly seen in bad company, so that a special investigation becomes desirable. The point imme- diately arises as to whether there are any special checks, or verifications, which are not usually resorted to in an ordinary audit, but which might be useful when applied to specific cases. Possibilities to be Studied In all cases where suspicion exists the quickest way to locate fraud is to ascertain definitely the opportunities which are normally open to the person suspected, and the possible chances which may not be usually open to such person, but of which he may have taken advantage. For instance, the treasurer of a company may be known to be spending more tl^n hi» income, and an inquiry is ordered. If the business is at all large, it is obviously not worth while to commence the investigation in the same way as a general audit, but the wise course would -Q4 AUDITING be to look into the matters under the personal charge of that officer. Any securities supposed to be in his hands should be called for, and the method of handling cash transactions should be inquired into. If he has always insisted on opening the mail, it may be that customers' accounts have been tampered with; if he has assumed per- sonal charge of the periodical reconciliation of the bank's pass-books with the bank balance, it may be that funds have been withdrawn from the bank and not reported. If the gross profit is unexpectedly small, it may be that stock is being stolen or that fictitious purchases appear in the bocks. Extent of Fraud Frequently the professional auditor is not called in until the embezzlement has been disclosed and his services are desired to fix the total. In such a case experience is invaluable, for the position of the auditor may be a most difficult one. The embezzler usually is called upon to give, or profTers, his assistance, and professes to be most anxious to help get at the whole truth. He will state the total amount as positively not exceeding a certain total, and his employer is apt to believe him and to doubt the auditor, whose experience warrants him in stating that thieves rarely tell the truth, and that embezzlers hardly ever know the extent of their own fraud, and when they do know will understate it materially in the hope that their attempts at concealment may be at least par- tially successful. There is only one safe rule, and that is to calculate every possible source of income open to the embezzler, the maximum amount of such income, and the longest time possible during which the fraud may have been ffoinsr on. INVESTIGATIONS 505 Records are often destroyed and many sources of income cannot be traced subsequently; therefore it is never wise to take the word of an embezzler for the amount of his theft. Attitude Toward an Embezzler Whenever possible the embezzler should be required to attend and assist the auditor. This does not mean that his word is to be taken blindly or that he is to be left alone with the books, but he can do no harm, and in countless cases his presence has been of the greatest assistance. Here the experience and skill of the auditor have full play. By the exercise of tact he may persuade the crimi- nal to disclose many things which the closest examination of the records would not reveal. A clue is often as valu- able as a complete disclosure, and it rarely happens that a trained auditor spends any considerable time with an embezzler without discovering directly or incidentally the system employed and other valuable information. No one knows so well as professional auditors how small a proportion of these crimes are made public, but embezzlers themselves seem to feel intuitively that if they promise to tell all they know and to make restitution, all will be forgiven and forgotten. Unfortunately, from the standpoint of example this is often too true, but even though it is true there can be no objection to an auditor pointing out to the embezzler the fact that if he lies to him (the auditor), it will aggravate his possible punish- ment. If an examination is Hkely to result in litigation, the auditor must pay particular attention to any admis- sions or statements by the suspected party. The chairman of a board of water commissioners kept a cash book showing his receipts and disbursements. 5o6 AUDITING When the balance was ascertained by auditors appointed by the municipality, the chairman was informed of the amount shown by the book to be due from him, the cor- rectness of which he did not dispute. On being asked if he could explain the balance against him, he said he could not, and being then told that it would have to be reported to the authorities, he replied: "Well, you will just have to report it." When he refused to pay subsequently and suit was brought, the court held that this was sufficient evidence upon which to recover the balance. This supports the principle of law that the statement of an account need not be confined to the original parties. The auditor may have an exceptional chance to secure an admission, and if there is any likelihood of its being used later, he should reduce it to writing at once. This record may be useful in refreshing his memory. Definitions Auditors usually work for or with lawyers in cases of fraud, and it is well for them to understand the legal significance of terms in general use. Fraud, as applied to accountancy matters, embraces all dishonest or deceitful acts whereby the owner of prop- erty is deprived thereof without his knowledge or consent. The intention to deceive is a characteristic of fraud, but deceit in itself does not reach the gravity of fraud. Embezzlement is the fraudulent appropriation to one's own use of the money or goods intrusted to his care by another. The auditor should distinguish embez- zlement from larceny or theft, because in the case of embezzlement the original custody or receipt of the money or other property was lawful, or with the consent of the owner, while in larceny the felonious intent must have existed at the time of the taking. Therefore, if an INVESTIGATIONS 507 ofificc boy were to take and retain currency out of a cash, drawer, he would be guilty of larceny. If the cashier were to take and retain it, he would be guilty of embezzlement. In other words, there must be a relation of special trust in regard to the property appropriated, and it must be by virtue of such employment that the money or other prop- erty comes into the possession of a person to make it embezzlement within the meaning of the statutes. Misappropriation is not a technical term of law, but is appHed to those who fraudulently deal with money intrusted to them. The correct term for such an act is embezzlement. Defalcation is not a technical term. As a default usually implies that property appropriated to one's own use originally came into his possession legally, the correct term is embezzlement. CHAPTER XXI HOLDING COMPANIES Consolidated Balance Sheets and Profit and Loss State- ments In the face of the Sherman Act, business combinations are being formed daily. They may be in flagrant or in reasonable restraint of trade, or they may deal with con- cerns operating solely within the boundaries of a single state and thus escape Federal prosecution and be subject to state regulation only if buying or selling necessities. Politicians and friends of the "plain people" may cry aloud that competition must and shall be preserved, but the real fact is that business men will compete up to a certain point only, and any law which prohibits competi- tors who are losing money from coming to an understand- ing or consolidating is doomed to ultimate failure. Auditors will therefore be called upon more and more to investigate proposed consolidations and to advise with respect to their accounts after mergers have been efifected. It is not intended to discuss the economic features of holding companies. Anyone interested in this phase of the subject is referred to the paper by William M. Ly brand, C.P.A., which appears in the Year Book of the American Association of Public Accountants for 1908. Balance Sheet The usual statement of assets and liabilities published by a holding company is wholly devoid of the information 508 HOLDING COMPANIES 509^ an investor or stockholder seeks. On one side appears a huge sum opposite the caption, "Securities of Subsidiary Companies." Then there will be another item represent- ing advances (usually huge also) to subsidiaries; there may be a little cash, but other assets are scarce. Nor is the lack of information found in connection with the so-called ''trusts" only. There are a great many combinations of small concerns, and with these the failure to render intelligent accounts is quite as marked as is the case with larger enterprises. The chief criticism leveled against these formal state- ments is that in the absence of data relative to the quick assets and liabilities of the subsidiaries, no opinion can be formed as to whether the concern as a whole is properly financed or whether there is absolute need of additional working capital to prevent bankruptcy. The balance sheets of some holding companies show among the assets the net assets of the subsidiaries. That is, from the accounts receivable and inventories will be deducted the accounts payable, the resulting balance being shown as an asset. This is obviously wrong. The trade debts may be out of proportion to the assets and may be overdue and pressing. ..^i^ Strong pressure is sometimes brought to bear on an auditor to induce him to prepare the balance sheet of a holding company so that it will indicate a stronger finan- cial position than actually exists. The best answer to such a request is a positive declaration on the part of the auditor that proper accounting procedure requires a certain form of balance sheet and that there will be no deviation therefrom. Form of Balance Sheet As just stated, the form of the balance sheet is of Sio AUDITING great importance. Mr. Lybrand, in the paper heretofore mentioned, covers this point: It is now very generally recognized, however, that the sub- mission of the balance sheet of the holding company only does not furnish the owners of the company with the information as to its real financiah position to which they may justly consider them- selves entitled. The holding company was, as heretofore stated, organized for the purpose of acquiring the capital stocks of affiliated companies, and thus effecting a combination which would bear the test of adverse legal scrutiny. While each company under this scheme retains its corporate identity, and is in the eyes of the law a sep- arate corporation, yet there is a virtual consolidation of ownership, the results of which can be properly expressed in a statement of their accounts only by consolidating the balance sheets of all com- panies into one balance sheet, eliminating therefrom the inter- company stocks, bonds, and accounts which indicate the relation of one company to another and not to the public. A consolidated balance sheet, therefore, is intended to reflect the financial position of the whole group of affiliated companies, considered as one undertaking. In a typical balance sheet of this character, the following grouping and arrangement of the assets and liabilities has been adopted: Assets Liabilities Property Account Capital Stock of Holding Cor- Deferred Charges to Operation poration Investments Capital Stocks of Subsidiary Sinking and Reserve Fund As- Companies Not Owned by sets Holding Corporation Current Assets Bonded Indebtedness Current Liabilities Sinking and Reserve Funds Surplus When a holding company purchases the capital stock of an- other company, the price paid for this capital stock presumably represents the holding company's estimate of the value of the equity in the subsidiary company's assets. This price may be greater than the combined capital stock and surplus account of the subsidiary company, in which event the difference must be assumed to denote the value of the subsidiary company's good- HOLDING COMPANIES 5II will, or other assets, not appearing on its balance sheet, otherwise, if they were included there, the cost of the capital stock to the holding company would be exactly equal to the combined capital and surplus of the subsidiary company. On the other hand, if the price paid by the holding company, for the capital stock of the sub- sidiary company, is less than the combined capital and surplus, the difference must be assumed to express the amount at which the assets of the subsidiary company are overvalued on its books. In consolidating the "Property" accounts of the subsidiary companies (their property accounts including good-will, trade- marks, franchises, etc., as well as tangible property) the total must, therefore, be increased or reduced by as much as the cost of the capital stocks of the respective subsidiary companies, as at the date of their purchase by the holding company exceeds or falls below. their combined capital and surplus account. It might seem at first thought that the surplus accounts of the subsidiary companies should not be applied as stated in the fore- going paragraph, but that they, together with the surplus accrued subsequent to the purchase by the holding comi:^any, should be combined and their aggregate entered on the consolidated balance sheet as the surplus of the whole undertaking. The fallacy of this statement has been proven in various ways. Perhaps the most simple and direct argument is somewhat along the following lines: the surplus of ^ corporation, generally speaking, represents the balance of earnings which have accumulated from its operations, and which have not been paid out to the stockholders, applied in immediate reduction of valuation of assets or reserved for the ulti- mate replacement thereof. As a surplus can accrue only during the operating of a company, it is fairly obvious that the holding corporation prior to its organization cannot have earned such a fund, and that therefore it would be entitled to merge into its con- solidated surplus account only the balance of profits accumulated by the subsidiary companies during the period of their ownership by the holding corporation. Further, as the amount paid by the holding company for the capital stock of a subsidiary company represents the holding com- pany's estimate of the equity in the subsidiary company, and as that equity is presumed to be represented by its capital stock and surplus account, it follows that in the process of consolidating, the capital stocks of the subsidiary company in the holding company's books will be eliminated, as will be the capital stock and surplus account on the subsidiary company's books. The surplus account being thus absorbed, cannot, of course, appear again as a surplus in the consolidated balance sheet. - 512 AUDITING It will be noted from the foregoing that all intercom- pany accounts are eliminated, thus exhibiting the debts due from the public and to the public. Any other form of balance sheet which includes as assets accounts due by one company to another, and as liabilities accounts due from one company to another, is misleading and useless for the purpose of disclosing what will be realized from the quick assets and the amounts which will have to be paid. Some question may arise as to the treatment of bonds of a subsidiary not guaranteed by the holding company. Where the assets of the subsidiary are sufficient to cover this liability the point is an academic one, but instances may be found where the bonds of a subsidiary are not fully secured. The consolidation of the balance sheet of one with the other would thrust upon the holding company a liability not directly assumed, and if the auditor were sure that no contingent liability existed in respect thereof, he might sanction the omission of both the assets and liabilities of the subsidiary. As mentioned hereafter, however, it will usually be found that the holding com- pany will assume such a liability for the sake of continuing the business, in which case the full amount of the bonds must be carried as a liability. It is obvious that the capital stock of the subsidiary, all or partly owned by the holding company, is of no value unless the depreciation in the value of the assets is abnor- mal, and there is a reasonable assurance that the deficit will be more than made good out of future earnings. Accounts Receivable ^ Where advances have been made to subsidiary com- panies by the holding company itself, the aggregate thereof will appear among the assets of the holding com- pany, but the auditor should never permit the item to be HOLDING COMPANIES 513 Stated in such a manner as to sustain a belief on the part of any outsider that the receivables are due from debtors other than subsidiary companies. Quoting again from Mr. Lybrand: Frequently other large items of assets are advances made to the subsidiary companies for which the latter may have issued their notes in favor of the parent company. Such advances are usually made to provide for extensions or additions to the plants of the subsidiary companies after they have been acquired by the holding company, or they may have been made for the purpose of furnish- ing additional funds to purchase larger stocks of materials, to carry contracts requiring considerable time to complete, or for any other legitimate business purpose. If the moneys advanced have been for the purpose of adding to the plants of the subsidiary companies, it may be that these loans will subsequently be funded by the sub- sidiary companies through the medium of mortgage bonds, which, if sold to the public, will enable the subsidiary companies to dis- charge their debts to the parent company. Or possibly, if the whole of the authorized stock of the subsidiary compar^y is not outstanding, a further amount may be issued and delivered to the parent company in settlement of the advances, thus changing the form of the asset on the holding company's books from an account receivable to a security ownership. It is improbable that such a course would be pursued except in very special instances, as the holding company would doubtless prefer to appear as a creditor of the subsidiary company rather than as an owner of more shares of its capital stock, because, if the subsidiary company were un- profitable and it became necessary to wind it up, the holding com- pany would claim, with the other creditors, its proportion of the realizations from the subsidiary company's assets. Such a position, we believe, would be assumed by the holding company in the ab- sence of direct ruling to the contrary, but serious doubt has been cast recently on the ability of a holding company to sustain such a contention where it is the owner of the entire capital stock issue of the underlying company. Advances made by a parent company to its subsidiary com- panies are not always represented in the latter by tangible prop- erty. Such advances may have been made to recoup the subsidiary company for losses sustained by it in operating. The advances appearing on the books of the parent company- would, under such conditions, be nominal assets only, and as such in a balance sheet of the holding company they should be offset by a reserve sufficient ^I^ AUDITING to provide for the whole or such part of them as may be repre- sented by losses. Profit and Loss Account Certain holding companies continue to show as gross earnings only such dividends as have been received during the period from the subsidiary companies. Such practice merits the strongest censure. The author has heard it contended that inasmuch as the only legal method which a corporation has of distributing profits is by means of dividends, it would be most improper for a holding com- pany to take credit for part or all of the earnings of a subsidiary company which had not been so distributed. This sounds well in theory, but in practice it is the argu- ment of dishonest men. Almost invariably the sole reason for taking advantage of this technicality is that one or more of the subsidiaries have incurred a net loss in excess of the aggregate profits of all of the companies, and the management of the holding company, wishing to conceal such loss, seeks by subterfuge to justify the action. An auditor cannot be too positive on this point. Wherever a holding company owns and controls one or more subsidiaries, the profits or losses of the subsidiaries must be stated for the same period as that of the holding company and consolidated. Any other method may lead to gross abuse. The directors of a holding company, the sole income of which was the dividends of subsidiaries, could withhold dividends from prosperous companies while they were accumulating the stock of the holding company, and would be lavish with such dividends whenever they desired to sell their holding company stock. This is not mere supposition on the part of the author. Holding company profit and loss accounts are made up in the manner indi- HOLDING COMPANIES 515 cated, and inexperienced professional auditors are some- times induced to certify to their accuracy, being misled by the apparent legality of the procedure. As experienced and reputable auditors invariably de- cline to permit their names to be connected with a form of statement which is dishonest in fact if not in theory, this caution as to the profit and loss account of holding companies should be taken advantage of by an auditor who may have the matter presented to him for the first time. Ernest Reckitt, C.P.A., relates the following incident: I have in mind a case where I was called in to make, as I sup- posed, an audit of the books not only of the "Holding Company," but also of the subsidiary companies, and was amazed to find that it was proposed to have me audit only the "Holding Company's" books. Upon explaining that I could give no certificate on such audit, the most specious arguments were advanced and the presi- dent of the company attempted to use the full force of his strong personality to persuade me to defer to his wishes, which naturally only made me suspect still more the motives which actuated him. Finally, and with great reluctance, they handed me the books of the subsidiary companies, and I found out that two of the com- panies had made losses aggregating over $200,000, no part of which losses had been taken care of on the books of the "Holding Com- pany," though they had been careful to bring on to the books of the "Holding Company" the profits made by other subsidiary com- panies. One year later, the "Holding Company" and most of the subsidiary companies were in bankruptcy, as they deserved to be. The author was called upon several years ago to audit the accounts of a holding company in a large Southern city, and of all of its subsidiaries. The latter included enterprises of different kinds, but as the holding company owned practically all of the stock of each underlying company, it was necessafry to consolidate the operations of the entire group in order to show its exact net earnings. Unfortunately, several of the concerns were not profitable, 5i6 AUDITING and the consolidated profit and loss account was not a document to be proud of. One of the subsidiaries, however, was quite prosperous, and its net earnings in themselves were sufficient to pay interest and dividends on the holding company's bonded debt and capital stock, but the losses of the other com- panies seriously depleted the funds of the holding com- pany and rendered dividends impossible. A short time afterwards, the president of the company appeared in New York with a large block of the holding company's bonds for sale. He submitted to the bankers, not the auditor's report, but a statement showing the earnings of the profitable subsidiary and ignoring so far as possible the existence of the other companies, and the bonds sold readily. Quoting Mr. Lybrand on the matter of the prepara- tion of the profit and loss account: ! Most of the comment that Is applicable to the consolidated balance sheet is pertinent to the consolidated profit and lo/ss ac- count. In the consolidated profit and loss account transfer of profits from subsidiary companies to the holding company through the medium of dividends will be ignored, and the earnings, ex- penses, and charges of the several companies will be combined and stated as though the corporation were one enterprise. In the consolidated statement, therefore, will appear the entire gross earnings of the group of affiliated companies. Such gross earn- ings will represent cumulatively the operations of the several un- derlying companies, i.e., merchandise transformed into a market- able condition by one company and transferred to a second com- pany for further manipulation and sale in a different form would appear in the gross earnings of each company and their aggregate in the consolidated profit and loss account. While on the surface it would seem that there is a duplication of gross earnings under this method, it is probably the only practical way in which to state them where there is a large number of. companies with very many manufacturing processes. Again, as the property account of the various subsidiary com- panies are consolidated in the balance sheet, it would seem that HOLDING COMPANIES 517 the gross operations of those companies should likewise be aggre- gated in order to show the relation of the volume of business to the property investment. From such gross earnings will be deducted the entire operating costs incurred in producing those earnings, the balance resulting being then subject to the addition of income of a miscellaneous nature, and the deduction of expenses which are not applicable directly to the manufacturing and producing operations. In stating the consolidated income and profit and loss ac- count there will probably be some difference of opinion as to the point at which charges other than for ordinary operating should rest, in order that the current net earnings of the undertaking may be shown. It is fairly clear that from the gross earnings must first be deducted the costs in labor, materials, and operating expenses in- curred in producing those earnings, in order that a — let us call it manufacturing — profit may be shown. It is true that in an indus- trial enterprise, which includes mining, land and water transporta- tion, as well as many forms of manufacturing, such an expression is in a sense a misnomer, but as the mining and transportation are really tributary to the manufacturing, the title might stand. It is true also that there are so many different kinds of products, with varying rates of profits included in the gross earnings that com- paratively little use can be made of the figures as a basis of com- parison from year to year. Nevertheless, as it is impossible in a con- densed statement to show the volume and profit of each Hne of business, the aggregate figures will give the stockholder some in- formation as to the total business, and, in a rough way, the rate of profit thereon for comparison with preceding periods. From the gross profit so ascertained would be deducted the ad- ministrative, selling, and general expenses, virtually common to the whole enterprise, and chargeable against the operations as a whole. The resulting balance will be subject to adjustments be- cause of extraordinary items relating to operating, but which can- not be included fairly in the current operating costs; and by income from investments other than those representing the holding com- pany's ownership of the subsidiary companies. The balance then carried forward from the current profit and loss to the income or general profit and loss account will be re- duced by reason of reserves for depreciation, replacement, sinking fund requirements, etc., which are properly appropriated out of current earnings. Logically, such items should be deducted before the balance of current profits is struck, because the depreciation ^nd replacement reserve at least are charges directly connected 5i8 AUDITING with operating, but as heretofore remarked, depreciation statistics are not sufficiently accurate, and the practice of reserving for depreciation is not yet common enough to justify the inclusion of such charges with the ordinary operating costs. Further, if they are stated separately, attention is drawn to the fact that reserve for depreciation has been made and to the amount of that provision. The balance of profits, after deducting the foregoing reserves, shows the position of the earnings with respect to the interest pay- able on the debt of the subsidiary and holding companies. It may be held that interest on bonds of subsidiary companies (being a lien which must be deducted by the subsidiary company from its earnings before it can appropriate the remainder to the holding company) should be applied before the balance of current earnings fs shown. It is suggested, however, that it is preferable to embrace all of the interest on the funded debt of the companies in one- group, in order that the total thereof may appear; also because the bonded debt of the subsidiary companies may change by reason of new securities of the holding company being issued in lieu thereof, or it may be reduced through the operation of the sinking funds, in either of which events the interest charge would be les- sened and a comparison of operating profits from year to year dis- turbed. After the deduction of interest on the bonded debt, the balance remaining represents the profits available for dividends. Partial Ownership of Subsidiaries The foregoing remarks apply where the holding com- pany owns all of the stock of the subsidiary companies, but in those cases where the holding company owns part only of the stock, some adjustment of the consolidated profit and loss account may be necessary. Where a profit is shown, the amount to be included as the share of the holding company is the proportion the stock owned by the Irolding company bears to the total capital outstanding. It must be assumed that the minority stockholders will eventually receive through dividends their share of the profits. Where a loss is shown, and where losses form the chronic condition of the subsidiary, it may as well be rec- ognized that the holding company will have to assume all HOLDING COMPANIES 519 of it. This, of course, applies only to those cases where a subsidiary company is so largely owned by the holding company that the minority interest cannot be depended upon to advance its share of the funds necessary to take care of the loss. The holding company may carry these advances as an asset, but the auditor will place such a value upon these items as the facts warrant, and it is reasonably certain that the final result will be to include all of the loss in the con- solidated profit and loss account, although something less than 100 per cent of the stock of the subsidiary is owned. Comparative Statements Where the accounts of several subsidiaries, operating along substantially the same lines, are examined, one very important object is to endeavor so to state the accounts that the results are reduced to a uniform basis. Many ad- justments may be necessary to take care of local condi- tions, etc., but no form of presentation is clearer or more valuable. Where comparative costs are feasible, it is important to ascertain the amount of the plant investment, as it may be that the costs as reported do not include depreciation nor interest. The latter is usually omitted from costs on the ground that it is a profit on capital employed and therefore cannot be an element of cost. Admitting this, "without prejudice," it might nevertheless serve to con- ceal actual lack of ability on the part of the manager of one factory as compared with another. One might keep twice as much capital tied up in raw materials and goods in process as the other, and where units of costs are stated in fractions of a cent, the interest on the excessive capital employed might be sufficient to prove the superiority of one manager over another. CHAPTER XXII INTEREST The professional auditor should be thoroughly ac- quainted with the various methods of calculating interest. There is a remarkable lack of uniformity among business houses, and even banks, on the subject. The audit clerk who verifies interest collections or interest payments feels relieved if his own calculation agrees within a few dollars with the amount received or paid and lets it go at that. As the ''few dollars" multiplied a number of times will aggregate a considerable sum, it is important that the auditor familiarize himself with, and require his clerks to learn, the laws and customs governing interest, so that when a test is made it will be done intelligently, and if the amount received is insufficient or the amount paid is ex- cessive, a report may be made thereon with confidence in the correctness of the criticism. The three factors entering into the calculation of in- terest are principal, rate, and time. Principal Principal is the amount on which interest is to be cal- culated. There are two methods of reckoning principal. In bank discount the principal is regarded as the entire face of the note. For example, the bank discount on a note for $1,000 payable at one year at 6 per cent would be $60, and the proceeds paid to the customer would be $940. It will be noted that here the customer has the use of only 520 INTEREST 521 $940 for one year, and yet he pays interest for the use of $1,000 for one year. The actual principal on which in- terest should be chargeable is only $940. The fictitious principal, on which interest actually is charged, is $1,000. The true principal in such case is found by the following proposition: 1.06 : 1.00 :: $1,000 : X which gives a present value of $943.40 for X In spite of the foregoing facts, it is now thoroughly well settled by universal usage that this system of bank discount will be permitted by the courts, even though it does actually effectuate usury. The right is expressly given to national banks by U. S. Rev. Stats., Sec. 5197, now Sec. 5197 of the U. S. Compiled Statutes. The right is also given to New York banks by Section 74 of the Banking Law of that state. But the practice of anticipating the interest in this fashion has been held not to authorize the charging of in- terest on the anticipated interest in case such interest is not paid at the date of the execution of the note. In the case of First National Bank v. Davis, 108 111. 633 (Sup. Ct. 111., 1884), a note was given for $8,000 at one year at 10 per cent. It was renewed at maturity. The renewal note, instead of being for $8,800, was for $8,880, made up as follows: $8,000 principal, $800 anticipated in- terest, and, as the bank did not receive the $800 antici- pated interest on the date of execution of the renewal, but merely took the debtor's promise to pay the $800 at one year, the bank added 10 per cent of this $800 (or $80) to the face of the renewal note, making it total $8,880, as stated. The court held this to be usury. 522 AUDITING The question of principal also occurs where payments are made on an old account which is drawing interest. Under 3uch circumstances the debtor sometimes claims that all payments should apply on account of principal; but unless there is a clear and specific agreement that they shall be so applied, the rule is well settled that such payments are applicable in the first instance to all arrears of interest before any application can be made on account of principal. The question of principal is also involved in cases dealing with compound interest. It has been held that interest may be added to and become a part of principal at stated times and under certain conditions, and the ques- tion of whether or not this is permissible will sometimes determine whether or not the transaction is usurious or otherwise. This is a point upon which an auditor is fre- quently required to pass. Loan accounts and book accounts between interre- lated enterprises sometimes run along for years without a final settlement. When a statement is desired upon which a settlement may be based, there is always a temp- tation to state the transactions in as short rests or periods as possible, the interest being calculated and included in each balance carried forward. This results in compounding the interest, is illegal, and should never be permitted by the auditor. It may be a hardship to the lender, as compound in- terest would be legal and proper in such a case if the accounts had been written up properly at the time, interest actually entered in the books, and statements prepared therefrom and submitted to the borrower or debtor. If not objected to at the time nor within a reasonable time thereafter, the transaction would have the legal efTect of an account stated, and each new starting balance, although INTEREST 523 including interest calculated at shorter intervals than a year, being acquiesced in, would be binding. In the absence of special custom or agreement, how- ever, interest should not be compounded. Rate of Interest This rarely or never admits of dispute except in those cases where a note, contract, bond, or other obligation is made in one jurisdiction, to be paid or performed in an- other jurisdiction without specifying the rate of interest, and the legal rate of interest in the two jurisdictions is difl'erent. Then the question sometimes arises whether the rate at the place of making the note or the rate at the place of payment is to govern. A similar question arises where one rate of interest is the legal rate at the time of making the note, contract, or bond, and another legal rate is in force when the obliga- tion falls due. In the absence of an intention to the contrary shown by express stipulation or otherwise, the rate of interest is to be regulated by the law as it existed at the time and place of making the contract, and not by the law existing when the debt falls due or when the remedy is sought. (8 Cyc. 310.) It is well settled, however, that the parties may con- tract for the legal rate in either place and the contract will govern. Time The time which interest is to run gives rise to a wide diversity of practice. There is an underlying principle which is of very gen- eral, although not absolutely universal, application, and it is this, that if the first day of the interest period is in- ^24 AUDITING eluded in the computation, then the last day shall be ex- cluded; and if the first day is excluded, then the last day is included. The parties can, if they will, contract other- wise. (See Blanchard v. Hilliard, 11 Mass. 85. Custom in Banks and Trust Companies In Kirkbride & Sterrett's "The Modern Trust Com- pany" (page 84), the rule is stated to be: 'Tn computing interest on loans, the actual number of days is taken. If the day on which the loan was made is included, the day of payment is not counted." It is more or less common, however, for banks to count both the first and last days when the interest is payable to themselves. This custom will not override the common law rule unless the parties expressly agree to it. The bank that figures time thus at the full legal rate of interest in the state of Vermont is guilty of usury, but not corrupt usury. Bank of Burlington v. Durkee, 1 Vt. 399. The bank that does this same thing in the state of Virginia is not guilty of usury at all. Crump v. Trytitle, 5 Leigh 251 (Court of Appeals of Virginia, 1834). In the Crump case, last cited, the court even held that it was proper for the bank to charge interest not only on the first and last day of the original note, but also on the first and last day of successive renewal notes, the result being that the bank received double interest on every day that a renewal was executed. Many banks follow that custom, although some banks are content with charging the first and last day on the original note, and not on the renewal note. The legal fiction of the common law was that a day is indivisible, and therefore even if a customer received his discount money just before closing on the date of his note, and paid it immediately after opening on the date of ma- INTEREST 525 turity, he would still, in strict contemplation of law, have had the use of that money all of both the terminal days, and on that fiction the decision in the Crump case was undoubtedly sound law. Whether it was equitable or not is another question. Where banks, however, have to pay interest, instead of receive it, they apply a widely different rule. First. They quite generally credit interest on deposits only the day after deposit, on the theory that most de- posits are made by cheque and it takes one day on an average to collect through the clearing house. Second. Some banks provide that deposits made be- tween the second and the fifteenth of the month shall draw interest from the fifteenth; and that deposits made between the sixteenth and the first of the following month shall draw interest from the latter date. Assuming a uniform volume of deposits for each day of the month, this arrangement is advantageous to the bank as against its depositors in the ratio of 2 to 1. Third. Savings banks quite generally provide that deposits made between the first and fifth day of the month shall draw interest from the first, while deposits made after the fifth shall draw interest from the first day of the fol- lowing month. Assuming a uniform volume of deposits for each day of the month, this arrangement is to the ad- vantage of the bank as against its depositors in the ratio of 5 to 1. Fourth. Some banks allow interest on savings accounts only by full calendar months. Fifth. Some banks provide that if the depositor makes a withdrawal during any semiannual interest period, he thereby loses all interest which may have accrued thereon since the last interest date. 526 AUDITING This rule works largely to the profit of the banks and to the loss of the depositors. As to how far an auditor may wish to criticize these rules is a question for individual determination. The fact is, however, that most business men know nothing about the customs with respect to interest. They can negotiate for a low rate of interest on loans or a high rate on depos- its, but they do not know that their bank may have estab- lished arbitrary interest rules which yield them a greater profit than other banks exact. It may therefore be proper for the auditor to examine into the whole matter and report thereon to the client. Custom Among Business Houses Business and commercial houses as a rule count only the first or last day, but not both, when they figure interest. Custom Among Stock-Brokers Stock-brokers settle purchases the day following the sale, and they debit the customer's account on the day of settlement. In charging monthly interest to the cus- tomer, the broker includes both the day of settlement and the last day of the month. The broker justifies this by showing that he, in turn, is compelled to pay interest on his loan to the bank in like manner by including both the terminal days of the period in his calculation. The stock-broker, by rendering accounts monthly and calculating interest for the same period, compounds the interest monthly. New York Clearing House In its of^cial announcements, the New York Clearing House includes the first day only and excludes the last day. INTEREST 527 The Treasury Department of the United States In the Treasury Department it is provided that: ''Only one of the two days of date and due date of an obli- gation is taken into account in stating the time for which interest is to be calculated." The Unit Period Interest, either expressly or impliedly, is at such a rate "per annum." Where the interest runs for one month, quarterly, or semiannually, the proportion is one-twelfth, one-fourth, or one-half of a year. A month is held to be one-twelfth of the year, no mat- ter whether the month have twenty-eight, twenty-nine, thirty, or thirty-one days. Both of the foregoing rules are in force universally and are sanctioned by the rules of the United States Treasury Department. Where the interest runs, however, for so many days, there is a sharp diversity of opinion as to whether a cal- endar year of 365 days (366 days for a leap year) or an artificial year of 360 days is the proper unit of calculation. The New York Clearing House calculates interest on the basis of 360 days to a year. For instance, the interest on $1,000 from January 1, 1912, to March 12, 1912, at 4 per cent per annum was officially calculated as $7.89. This represented 71 days on a 360-day-to-the-year basis. It has also been held by the courts that the artificial year of 360 days is a proper basis. State Bank of North Caroline v. Cowan, 8 Leigh 238 (Court of Appeals of Virginia, 1837). But the better rule, at least in modern times, would seem to be that the calendar year of 365 days is the proper basis. 528 AUDITING N. Y. Firemen Ins. Co. v. Ely, 2 Cowen 705 (Supreme Court of New York, 1824), held that taking interest on the basis of 360 days to the year was usury. Chapter 148 of the Acts of Massachusetts of 1909, approved March 6, 1909, entitled ''An Act Relative to the Computation of Interest on Bonds and Notes in Dealings with the Commonwealth," makes the year of 365 days the standard for all loans to or by the Commonwealth. After many vicissitudes, the state of New York now has in force the following (Sec. 58 of the General Con- struction Law of New York): The term years in a statute, contract, or any public or private instrument, means 365 days, but the added day of a leap year and the day immediately preceding shall, for the purpose of such com- putation, be counted as one day . . . the term year means twelve months, the term half year, six months, and the term quarter of a year, three months. The rules of the Treasury Department of the United States Government are as follows: In calculating interest for a fractional period, the time is the true fraction of that period. For an annual rate, the time is the exact number of days for which the interest runs divided by the number of days in the year, 365 or 366; for a semiannual or quarterly period, it is the number of days for which the interest runs divided by the number of days in the particular half year or quarter year. Unless the unit period is a month, the month does not enter into interest computations, only days and the full unit period being considered. The rule just enunciated is somewhat at variance with the rule generally obtaining on bonds or mortgages where the interest accrues regularly, as for example, quarterly or semiannually. There, when interest is com- puted for a part of such quarterly or semiannual period, it is the usual custom to state the time in months and INTEREST 529 days rather than entirely in clays. In such a calculation the number of full months from the initial date to the same numbered day of the month next preceding the final date should first be ascertained, and then the odd days to the final date. When we figure these odd days, there are two ways of making the computation. First. They may be taken at so many thirtieths of a month (on the 360-day basis). Second. They may be taken as so many twenty- eighths, twenty-ninths, thirtieths, or thirty-firsts, according to the month in which they fall. Third. They may be taken as so many three hundred and sixty-fifths of a year. It is not assumed by any means that the foregoing dis- cussion covers the question of interest at all exhaustively, but the author hopes that the customs and decisions re- viewed will enable a student or practitioner to substan- tiate any criticisms which he may deem proper to make during the progress of an audit. CHAPTER XXIII SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS Introductory It is impracticable to discuss in one book all the special points which arise in the audit of various enterprises. The general principles which underlie all audits have received full consideration and the rules which have been formulated will serve as a working program for the audit of any con- cern. Nevertheless, it is of great value to a practitioner to acquire special knowledge of as many kinds of business as is feasible. The knowledge of the possible weak spots and the points of greatest importance in any given audit enables an auditor to make a better start than if his equipment consists solely of a knowledge of general principles. Human activity, so far as the relation of one person to another is concerned, finds expression in the universal medium of exchange — ^money ; and the records of any or all of these activities, no matter how well or poorly kept they may be, constitute the field of the professional auditor. The various classes of accounts with which an auditor has to deal are : Financial Insurance Manufacturing Mining Trading Transportation Public utilities 530 BANKS 531 Governmental Executors and trustees Institutional Professional Miscellaneous The foregoing groups will be considered with reference to those points only in which peculiar conditions exist or where special emphasis is required. No attempt will be made to cover any class of business in detail. FINANCIAL National and State Banks In recent years the subject of bank examinations has received much more attention than formerly. This is largely due to the passing away of the opinion once held by many bank directors that the examinations made by government examiners for the Comptroller of the Currency and for the banking commissioners of the various states covered all that was necessary in the way of inspection of a bank's condition and accounts. The status of national bank examinations probably will undergo some change in the future arising out of the de- velopment of the federal reserve act. The section of the law relating to national bank examiners provides for their appointment and control by the Comptroller of the Cur- rency, but their salaries, which were formerly paid in fees, are now fixed by the Federal Reserve Board. While the Comptroller of the Currency is required by law to have examinations made of all national banks several times each year, the Federal Reserve Board has authority to order special examinations whenever it desires. As a matter of fact, the examiners of the Comptroller's office are now actually examining all national banks, while the ^32 AUDITING examiners of the Federal Reserve Board are examining all federal reserve banks, and the thirty or more state banks which have joined the federal reserve system. While there is no duplication of work, one must be struck by the fact that the examining authority of banks is not centralized or unified. Despite these governmental examinations, reports of bank failures and defalcations are frequent, and subsequent investigation has often brought out the fact that the defalca- tions had been more or less cleverly concealed for a period of years. Government examiners should not be too sharply criticized for their failure to detect such conditions, as the time allowed for separate examinations is limited, and it is physically impossible for them to make thorough audits within the time available. Again, it must be remembered that the chief object of these examinations is to ascertain that the banks are solvent and are complying with the law. Some degree of protection is afforded depositors by these examinations, but the examiners do not represent the stock- holders or the directors, and the directors should not regard the work of the examiners as being done for their benefit. Official examiners recognize this state of affairs and are making a determined effort to improve the unsatisfactory conditions which exist. The New York Times reported a meeting of the official examiners in its issue of July 9, 1912, as follows: Low Pay Endangers Bank Examinations Paltry Fees for Inspection of Country National Banks Result in Slurring of Work Dishonesty Is Undetected The subject that received the most attention in the meetings was the low rate of pay of the national examiner working in the country, BANKS 533 both from the standpoint of its inadequacy and from that of the cor- responding menace to depositors, caused by the hurried way in which he must complete his task and get on to the next town, if he is to make enough to pay for his keep and travehng expenses. It seems that the rate of compensation was fixed in 1875 and has never been changed. For examining a bank with less than $100,000 capital the examiner gets $20. At least two days, it was declared yesterday, should be de- voted to a thorough examination, and sometimes it is necessary to em- ploy an assistant. All this comes out of the $20, including the assistant and his expenses. The rate advances with the size of the bank, but never gets up very high. For a bank capitalized at $100,000 to $300,000 the fee is $25 ; for a $300,000 bank, $35 ; for a $400,000 bank, $40 ; for a $500,000 bank, $50, and for a bank capitalized at $600,000 or over, $75. A recent defalcation in this state was cited as an instance of what may happen under a system where the national bank examiner has not time and cannot afford to take time to make much more than a super- ficial inspection. One of the officers had been robbing this bank for years, his peculations aggregating some $350,000. It had been examined by three or four different men in that time, but none of them had found anything wrong, and one of the examiners said yesterday that this affair was the worst black eye the government examining system had received in many years. Because of the agitation for government guarantee of bank deposits, in which case losses would prohably be paid from a fund sustained by a tax levied against the banks, the latter have in some large cities made a determined efifort to allay public feeling by decreasing the number and size of bank failures. The outcome of these efforts has been that in some cities all of the local banks clearing their cheques through the clearing house are now examined periodically by a salaried examiner appointed by the clearing house association. Clearing house examiners have been appointed in com- paratively few cities, and in some quarters much opposition has been shown toward the movement, as it is argued that so long as a bank is solvent and is permitted by the govern- ment to continue business, it should have the privilege of naming its own independent auditor, and that the in forma- ^24 AUDITING tion received and reports rendered by such auditors should not be in the hands of anyone with discretionary power to discuss the bank's affairs with competitors who are mem- bers of the clearing house association committee. While the examinations made by clearing house exam- iners are usually quite thorough, they will in all probability be limited to a few of the larger cities, as in small cities and rural communities no clearing house associations exist. Some states require semiannual examinations to be made by committees of directors of each bank, with liberty to the committee to employ professional accountants for the pur- pose, the latter to report to the committees and the com- mittees to report to the state. The following quotation from an address by James B. Forgan, president of the First National Bank of Chicago, delivered on September 17, 1909, at the Convention of the American Bankers' Association, at Chicago, is of especial interest, as it refers to the responsibility of bank directors and the necessity for the employment by them of competent auditors to make investigations : The same ordinary prudence which men exercise in their own affairs is required of bank directors. The application of it differs with the varying circumstances of the banks. Just as men of small or moderate affairs can undertake the personal management in detail of their own businesses, while those of large affairs must of necessity employ others to manage for them and must relieve themselves of details, so bank directors, under similar circumstances, may assume the details of management or appoint others to do so. Their delegating authority to others does not, however, relieve them of responsibility for the direction and supervision of the management or of keeping in touch with what is done. In banks of moderate size this can be accomplished by committees. In the largest banks, however, it be- comes necessary for the directors to delegate even the details of their supervisory duties to experts and to rely on their investigations and reports for an intelligent knowledge of what is being done and of their bank's condition. Systematic organization is necessary, whether a bank is small or large, and directors must see to it that one of its BANKS 535 results is that they are kept fully posted as to the bank's operations and condition. This can be accomplished quite as effectively in large as in small banks through the employment of competent auditors, either permanently or when they are wanted. Such auditors, in their investigations, should represent the directors and should report direct to them, uninfluenced by any of the executive officers. But, however it may be accomplished, it is up to the directors to keep themselves posted as to their bank's operations to the extent of enabling them to form a correct opinion of actual conditions in them and to judge of the integrity and ability of the management, as it is conducted by the officers to whom they have delegated managerial powers. Only thus can they intelligently exercise their control of the management, a re- sponsibility from which there can be no escape. The auditor engaged to examine the affairs and accounts of a bank should procure a copy of the statement pubHshed by it in response to the latest call of the Comptroller of the Currency or the State Banking Commissioner. A careful scrutiny of this statement will give him a good idea of the volume of the work and nature of the assets and liabilities w^hich will shortly demand his attention. The audit should be started without notice to either officers or employees of the bank, and a large staff should be available so that all the changeable assets can be examined on the first day. Cash and Securities The verification of the balance sheet items should receive attention first. This involves the actual count and examina- tion of such assets as may be actually on hand, and compari- son thereof with the general ledger accounts; the inde- pendent outside confirmation by correspondence of such of the assets as admit of such verification ; and a thorough test of the integrity of every other account in the general ledger. If there is a large quantity of cash on hand and the entire staff must be used to count it, the other changeable assets, such as securities owned by the bank, notes dis- 536 AUDITING counted, notes for secured loans and the collaterals therefor, etc., should be locked up in a safe and the latter sealed, and access thereto refused, except with the approval of the auditor, until they have been examined. All of one class of the assets above mentioned should be brought to the auditor before the examination of each is begun so as to prevent duplication in counting; e.g., all cash should either be brought from the vaults and tellers' cages to one point, or the auditing staff should be so distributed that counting of the cash at all points will begin simul- taneously ; transfer, of cash between the cages and the vault should be prohibited until all of the cash has been counted and the aggregate amount is proved with the general ledger account therefor. It is important that the genuineness of the cheques on hand, which are to be sent to the clearing house, be verified. The only safe method to accomplish this is for the auditor to insert in each clearing house envelope a confirmation slip (and stamped envelope addressed to himself) requesting verification of the aggregate amount of the enclosed cheques and detailed advices as to any which may be returned as unpaid. The failure to do this may be serious, as forged or "fake" cheques may be returned to the bank without being brought to the auditor's attention. In addition to this, it is desirable that the source of cheques of large amount to be sent either to the clearing house or to out-of-town correspondents, or to be collected by runner on the following day, be ascertained, and that examination be made to see that the depositor has received credit therefor. The method of making investments should be investi- gated by the auditors. Generally the investing of the in- stitutions' funds must be authorized by a committee; if such is the case, then the minutes of such committee's meet- ings should be examined and a notation made of the regu- BANKS 537 larity or irregularity of directors' attendance at such meetings. Correspondents* Accounts Accounts current should at once be requested (to be sent direct to auditor) from reserve agents and out-of- town correspondents with which the client carries deposit accounts. It is also important to make note of the last deposits made and the number of the last draft drawn by the client against these banks, for use in later reconciling the accounts current with the client's records. The auditor should examine these draft books carefully to ascertain that none have been used out of consecutive order or from the back of the book, as missing drafts may have been cashed and the proceeds counted as cash, or the cheque may have been included that very day with other cheques and sent to another out-of-town correspondent and charged to the latter as a deposit. Defalcations have been cleverly concealed for some time by this method, as the account with the bank on which the draft was drawn was not reduced on the client's books until after the date of the audit, and the item did not appear on the account current of the depository until the end of the month. Confirmation of Demand Notes, etc. All borrowers on unsecured demand notes should be requested by mail to confirm the amounts of their loans direct to the auditor. If any payments on account have been misappropriated and not indorsed on the notes, these confirmations should reveal that fact. Similar confirma- tions, showing the collateral as well as the amount of the loans, should be secured from borrowers on time or demand collateral notes. 538 AUDITING All securities owned by the bank or deposited by custom- ers as collateral for loans, should be carefully examined. Denominations of stock certificates have in the past been so cleverly raised as to deceive bank officials, who accepted them as collateral for loans. Correspondents who may hold notes or securities for the bank's account should be requested to confirm the amounts thereof direct to the auditor. In the case of a national bank, the Treasurer of the United States should be requested to confirm the amount of bonds held by him to secure circulation and government de- posits, and the amounts of the circulation redemption fund, outstanding circulation, government deposits, and any bal- ances which may be due by him to the bank. Certificates of Deposit and Certified Cheques The balances in the cashier's cheques, certificates of de- posit, and certified cheque accounts, should each agree with the aggregate of the respective classes of items outstanding. In this connection the canceled items should be inspected and compared with the stubs or original records in order that the auditor may assure himself that none posted on the ledger as paid are outstanding. Certificates of deposit and cashier's cheques should have attached a stub containing a record of payees and amounts. These should be detached by the officer signing, and deposited by him in a locked box to which access can be had only by a staff or professional auditor. Comparison of these slips with the original records would disclose discrepancies if any. Frauds have fre- quently occurred through the insufficient entry of deposits against which certificates of deposit have been issued, and in some cases no entry of the deposits has been made in the books of the bank. BANKS 539 Capital Stock The capital stock certificate book and stock ledger should be examined and the aggregate of the outstanding stock proved with the general ledger account. Recently in New York the vice-president of a national bank was arrested, convicted, and sentenced for forgery and fraud in connection with the misuse of his bank's stock certificates. He had torn certificates from the stock book, forged the cashier's name thereto, added his own name, and had de- posited them as collateral for a personal loan from a large trust company. Depositors* Accounts Opinions differ as to the responsibility of an auditor in connection with the verification of depositors' accounts. As these form the largest portion of the liabilities, he should make some effort to verify their correctness, in addition to merely taking a trial balance from the depositors ledgers. He should ascertain that trial balances are taken off regu- larly, that the ledger clerks are transferred occasionally from one ledger to another, that some one other than the ledger clerks compares the balances in the ledgers with the pass-books when the latter are ''settled" and delivered to the depositors, and that the clerk initials the pass-books and ledgers as to correctness. In addition to this the bank should insert in the pass-books a form of confirmation of the de- positors' balance, which should be carefully filed when signed and returned by the depositors. The auditor should mail statements of their balances to all depositors with inactive accounts, should verify the settlements of all pass-books in the bank, send out requests for pass-books of all other active accounts, and verify the settlements of the latter when received and balanced. It is ^^O AUDITING hardly to be expected that every depositor will send in his confirmation or pass-book promptly, and it will be necessary for the auditor to keep a list of all depositors, on which to make note of those accounts which have been verified, and which may be used as a guide at future dates for the con- firmation of all accounts. In comparing pass-books with the ledgers, it is im- portant not only that the balances be compared, but that the deposit entries in the pass-books for some time prior to the settlement date be examined. This will disclose any ledger cross-entries which may have been made and which should be especially investigated. They should not be permitted, except upon officially signed debit or credit slips, as defalca- tions have been cleverly concealed through the use of such cross-entries. In banks where the practice of balancing pass-books has been superseded by the system of rendering monthly ac- counts current to depositors and returning to them at the same time all paid cheques, the auditor should compare the statements with the ledgers, enclose his confirmation form, and mail them himself. Verification of Income Tests should be made to ascertain that the bank is receiv- ing at proper times and in correct amounts the income on its securities and interest on the loans it has made or notes it has discounted. Almost all banks include discounts among their earnings as soon as the notes are discounted, and the conservative and proper method of carrying reserve for unearned discounts is not generally followed. In the Middle West, however, a number of large institutions now show such a reserve in their balance sheets, and it is to be hoped that in time the practice will become general. BANKS ^41 Expenses The details of the charges to expense accounts should be scrutinized, the unusual items thoroughly investigated, and tests made of the correctness of the usual ones. The salary rolls should be checked and thorough tests should be made of the correctness of interest paid on deposits. Postage stamp payments are usually large and should receive careful attention. Secret Reserves If these are found, they should be noted in the auditor's report if the audit is made for the first time. Such reserves are hidden in various ways, generally in understating on the books the value of the banking house or in carrying an ac- count in the depositors ledgers. This latter method should be discouraged, as only bona fide depositors' accounts should appear in these ledgers. Internal Checks The auditor should carefully investigate all of the bank's methods of conducting its affairs, for the purpose of ascer- taining that the work is so divided and carried out as to reduce to a minimum the opportunity for fraud, and that in so far as possible the system in use provides for internal check on the integrity of the accounts. Employees handling cash, securities, notes, or cheques should not have access to or assist in writing up or proving the general bookkeeping records, nor should bookkeepers have access to the records of the tellers. Clerks making original entries should not see the records, which are a check on those entries, and so far as possible the clerks should occasionally be transferred from one set of records to another, so that if fraud be committed, it cannot remain concealed for any length of time. Ledger transfers and ^42 AUDITING other unusual entries should not be permitted except upon written order bearing official signature. Scope of Report The auditor's report should be very complete, including not only statements of the bank's condition and income and expense accounts for the period under review, but also de- tailed statements of the securities owned, collateral loans and value of collateral, single name and indorsed paper, and total liability of each borrower. He should also call particu- lar attention to any memoranda which may have been carried as cash, all overdue notes, insufficiently secured collateral loans, loans to officers and employees, overdue interest, and uncollected income on securities. The auditor should bear in mind, when examining the affairs and accounts of banks and financial institutions gen- erally, that his certificate will be regarded as an assurance of the reliability of the statement so certified, and that while he does not guarantee the security of the deposits made* by the public, the latter will, and justly so, severely criticize him if subsequent developments show that at the time of his examination the bank was insolvent, but that his report did not reveal the fact. Instances of Fraud Defalcations are especially to be guarded against in financial institutions. The following are some of the schemes which have been used by defaulters. A note teller in a bank, in order to cover up cash ab- stracted, would increase the amount of total of loans made for the day. He would turn in to the general bookkeeper, accompanying his voucher, an adding machine list which, if it had been footed, would have been found not to be the same as the total shown by the adding machine. Later BANKS 543 on, at such times as the accounts were examined and the notes proved either by a bank examiner or others, he would put in forged notes to cover the amount short, using the name of some concern which had a good Hne of credit with the bank. A note teller started in this way by taking about $200 and was finally short $7,000. He made no false entries in the books, outside of the adding machine list and the total of the daily ticket which he turned in to the general book- keeper. The defalcation was not discovered until the bank was merged with another bank. If the notes had ever been checked back with the original discount register, it would have been found that the forged notes were not entered therein. Another note teller, among whose duties it was to send out items for collection, would abstract cash and enter in his accounts certain items as being out for collection. These items he represented to be notes deposited for collection for which he had paid cash, and the record was made to show that the notes were on some distant point which would take several days for return. In doing this he always used the name of some good customer whose line of credit was unquestionable. This practice went on for a long time until a bank examiner, who had been over the accounts several times before, happened to question the teller about one of these particular items at a time when the teller had just returned after a few days' absence from the bank. The teller became nervous and somewhat evasive in his answers. The examiner then wrote to the firm whose name was used in connection with these items and found they had deposited no such items for collection. In this connection the auditor would have discovered the true condition if he had verified the outstanding items for collection, either by correspondence with the bank to 544 AUDITING which the collection was sent, or by writing to the in- dividual or firm who it was claimed had deposited the item. Another bank teller in a large bank opened an account with a small bank in another part of the city. He would draw cheques on the bank in which he worked, using some fictitious name, and deposit them in the bank in which he had an account. When those cheques came in through the clearing house to the bank in which he worked, they came to him and he would promptly tear them up. At the end of the day his department would be short and this shortage would be charged to an ''over and short" account, as would other items, until such time as the errors would be discovered, when they would be taken out of this account. He continued this practice over a long period, taking small amounts, till the fraud was discovered, when the bank's "over and short" account amounted to some $40,000, a part of which represented the stealings of this teller; but it was not known just how much. It was extreme carelessness on the part of the bank to allow such an ac- count to assume large proportions. The bank stated that there were certain losses which it could not guard against, and it estimated that these losses would amount to several thousand dollars a year, no matter what precautions it might take. A cashier abstracted from a bank $120,000 by the use of fraudulent certificates of deposit of which he had dupli- cates printed and numbered. An individual who was treasurer of a savings bank and cashier of a national bank, entered savings items in depositors' pass-books but not on the books of the bank. He also carried memoranda as cash; when examiners ap- peared he took enough from the national bank's funds to temporarily make good the cash shortage. BANKS 545 The following extract from the (New York) National City Bank's July, 1912 circular is of particular interest in that it contains the suggestions made by the Comp- troller of the Currency to examining committees of national banks : Bank Examinations by Directors. On June 1 the Comptroller of the Currency requested the boards of directors of national banks to send to his office a copy of the reports of the annual or semiannual examinations made by the examining committees or by other parties at the instance of the directors, and not a single bank has declined to comply with such request. A review of the reports that have been received shows that many of these examinations are deficient in their scope and that many features essential to a thorough understanding of the bank's affairs are not covered. As heretofore pointed out in this circular, a number of states have provided by law for reports by the examining committees of state banks to their state banking departments, and in these states a form of report has been prepared for that purpose. At the beginning, however, the Comptroller of the Currency does not intend to prescribe a form for the directors to use in making reports to his office, or to require examinations of a technical character, but rather to offer such suggestions as will lead to really effective examinations. The following list of general points to be covered has been drafted by the Comptroller with a view to sending the same to those banks where the report of the examining committee shows the examination to be superficial : 1. The cash should be counted and the total compared with the books of the bank. Cash items should be carefully scrutinized, and any improper items, such as unposted cheques held for the purpose of not showing overdrafts, and any other items that cannot be readily con- verted into cash, should be reported. 2. The bonds and other securities of the bank should be examined and those not on hand should be verified by reference to the receipts of the parties with whom they are deposited. The market value and the amount at which carried on the books in the aggregate should be shown, and any stocks held by the bank should be listed with a state- ment showing the reasons the securities were taken by the bank. 3. The notes should be carefully checked and their total compared with the general ledger. The genuineness, value, and security of each note, and of any collateral thereto, should be carefully determined, and any losses ascertained, or probable, in the judgment of the committee, should be noted. The liabilities of each of the larger borrowers, and -^5 AUDITING loans to affiliated interests, should be aggregated and carefully consid- ered. The report should also show the general character of the loans; whether well distributed; the general character of the collaterals; whether corporations in which officers or directors are interested borrow to an undue extent; also any large liabilities of the officers or directors. It should also be shown whether all paper claimed by the bank as its own property, including collaterals, is properly in- dorsed or assigned to it, and all mortgages recorded. Any loans ex- ceeding 10 per cent of the capital and surplus of the bank should be reported. The signatures of all note makers and indorsers should be carefully scrutinized and any erasures and alterations or any indica- tions of manipulation should be carefully investigated and reported to the full board. All overdue paper should be listed and comment made as to its collectability. 4. The certificates of deposit and the cashier's cheques should be verified by totaling those outstanding and as shown by the register and comparing with the general ledger, and also by comparing the can- celed certificates and cheques with the register and checking them against the stubs. 5. The copy retained by the bank of the report of condition made to the Comptroller at the last call should be compared with the bank's books at that date, particularly with reference to the excessive loans and directors' and officers' liabilities reported to the board of directors. 6. The bank's last reconcilements of accounts with correspondents should be compared with the bank's books and a transcript of the bank's account from the the date of the last reconcilement to the date of the examination sent to the corresponding bank, with a request for verification. 7. Individual ledger balances should be verified in such manner as the directors may deem advisable, by calling in pass-books, by sending out reconcilements of certain accounts selected by the directors, or in some other suitable way. A trial balance of the ledger should be taken by some member of the committee, or at least by some person other than the clerk engaged on the ledger. 8. Overdrafts should be totaled and carefully considered and the report should show any estimated losses. 9. The committee should consider carefully the Profit and Loss and the Expense account, with a view of determining whether the charges against those accounts are proper and whether the earnings of the bank warrant the expense charges, and the bank is making a legitimate profit. 10. The examining committee should inquire carefully into the ar- rangement of the working aflfairs of the bank and ascertain whether BANKS 547 any employee who keeps the individual ledger receives deposits or balances pass-books, and whether the employees are properly bonded and in whose custody the bonds are lodged. 11. Any liability of the bank for borrowed money should be listed and the proper authority and the necessity for such borrowing ascer- tained. The total amount of the present liabilities of that nature should be reported to the board, including money borrowed from other banks on certificates of deposit. The Comptroller desires that the report of the directors or the ex- amining committee should show that the above points have been covered and that it should recite any deficiencies discovered. The report will also be expected to contain a complete statement of the total assets and liabilities of the bank, with any additions or deductions that in the judgment of the directors should be made as a result of their investigation; and a detailed statement of the loans which the directors estimate as worthless, doubtful, or insufficiently secured, giving reasons therefor, and as nearly as possible the real value. It is furthermore desired that the report contain a statement of any matters which in the opinion of the committee affect in any way the bank's solvency, stability, or prosperity. The Comptroller believes that there are few instances where the ex- amining committee cannot, if they will take the necessary time, cover these points fully and satisfactorily, and that an examination twice a year, along the above lines, by a committee of the directors who will give sufficient time to the work to make it thorough and complete, cannot fail to be of great benefit to all concerned, especially to the shareholders who have placed them* in their positions of trust. Savings Banks The general procedure in auditing a savings bank is more or less similar to that necessary in auditing a national or state bank. Savings banks are limited by the laws of most states to certain classes of investments, and are not per- mitted to discount notes or to make unsecured loans. For this reason most of their assets consist of bonds, mort- gages, and other long-term investments. At the time of examining the mortgages the auditor should ascertain that in those cases where the mortgage covers improved prop- erty, sufficient insurance is carried (payable to the bank as 548 AUDITING 22 C 5 rt o o ^ . & >> CD c +- O a> C •- I'M rt 'P. be •*- O c (U OJ •5 Is 4= CVJ TJ -t-« OS C ii C ^ •i^ 2i ^ CO .— I u 3 cQ u •5 c o o rc •:: o ^ J*: S -^ • - o TO r; Clr CQ ti • - <" •^ *£ '^ ^ be . 4-? dj 03 . 3 C o m V O C JZ c n1 ^ be a >+-l m o T) X5 (U t/) c fc u - -^ -^ 3 PQ *- o 5 Is < Pc5 i: o c/3 PQ ca. V . . :-5 •5b r^ £^ • • ^ u • • • • f.i . . q; . . . . . . W xn o. C i^ .. >•- to C 2 5 5= s<; 3 c £ u cc S •Q • O CO W 4< a, ID O U U < D *-) Ph ID c rt 3 Ul C ' rt-rj 'I (U (U n a *^ X .. ^.W o u Cot . ■!-> W f^ i^ ^2 • >i cnti ^ C C •• g S 3 o.St? o 1-, upi w o o*^ <: C O O.C .^ '^ 3'7J o;:s "^PQ o o'53 '^ to to I ra C C « • t) «; o • o w . O rt 2S^ -"^^a 3 2 INSURANCE 585 rtT3 C 4) C « .5 SI II 0) bo rt i nJ 111 ill (73 m C c X a 0. & < 1 C 1 ,0 In V E i c H to ^ 1- 586 AUDITING < o U w u z < m w H m H U H W OS CO w « u Q o g w w a H O w % w Ph X! w < w o o Q < U 4) 0) W^ 3 3 <"'<-' o lU g V <" rt £ M •c^.2 Z 3 P3 J^ >>• ■-Sew . (U S 60'-5 CI o § fe P S £ 3iiga^a:S§3:SSccHo'S-t;;2-5 oT^ 0.m o 2'2'2 C Si O E j: iu;r; 1) 3---- r" >^ !30!2 oJ2 3'« "' Xcj.S3;.co C "Ph C 4) (U~ *j 5 3 3 « C CO O )_ u u ftj— O O o en u c .. 3 CO o .-2^ o a> u o. to t/2 g : 3 « ?? M o o w WW O « 3 M U C/2C/3 H w w u pq c • a^ ^ « 3 a> opQU II •a w (0 y;;: rt (U S CO 1^ " 3 ° o >Oy2m c I Oj3 Cum ^2 « 4).— MANUFACTURING 591 E3 O W CO . en w V c/3 . Wi J. rt t. 6 P "U c CO > to gJSP P a (4 o o '♦3 73 •^ 3 ^S •S - > ••r.S (u = « . OS •ja • rt o "^"^ •3 Wt) >» •- Sq e* .03^ s . :2 ifi>.-s « ^ ••o-a 0.2 •*. l3 c ** ^3« » 2^ -J" ' J3 ™ 59^ AUDITING In those industries in which there is but a single unit of production — such as tons, pounds, barrels, or gallons — at least the sales accounts should be kept not only as to values, but also in quantities. Under such conditions it will occasionally be possible to lay out the accounts on the general books in such a manner as to show therein the aver- age manufacturing cost per unit of production. Keeping cumulative records of quantities in connection with the values, not only of sales, but also of materials purchased and used, will enable the auditor to make a comparison of the quantity of materials used with the resulting quantity of finished product, and ascertain whether the ratio of one to the other is within a reasonable range of the average experienced in the particular industry. Uniformity of detail in the financial statements of manu- facturing concerns is not to be expected. It will doubtless be of interest to students, however, to see forms of state- ments which are actually in use. On page 590 is shown the general form of balance sheet which is used by quite a number of American manufacturing corporations, following which is the form prescribed by the English Companies Act. Publishers of Books Publishers who do not do their own printing and bind- ing are in the position of merchants who have goods manu- factured for them according to their special pattern and design. Those who, in addition, have their own printing- plants are both manufacturers and merchants. In practi- cally all cases, even if there is not a retail store connected with the business, there is a department for filling retail mail orders. There are several considerations more or less special to publishers' accounts, and reference will be made to these. Royalties paid to authors, while not exclusively found in PUBLISHERS 593 publishers' accounts, are in point of proportion a more im- portant item here than in most businesses. Royalty ac- counts with authors should be carefully checked. The credits thereto should be thoroughly tested to see that they are for quantities actually sold and that the rate per copy is in accordance with the contract between publisher and author. Sometimes the contract will be on a profit-sharing basis, and in such cases the auditor will need to satisfy himself that all costs have been taken into account. Advance payments on account of royalty should not be included among the accounts receivable from customers, but should be set out separately in the balance sheet. The matter of royalties also raises an important question re- garding the valuation of unsold books at inventory dates. If authors are credited with royalties only as their works are actually sold, care should be taken to see that the cost of production at which the books in the inventory are valued does not include the item of royalty. Of course, if authors are credited with royalties as books are bound, even though they are not yet sold (there are some publishers who pur- sue this plan, though they are in the minority), it is quite proper to value the books at a figure which includes the royalty. Another very important question in connection with the valuation of sheet stock and bound books is that of sala- bility. Cost is far too high a valuation of books for which the demand has died out, or for which there may never have been a demand. The best way to determine the strength of the demand for books of which large quantities are on hand, is to ascer- tain the number sold during the last fiscal period. The ratio of the quantity on hand to the quantity sold will furnish data for determining whether or not the stock should be valued at full cost or only a fraction thereof, or, if quite 594 AUDITING unsalable, at the price of waste paper. Even in applying this test, however, care must be taken not to be misled by large sales early in the period which may have dwindled away in the latter part of the period; the facts in such a case probably being that the demand has died out. Still another consideration in connection with inventories — and this affects accounts receivable as well — is to see that the latter do not include consigned stock in agents' hands. Such stock should appear in the inventory at cost or less and not among the accounts receivable at selling prices. Such stock on hand as paper, ink, binding materials, and other supplies, presents no unusual problems. With regard to the quantities of stock, books are an article of which the auditor can readily verify the quantities stated in the in- ventory by making an actual count. It is very desirable to make some such tests, especially of the larger quantities. The overvaluing of artists' drawings (for illustrations), if indeed any value whatever is to be allowed for them, must be guarded against. Such values are sometimes based on sentiment rather than on what would be realized if the articles were sold. Whether or not the values placed on the book plates are reasonable, demands careful inquiry on the part of the auditor. "Circumstances alter cases," and this adage is true of book plates as well as of other things. Obviously, it would be quite proper to carry the plates of an edition of the Encyclopedia Britannica or of some standard scientific work at a considerable part of their cost long after the entire cost of the plates for a more ephemeral piece of litera- ture, like a novel, should have been written off in toto. The plates for a novel should be written off entirely as a part of the cost of the first edition — there may never be another; the great majority of novels do not run through more than one. As already indicated, the plates of a work which will PUBLISHERS 595 be standard for a number of years may be written off more gradually, particularly as the greater initial cost frequently includes large expenditures for contributions and editorial work which take the place of royalties payable over a period. The fact that the effective demand for such a work is realized over a long period of time is another justification for charging off the cost of such plates more gradually. At the same time, the world moves so rapidly and new discoveries are so frequent that works which are standard today are out-of-date tomorrow, and an issue of an encyclo- pedia or other reference work is not authoritative for as long a period as was formerly the case. Some large failures in the publishing business are trace- able to the omission to charge against the cost of books a proper proportion of the cost of plates. In view of the large profits which were apparently being earned, liberal amounts of cash were withdrawn from the business. The actual facts were that the liquid assets or working capital of the business were being replaced by a growing fictitious investment in plates and copyrights. The only safe plan is to charge off liberally. As a parting word on the subject it may be said that the value of plates and copyrights should never be increased above cost. Even though there is every indication that the demand for certain publications will continue, or even in- crease, and result in large profits in the future, that is no reason for anticipating such profits and capitalizing them by raising the book value of the plates, and correspondingly crediting current income or even surplus account. Accounts receivable require especially close scrutiny in a publishing business. One pitfall has already been referred to, viz., that accounts will frequently be found among the receivables which are in reality consignment accounts. Where books are sold on the instalment plan, the balances 596 AUDITING on such accounts also require careful examination. The right to reclaim such books if they are not paid for in full, does not put the accounts in the secured class, as it usually costs about as much to recover books sold on the instal- ment plan as they are worth. An especially liberal reserve for losses on instalment accounts should be made, as there is a large margin of profit in instalment sales to offset the losses which may con- fidently be expected. The condition of the other customers' accounts as to promptness of payment will naturally be an important element in the determination of how large the reserve for possible losses thereon should be. Large amounts of postage are used in a publishing busi- ness. A record of the purchases of stamps and of the quanti- ties issued for use on requisitions of the shipping, advertis- ing, correspondence, and other departments, should be kept as a means of preventing abuses which may otherwise occur. There are quite a few sources of miscellaneous receipts in the publishing business, particularly in the printing end, such as waste print paper, cuttings, ink barrels, boxes, gilt sweepings, etc. So far as possible all such items should be carefully accounted for. Publishers of Magazines and Newspapers These accounts present some problems quite different from those of book publishers' accounts. Finished stock is usually a minor item, consisting of back numbers and bound volumes of magazines. Past issues of newspapers are never given any value in the inventory other than as waste paper. Plates also are not a vital factor. Their value should be limited strictly to that of the metal as such, excepting per- haps the small amount of plates for advertisements under long contracts and similar standing matter, on which a somewhat higher value may be placed. PUBLISHERS 597 When the estate of Joseph Pulitzer, former owner of the Nezv York World and St. Louis Post-Dispatch, was being valued for the inheritance tax, experts gave their opinions on this question as follows : Melville E. Stone, general manager of the Associated Press, and several others, testified that in their opinion the properties should be valued on the basis of the capitaliza- tion of the average earnings over a period of years at 15 per cent. Others thought that 17j/^ per cent would be more nearly correct, while the surrogate representing the State of New York thought 10 per cent was fair. Two of the most important items which are peculiar to magazines and newspapers are the revenues derived from advertising and "circulation" respectively. A century ago, newspapers may have been published on the basis of the income from subscriptions furnishing the bulk of the where- withal to pay the cost of publication, but that day has past long since, and the same thing may be said of magazines. Ordinarily, the subscription or circulation revenue does not cover the cost of production and distribution, and the only inducement to extend the circulation is because of the higher rates for advertising space which the larger circulation commands. In the case of a monthly magazine, all the advertisements in several numbers out of the year's issues should be com- pared with the charges for advertising recorded in the books. Proper authority should be shown for such advertisements as have been inserted without charge. Some of the contracts should also be consulted for the purpose of testing the correctness of the rates charged. If the accounts of a news- paper are being audited, the charges for the advertisement in one or two days' issues of each month should be verified. More difficulty is likely to be encountered in verifying the revenue from classified advertising than in verifying the 598 AUDITING income from display advertising, particularly if the system of recording the classified advertisements is of the happy- go-lucky kind which not infrequently obtains. The im- portance of examining the commission accounts of advertis- ing agents and solicitors should not be overlooked. Subscription income is difficult to verify. On account of the immense volume of detail it is out of the question to check it with any approach to completeness. The best that can be done, in addition to making tests of the clerical work, is to assure oneself that the system is the best that can be devised to safeguard the integrity of the subscription, or — as it is usually termed in the case of newspapers — cash cir- culation, and to compare the total circulation revenue with the approximate amount which it would seem that the num- ber of copies printed, after making due allowance for unsold and returned copies, should have yielded. Data for making the latter test will be obtained from the press-run record, the circulation manager's statement of the disposition of the number of copies printed (sold, exchanged, returned, distributed free, etc.), and the news agency's reports. That part of a magazine's circulation which goes directly to subscribers by mail may be approxi- mately verified by dividing the weight per copy (including wrapper) into the total weight shown by the post-office receipts for second-class postage paid. This must be done separately for each issue, as the number of pages will probably vary from one issue to another, and this will in turn change the weight per copy. Knowing the circulation of a magazine, some idea can be formed of the approximate amount of subscription revenue which should have been received. Precautions should also be taken to prevent abuses of the free list. Names should be entered thereon only with the approval of some one in authority. PUBLISHERS 599 While on the subject of verifying circulation, it may not be amiss to refer to so-called ''circulation audits" which are at times made on behalf of advertisers' associations or directly for newspapers which desire to substantiate their claims of having a certain circulation. There are a number of ways of manipulating newspaper circulation records which can be detected only by an audit of the general accounts. For example, the cash sales (office sales and mail subscriptions) may be inflated, making them, say $100 or $200 or more, larger than the amount actually collected, and then charging off the inflated amount monthly, quarterly, or at irregular intervals, to some expense account, no details accompanying the entry therefor in the general cash book. Another method which has been used is to over- charge news agents' accounts, or to charge to fictitious agents papers which were never actually delivered. Event- ually such charges, which served the purpose of inflating the circulation earnings when they were made, are written off as bad debts or to some expense account (really an offset against the circulation earnings account and frequently so treated in preparing the confidential statements for the management). In the circulation accounts receivable ledger these credits may be entered as cash instead of as allowances or as bad debts written off. From the foregoing it is obvious that a circulation audit which is restricted to an examination of the circulation records, and during which the auditor does not have access to the general books, is absolutely worthless. It proves nothing except, perhaps, that the circulation records may have been very cleverly manipulated. A verification of the revenue purporting to have accrued from circulation can be conclusive only when the disposition of the cash repre- sented to have been received is traced and the outstanding accounts receivable are satisfactorily verified. Other means, 6oo AUDITING or rather partial means, of verifying the circulation are the press-run book, which is a record of the number of papers indicated by the automatic counters on the presses to have been printed, and the quantity of paper used, the latter being ascertained by referring to the purchase invoices and applying the quantity of paper on hand at the beginning and end of the period. The auditor must, of course, take steps to assure himself that the press-run book which is submitted to him has not been "faked" for his especial benefit. From either of these sources only the gross circula- tion printed is obtained. It will still be necessary to ascer- tain the number of copies spoiled, unsold, returned, sent to exchanges, etc., and deduct the total thereof from the num- ber printed, before the net paid circulation can be determined. The Subscription Earnings account of a magazine should include only that part of the subscriptions received which has actually been earned during the period. That portion of subscriptions received previous to the period under review, but which has been earned during the period, should, of course, also be included therein. The unexpired pro rata of subscriptions in force at the close of the period should appear in an Unearned Subscriptions account and be entered among the liabilities in the balance sheet as unearned or deferred income. There are several methods for de- termining the actual subscription earnings of the period and the unexpired amount at the end of the period. Under either plan the subscription receipts are credited to an account termed, say, "Unearned Subscriptions," and periodically, usually monthly, the amount earned during the period is transferred to a "Subscription Earnings" account. One way of determining the amount of the monthly earnings is to classify the subscription receipts according to expiration dates, from which the actual earnings for a given month can readily be determined. Another way is to ascertain the PUBLISHERS 60 1 average annual realization per subscription and then multiply the number of copies mailed by one-twelfth of the average annual rate. While the second plan can be safely followed if the data used in making the calculations is care- fully verified, the first mentioned plan is, perhaps, less liable to give rise to inaccuracies. With many newspapers the ajinual or semiannual sub- scriptions form such a small part of the total circulation that a reserve for unexpired subscriptions is almost or quite unnecessary. Others again have a very large mailing list of individual subscribers, and in such cases a reserve for unexpired subscriptions should, of course, be created. A reserve for returns should also be made in the case of both magazines and newspapers. A very few of the magazines do not permit agents to return unsold copies, but the great majority do. Almost all newspapers accept from newsboys unsold copies of the previous day's issue in ex- change for the current day's papers. In the case of regular news agents, credit is allowed in the monthly settlement for copies charged, but not sold by the agents. The reserve should be based on past experience as to the ratio of returns to gross circulation, and if set up only at the end of the fiscal period, will be determined by applying the percentage de- cided upon to the circulation accounts receivable. Not all magazine publishers print the magazines them- selves. The printing and mailing is sometimes done by contract, the publisher supplying the paper, which he buys direct to eliminate the printer's profits thereon. Frequently, however, a newspaper publisher will have his own printing plant. The accounts pertaining to this end of the business will naturally call for much the same general treatment as those of other printers. Publishers who have their own printing plant frequently do job printing. Even if there is not a regular job depart- 6o2 AUDITING merit, special work like circulars of newspaper-sheet size may occasionally be run off. This, as well as other sources of miscellaneous receipts, which are often quite numerous, should not be overlooked. Magazine and book publishing is very frequently com- bined in one business, but this fact of itself does not intro- duce any complications except in the apportionment of gen- eral charges. The magazine and book departments will ordinarily be found to be quite distinct. Breweries In breweries there is probably a greater opportunity for theft of supplies or product and misapplication of collections than in almost any other business. The containers — boxes, bottles, kegs, and barrels — are never sold, but remain the property of the brewer. The value of these should not be set up in the balance sheet as accounts receivable if they are charged against customers. This is sometimes done. It is easily seen that the loss in such stock is considerable, and that the value set upon it should be investigated carefully. The auditor should see that adequate accounting methods are in force, not only for the containers, but for all other stock, and, if not, report should be made thereon. The fact that collections are frequently made by the drivers is a weak point, requiring special attention and necessitating close scrutiny of all allowances and discounts. Usually a large amount of money is invested in saloons, either owned or controlled by reason of loans made. Fre- quently the brewery pays for the license and collects on same from the saloon-keeper in monthly instalments. The auditor should see that the income from these sources is properly taken up, and at the same time see that adequate provision is made for bad and doubtful accounts, as the loss on these advances is considerable and is looked upon as being an MINING 603 expense of keeping the product before the public. In addi- tion to amounts actually loaned to customers, the brewery frequently guarantees loans made to customers by others. Such guarantees constitute a large contingent liability and should be set up as such in a balance sheet or indicated in a footnote. MINING Coal Mines A practitioner engaged to audit the accounts of a mining enterprise for the first time will do well to make an inspec- tion of the entire mine workings and equipment, accom- panied by the client's engineer or mine superintendent. Careful observation will give him some idea of the condi- tion of the equipment and scope of the undertaking, which should be of assistance to him when auditing the books and preparing the financial statements. As the largest source of income is from the sale of coal, the inventories and the sales tonnages should be proved with the production records. Deductions from miners' wages for "blacksmithing" (dressing their tools) are frequently made on the basis of production; when so, the collection of this income can be verified in total. Arrangements are usually made with companies operating general stores at the mines (unless the mining company operates its own store, which will, in that case, be audited separately) to allow the miners to make purchases on credit, the amounts due therefor being deducted from the wages of the mining company's em- ployees. Commissions on these collections are generally charged by the mining companies. The collection of rents from houses occupied by employees and owned by the min- ing company should also be checked. Some coal companies own railroad cars, for the use of 6o4 AUDITING which income should be received from the railroad com- panies on a mileage basis. The matter of royalties on coal mined from leased lands requires careful attention. They are based upon ton- nage of production or cubic yards or acreage o' the seams worked, and the royalty agreements usually provide for a minimum annual payment, in the event of the production being so small that the regular royalty rate would not require payments equal to the fixed minimum. In the case of comparatively new mines the minimum royalties will usually be paid during the sinking of shafts and period of development work. If the lease agreement allows a lessee to recoup himself subsequently for the proportion of the minimum royalty paid in excess of the amount earned (calculated on a tonnage basis), such ex- cess is usually carried among the assets as a deferred charge. As the production increases to a point beyond that at which the royalty, calculated on a tonnage basis, equals the fixed minimum, and the lessee begins to recoup himself for the advance royalties, the amounts of such retained royalties should be applied in reduction of the de- ferred charge above mentioned. It is important that all royalty agreements be carefully examined, and if they do not provide that the lessee may recoup himself for advance royalties, the latter should be charged against revenue. It sometimes occurs, where a mine is being operated under several leases, that only a portion of the leased lands are being mined, and that por- tions thereof will never be worked. Obviously, any mini- mum royalties paid under terms of leases covering lands in that class should not be carried as deferred charges, and for that reason the Advance Royalties account should be carefully analyzed and such charges eliminated if in- cluded therein. MINING 605 If a time limit is set in which the lessee must recoup himself for advance royalties, any portion still carried as a deferred charge at the time the limit expires should be at once charged off. All lands, plants, and equipment accounts should be scrutinized, and only such charges should be included as represent the cost of lands which add to the area of coal available for future mining, or which cover expenditures for development, construction, and equipment which will result in increased production. Provision should be made for reduction of equipment, development, and construction accounts to the amount of the residual value of the machinery included therein by the time the mines are exhausted. This is usually done by charging mining costs at a certain rate per ton of pro- duction. The depreciation of railroad cars, if any are owned, and of live stock, should not be taken care of on such a basis, however, but on the basis of probable length of service. While it is desirable to provide for depreciation in value of lands by reason of the depletion of the coal thereunder, it is not certain that mining companies are legally required to replace such wasting capital by reserving any portion of their earnings therefor. In instances where this is not done, the auditor can only call attention to the advisability of such a course, which, when followed, is usually based on the number of tons produced. The following extract from a paper prepared by A. Lowes Dickinson, C.P.A., and read at the St. Louis Congress of Accountants in 1904, is of interest in this connection : In the case of minerals, the product taken out of the land becomes the stock-in-trade of a corporation as soon as it is extracted, and whatever the land was worth before its extraction, it is clearly worth an appreciable amount less thereafter. The provision to be made should 6o6 AUDITING be on the basis of the number of tons extracted, having regard to the total tonnage available and to the realizable value of the property after the minerals have all been extracted. The same principle would also apply to timber lands where no provision is made for reforesting. The contention is sometimes made that no provision need be made for exhaustion of minerals where the amount of mineral known to be in a definite tract at the end of any period is largely in excess of that which had been discovered at the beginning of the period. This argu- ment 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 extinction from, say, one dollar to one cent per ton, the original principle that provision must be made holds good on the smaller figure, whatever it is. It may be, of course, that the provisions made in earlier years have been sufficient to cover a number of future years on the basis, from the commencement, of the rate subsequently found to be sufficient in view of the new 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. Mortgages upon coal and ore lands usually provide for the establishment of a sinking fund from which to pay off the mortgage, either in instalments or in full on a specified date. The auditor should read carefully all the mortgages of the property of his client and call attention to any unpaid sinking fund charges. The trustee cannot always be depended upon to collect the instalments. Some mortgages require payments to be made into the sinking funds on the basis of the entire tonnage mined (which would include all coal consumed in the company's operations), while others base the charge only on commer- cial production, which would be only that actually sold. The cash held by trustees of sinking funds is to be used for retiring mortgage obligations only, and therefore should be shown separately on the balance sheet and not mingled with current cash accounts. MINING 5o7 Gold Mines Accountants are often engaged by committees of dis- satisfied creditors or stockholders to investigate the disposi- tion of the cash capital invested in gold, silver, copper, and other mining enterprises. In instances where the ore is found in profitable quantities, the auditor should not feel compelled to accept the periodical cash, production, and shipping statements received from the mine office, unless accompanied by original vouchers, ore records, assay re- ports, and shipping data. Not only should the shipping memoranda be compared with the sales reports, the vouchers for expenditures at the mines compared with the cash statements, and all of the mine reports carefully checked and compared with the gen- eral books, but every effort should be made to account for the entire production. Where the product is sent to out- side smelters for reduction, tests should be made, using the client's assay reports of values shipped as a basis, to ascer- tain that the smelter returns are correct. The correctness of the distribution of expenditures be- tween capital and operating accounts should be certified to by the mine manager. He should be requested to furnish a certificate setting forth in detail the local current assets and liabilities or the fact that none exist. A report from the mine manager upon the efficiency of the plant and equipment, and upon the age and condi- tion of the buildings and other more or less permanent local assets, is necessary in order to consider properly the question of depreciation which should be allowed for in the accounts. A large portion of the mine employees* wages is based on production, and tests of the correctness thereof can readily be made. The balance of the wages should be care- 5o8 AUDITING fully scrutinized and portions of the pay-rolls compared with timekeepers' records. Often mining companies own and operate stamping mills, smelters, short connecting railroads, and other en- terprises, the accounts of which should also be carefully examined. As the accounts and the conditions under which various mining enterprises are carried on differ widely, no set in- structions for auditing them can be laid down; the audit should, however, be thorough and detailed enough to cover all possible sources of income, to reveal operating waste, if any exists, and to enable the auditor to satisfy himself that no operating expenses are charged to capital accounts. It is also desirable that the scope of the examination be definitely stated in the auditor's report. Many companies charge discount on sale of bonds or stocks to the Property account. If such is the case, the auditor should endeavor to segregate the amounts so charged, or if this cannot be done he should make a nota- tion on the balance sheet to the effect that the Property account includes such charges. The English Consolidated Companies Act of 1908 provides that such discount should be held up as a separate asset to be written off out of future profits, and that it is not allowed to be written out of the accounts in any other way than out of profits. TRADING Wholesale Merchants The audit of accounts of wholesale merchants demands extreme vigilance on the part of the auditor, because unless the system is complete, not only as to financial transactions but also as to accounting for the actual stock received and delivered, the discovery of loss by error or fraud, if any exists, is exceedingly difficult. WHOLESALE MERCHANTS 609 Comparisons should be made of the stock records with the details of the sales and purchases entered in the gen- eral books. These should reveal any payments charged as purchases which are not bona fide or for which all the goods were not received. Theft of stock or of the proceeds of such as may have been sold for cash, as well as the shipment of stock without charging customers therefor, should also be discovered by such comparisons. Additional to the possibilities of fraud above mentioned are those in which attempts at concealment are made by making false entries on the financial records only, such as the theft of customers' remittances, in whole or in part, and allowing their accounts to remain open in the ledger, or writing them off through the journal ostensibly as bad accounts, or as having been closed by discounts, allow- ances, or return of goods; by erroneously reporting the aggregate of cash sales, raising the amounts of vouchers covering cash paid for freight and expressage, etc. Particular care must be exercised (to avoid misstating the business results) to ascertain that the mathematical calculations of inventory are correct, that the unsold stock has been priced at either cost or market price — whichever is the lower — and that sufficient allowance has been made for probable discounts on customers' accounts not yet due in addition to the usual reserve for uncollectable accounts, depreciation of fixtures, etc. In concerns doing an export or import business, accounts with foreign houses are usually kept in both foreign and United States currencies. As many of such accounts are settled in foreign currency,- it is necessary to calculate at the current rate of exchange the equivalent in American money of the foreign balances, and to take up in the Profit and Loss account the differences between these equivalents and the balances in the accounts kept in American money. 5io AUDITING Differences between balances in foreign banks and the equivalent in American money should be adjusted in the same manner. In stating the results from trading, the total sales, the cost of sales, and the gross profit should be shown sep- arately, so that the auditor may judge if the percentage of the latter is up to the rate which may reasonably be ex- pected to have been realized. The subject of gross profits on sales is treated in further detail under the caption of ^'Retail Merchants." Retail Merchants The volume of detail in a retail business of any size, particularly if credit is extended to customers, is so great that it is difficult to make a satisfactory audit for a moderate- sized fee. It is obvious that a complete audit of all the details is out of the question, but the tests of the correct- ness of the different sections of the accounts should be sufficiently varied and comprehensive to disclose any sys- tematic manipulation of the accounts. If the business is a large one, some system of internal sales audit will probably be in use. The auditor should trace the daily totals into the general books and also test- the make-up of the daily totals. It may also be possible for him to suggest additional safeguards for the prevention of irregularities in the handling of cash sales. If the work in connection with the customers' charge accounts is properly systematized, the auditor can verify the accounts receivable with some degree of assurance. The sales, returns, and allowances and cash totals should all be traced into the controlling accounts and the trial balances of the customers ledger verified. A good verifica- tion of the outstanding balances is for the auditor to com- pare the monthly statements at the close of the period, RETAIL MERCHANTS 6l I either with the trial balance, or if that has not yet been prepared, then with the ledger itself, before the statements are sent out. It is customary to allow employees of the store a special discount on their purchases and also to permit their ac- counts to run until pay day, when settlement is made. If these accounts are numerous, they should be segregated either in a separate ledger or in a section of one of the customers ledgers. The auditor should see that none of these accounts has been permitted to run past pay day without settlement being made, and particularly that no balances are standing against persons who have left the employ of the store. In some businesses, particularly those handling small articles broken from original packages, it is not feasible to keep complete stock accounts, and some other check on the accounting, for the wares handled, must be us:ed. This is found to some extent in a comparison of the rate of gross profit earned in one period as compared with prior periods. Decided variations should be susceptible of definite explanation as being due to specific causes ; a decrease in the percentage of gross profit which cannot be satisfactorily explained raises at least a presumption that the proceeds of sales are not being fully accounted for, or that pay- ments are being made for goods which are not actually being received by the house. Percentages of gross profit are by almost all merchants calculated on the sales, and not on the cost of the goods sold. In some lines of retail trade, such as cigars, men's fur- nishing goods, etc., it is possible to apply a check on the accounting for sales, which is also used in some department stores. The plan is to charge all goods purchased to a stock account at their selling values; credits are made on 6i2 AUDITING the account for any changes in selling prices; the inven- tories at beginning and end of the period are priced at both cost and selling values, and the latter values applied in stock account mentioned. The crediting of the actual sales of the period should balance the account. There will naturally be some differences, but if they are not very large, the sales can be considered to have been fully accounted for. Some method of determining the approximate stock on hand, even if calculated only on the basis of an estimated rate of gross profits on sales, is needed by all merchants for the purpose of determining the proper amount of in- surance to be carried on the stock, as v^ell as to prevent overbuying. Whenever several different lines of good are handled, both sales and purchases should, as far as possible, be kept separate for each line. The rates of gross profits on the different lines will probably vary, and the information as to the results of the business done in each class of goods will be valuable to the manager. In a business conducted entirely on a cash basis, the number of customers' accounts is greatly reduced, but they are not in all cases entirely eliminated, as regular customers often leave deposits to avoid the inconvenience of paying* separately for each purchase. The auditor should see that deposit accounts are not overdrawn, and that if interest is credited, it is at the proper rate. A quite general practice is to issue a credit memoran- dum to customers returning goods, which memorandum may be either applied in payment of subsequent purchases or cashed on presentation to the cashier. It is desirable that these credit memoranda be controlled by an account on the general ledger. If this is done, it is possible for the auditor to satisfy himself, by testing entries for credit RETAIL MERCHANTS 613 memoranda issued and paid, and by reconciling the aggre- gate of the outstanding memoranda with the balance of the controlling account, that the credit memoranda have been properly handled. Retail Shoe Stores The Bureau of Business Research, Graduate School of Business Administration, Harvard University, in connection with an outline for a system of accounts for retail shoe stores has prepared a standard form of profit and loss account. This form is given below as it contains some commendable features. Profit and Loss Statement A. Merchandise Statement: I. (1) Gross Sales $ Less: (2) Returns $ (3) Allowances Net Sales II. Cost of Goods Sold: (4) Inventory at beginning of period . (5) Purchases at Billed Prices . . (6) Freight and Cartage on Purchases Cost of Stock Handled . . . $ (7) Goods on Hand at end of period at Billed Prices $ Less: (7) Discounts on Inventory. $ (8) Depreciation and Shrink- age (7) Present Inventory Net Cost of Goods Sold Nominal Profit on Merchandise ,...$. III. (9) Discounts Taken on Purchases (really deductions from cost) Gross Profit on Merchandise $. 6i4 AUDITING Expense Statement: I. Buying Expenses: (10) Salaries and Wages of Buying Force (11) Other Buying Expenses . . . , Total II. Selling Expenses: (12) Salaries and Wages of Sales Force (13) Extra Selling (14) Advertising: (15) Newspapers . . $... (16) Circulars (17) Other, including displays (18) Miscellaneous Selling Expenses Total .... III. Delivery Expenses: (19) Salaries and Wages of Delivery Force $. - (20) Other Delivery Expenses ... Total IV. Management Expenses and Fixed Charges: (21) Rent (22) Heat (23) Light (24) Power (25) Repairs and Renewals of Equipment (26) Depreciation of Equipment . i27) Insurance on Stock and Equipment (28) Taxes and Licenses (29) Management and Office Salaries (30) Office Supplies and Expenses (31) Miscellaneous Management Expenses Total V. (32) Losses from Bad Debts . . . .' .. . . Total Operating Expenses Net Profit from Operation . C. Other Business Profits (or Losses): I. (33) Repairing: (34) Receipts $ (35) Labor $ (36) Materials . $. Profit (or loss) on Repairing ^.,,.. RETAIL MERCHANTS 615 II. i37) Hosiery: (38) Sales . .$..... (39) Purchases . . . . $ (40) Expenses , Profit (or loss) on Hosiery . III. (41) Extraordinary Profits or Losses (not connected with operation) Total Other Business Profits (or losses) . Net Nominal Profit of the period . . $. D. Net Nominal Profit Applied to: I. (42) Interest on Borrowed Money $ II, (43) Interest on Capital, or (44) Dividends on Capi- tal Stock III. (45) Final Net Profit, or Surplus $. Explanatory notes on the foregoing form : Discounts on Inventory. It is intended that the inven- tory shall be net of a figure arrived at by multiplying the inventory at invoice cost by the average discount earned during the period. Depreciation and Shrinkage. The bureau recommends the reduction of stock in hand arbitrarily at the end of the first year in business, by 25, 30, or even 33 j/^ per cent, on the presumption that the stock would not bring more than 66^ per cent at forced sale. The adoption of this recommendation would be tantamount to creating a heavy reserve for inventory values and adjusting such re- serve to meet increases or decreases at the end of each period. In addition, depreciation or shrinkage in inven- tories, from any cause whatsoever, should be charged to this account. Other Delivery Expense. Includes stable or garage rent and all expenses for repairs, up-keep, and maintenance of the delivery outfit, including a fair charge for deprecia- tion. Miscellaneous Management Expenses. Includes tele- 5i6 AUDITING phone, water, wages of janitors, porters, cleaners and at- tendants, and any employees who are not engaged in ad- ministrative or office work or in buying, selling, bundling, or delivery. Department Stores A department store is really a group of retail stores in different lines of business with one general management and with the accounting centralized in one department. Practically all department stores have a more or less efficient staff auditing department. This department pays particular attention to the continuous auditing of the sales. The volume of detail in connection with the cash and charge sales is so great that the professional auditor is not ex- pected to go back of the summaries prepared by the audit- ing department. He should, however, see that the various totals on the summaries are properly carried into the general books. The auditor should also satisfy himself by careful in- vestigation that the system of internal audit is such as to insure an accounting for all sales. It is particularly im- portant to see that the system of handling C. O. D.'s and "will calls" (similar to C. O. D.'s, excepting that the cus- tomer will pay for the goods on calling for them at the store, instead of having them delivered) is such as to re- duce the possibility of fraud or error to a minimum. Con- trolling accounts for these classes of transient items are of decided assistance in this respect. The volume of merchandise purchases in a department store is very large, and it is out of the question under ordinary circumstances for the auditor to examine 2ni or even a considerable part of the purchase invoices. Tests should be made, however, and especial care should be given to see that a proper plan of verifying and approving each DEPARTMENT STORES 6x7 invoice is in use and that it is actually carried out. Tt is important that the plan be such as will guard against the failure to deduct freight when the goods are bought on a delivered basis, shortages in weight or count, and allow- ances for defects or inferior quality. Frequently goods are paid for before they are actually received, in order to obtain the cash discount obtainable for early payment. The system of approving invoices should insure such purchases being verified on receipt of the purchased goods, and insure that claims, if any be in order, are made. As discounts on purchases form no small part of the net income of department stores, it is desirable that this subject receive attention during the course of the audit. Almost all department stores are wide-awake to the im- portance of having all invoices approved as quickly after receipt thereof as possible, so that the discount day may not pass before the approved invoice reaches the treasurer's department for payment. Should the auditor, however, discover any deficiency or weakness in this respect, he may rest assured that his client will very much appreciate having his attention called to the matter. Salaries and wages form the largest single item m the expenses, and the verification of the expenditure therefor is of prime importance. The padding of pay-rolls, as far as sales clerks are concerned, can usually be detected by comparing the pay-roll with the auditing department's analysis of sales by sales clerks. Vice versa, this is also somewhat of a check on the statements of sales. The pay- ments for expenses will be found to be very voluminous, and it would not be practicable to vouch them with any ap- proach to completeness. A study of the comparisons shown by the departmental accounts for different periods will, however, indicate such of the expenses as should be specially investigated. 6t3 auditing Almost without exception, some form of departmental accounts, i.e., accounts showing the operations of each de- partment separately, will be found to be in use in every store. Their accuracy and completeness vary : in some cases they are very complete and are controlled by accounts in the general ledger; in other stores they are on a single- entry basis, arbitrary charges for rent, interest on stock, and similar items are made of which no cognizance is taken in the general books, and no attempt is made to bring the aggregate of the results shown in the departmental accounts into agreement with the final results shown on the general books. It is certainly most desirable that the departmental accounts be controlled by the general ledger, and if the system of accounts be well laid out, it is entirely feasible. While daily statements of sales and weekly or monthly statements of profits (based on estimated inventories) are furnished to the management, most stores close their books and state the final results of their business operations twice a year, the closing dates being either the end of January and July or of June and December. The first half of the year is called the spring season and the latter half the fall season. In comparing the operations of a department for different periods, the comparison should always be made between the same season in different years and not between the two seasons in the one year. The volume and char- acter of the business done in the spring season varies con- siderably from that of the fall season. In studying the operations of the various departments, one of the most important things to be considered is the rate of gross profit on sales. Any undue fluctuation therein from one year to another should be thoroughly investigated. Fluctuations in the ratio of selling expenses to sales should also receive careful attention. The volume of business done exerts, of course, a more noticeable influence on the per- DEPARTMENT STORES 619 centage which the expenses are of the gross sales, than should be the case with the gross profit. The basis of the apportionment among the various de- partments, of such expenses as delivery service, wrapping desks, insurance, general administration, etc., ought to be investigated. A rough and ready way of distributing such general charges may work serious injustice to some de- partments, undue advr.ntage to others, and result in mis- leading showings generally. In verifying the assets and liabilities, no unusual ques- tions of principle are encountered. The principal assets are accounts receivable and merchandise inventory. Cus- tomers' accounts receivable should be analyzed as to date; this will furnish a basis for the determination of a proper amount to be reserved for uncollectable accounts. Notes receivable held by a department store may ordinarily be viewed with some suspicion as to the financial strength of the makers. Goods sold at retail are usually purchased by the customer for consumption and not for resale; conse- quently, the account should be paid at maturity and the giving of a note therefor is a confession of the customer's having purchased in excess of his ability to pay. The important questions in connection with the inven- tory are the correctness of quantities, prices," arithmetical work, and salability of the stock. For the correctness of the quantities the auditor will be dependent largely on the certification of those who took the inventory and of the "buyer" (department manager). The investigation of large increases or decreases in the inventory as compared with prior dates will sometimes result in the detection of errors in quantities. Prices may be tested by reference to the purchase invoices. Goods which are still in original packages should be inventoried by reference to the purchase invoice therefor, and verification thereof is comparatively 620 AUDITING simple. Sufficient tests of the extensions and footings should be made to assure the correctness of this element. Goods should be so indicated on the inventory that those purchased prior to the current season can be readily iden- tified and allowance made for eventual loss thereon owing to the necessity for price reductions to close them out. Department store stocks and inventories are generally calculated by what is known as the retail method. The stock book has a sheet for each department. The first entry gives the inventory at the beginning of the period at cost, and at selling prices. The invoices for each depart- ment are priced and extended at selling prices, and weekly or monthly totals are entered in the stock book for both the cost and the selling prices. Columns are provided in the stock book for the mark-down figures and for the weekly or monthly sales figures. A book inventory can be prepared at the end of each week or month, as follows : Inventory at Selling, beginning of period $ Purchases at Selling, to date Total Inventory and Purchases at Selling Deduct : Mark Downs Sales . . . Inventory at Selling $. . To reduce to "inventory cost," multiply by ratio of total of inventory and purchases at cost to the total of inventory and purchases at selling. By ''inventory cost'" is meant that figure which will permit the department to earn its regular percentage of gross profit regardless of the fact that a portion of the goods inventoried might have been reduced or ''marked down." MISCELLANEOUS DATA FOR STORES 621 There are some who argue that the ratio should be : Total of Inventory and Purchases at Cost Total of Inventory and Purchases at Selling less Mark Downs It is obvious that the latter method might result in the inventory being figured at a higher amount than the cost, in cases where there had been heavy mark downs and prac- tically all of the reduced merchandise had been sold prior to inventory taking. As we must always have in mind that inventories should be priced at cost or market, which- ever is the lower, the auditor should thoroughly investi- gate the methods of figuring inventories where the "retail method" is employed. It is important that the auditor should have some knowl- edge of gross and retail profit figures, mark downs, and turnovers. He should endeavor to secure actual figures from many sources to determine whether those of his client compare favorably with the average results. The author gives below statistics which have been com- piled from available data. The figures are largely taken • from articles appearing in System, which magazine has been collecting data from many sources on retail costs and results. Miscellaneous Data for Retail and Department Stores The cost of delivering the average package varies from >. 5 to 8 cents per package. . \ v'-t * A New York department store delivered* 1,16S,511 packages by gasoline vehicles at an average cost of .0643; and 1,376,030 packages by horse vehicles for .0846 per package. An eastern department store reports that 28 per cent of its charge account packages are returned and nearly 30 per cent of its C. O. D. orders. 622 AUDITING ^ vO t^ "^ VO --< 00 CM ■^ lO -^ >o — « . on m o &^Tr o TT to CO u-> ro r>! ^r-<^fO,pCMOiOChOOOOsOMO ^ „ rer, '— ' '-' .—..—. r-i ^ a "^ > *"• o, "I g.&"00 Tf CO CO Tj- CO CO rr CO vO Cvj CO (J .5 f i O .- ;>,tJJO LO — « .-H TJ- -VOVOCM— < -co bH 'S ^ ° O vOloOO ""^OOOn -O "^ Q ■" ■ ' ' CM ' : ■ »-^ -h' ■ : CM fe rt^ ^o^ CVJOrMCM^O^-TCO— ^0\ s;:3 -<■ ;?^ (O * •i:^„ LOvOvO'-'CM— o vo <^ '^ '^ *~^ f^ '-^ •— ^^ — ^ ^ ■n ^ON '^. ON p Cx CO lO TT vO '-^ 00 On ^ ^O <^' O" NO* OO' CO O On On O 00* i^ g ^On P P on -^^ ON CM —. C\) rr TT o pj CO ^" "^' ^ ^ * ^ ^' «*5 fO* •^' cm" 't/J • c •E ■^K (Li (d So ,^'O'CJ "^^ \2 jj u"" o „; ^^ 5 bo"C 3 c -M S.^-i^'C U.5 c rt «-, o g-S ' C/3.S2 i: 2 33 ^.^^P-ogc^Sg^ 0*-^OcoS,-,__, to _E (-< - TO "O HJ O4 CO liais i i; 3 3 o 5 ^_2 &CU bO-S cC i::y c c m O ^ S -xj r;, ^ to So, •TO 03 MISCELLANEOUS DATA FOR STORES 623 Sales Salaries Small City Large City % % Carpets 16 4 Corsets . 5.5 5 Hosiery 6.5 6 Toilet Goods . 6 7 Gloves . 6 6 Jewelry and Leather ( joods 9 7.5 Notions 10 9 Dress Goods 10 9 Millinery 11 9 Shoes 5.5 Men's Clothing . 5 Men's Hats 6 Men's Furnishings 5 Waists 4 Candy 8 Pianos 10 House Furnishings 6 Furniture 4 Rugs 3 Art . . . 7 Books 6 Retail Stores Gross Profits % Chain Grocery Stores 15 to 49.5 Cotton Dress Goods . 32 to 41 Furniture ..... 49 Hardware, Large Store 33.3 Large Department Store 24.5 Ready-made Clothing 33.3 Shoes 40 Variety Goods, Bargain Basement 15 to 25 Net Profits % Dry Goods Store .... . 5 to 7 Furniture . 18 624 AUDITING Grocery . . . . 4 to 5 Large Department Store 3.1 * Mail Order House .... 6.8 Variety Goods Store .... 10 to 12 Variety Goods, Bargain Basement 5 to 10 Turnovers* Number of Times Groceries ..... 10 Department 7t Variety Goods 6 Drugs 4.5 Dry Goods 4 Hardware 3.5 Furniture 3 Shoes 2.1 Clothing . 2 Jewelry 1.5 Department Store Turnovers Number of Times Bedding 3 Books .... . 2V^ Candy .... . 7 Chinaware 2^ Clocks .... 3 Clothing (men's and boys') SVs Coats, Suits, and Dresses sy2 Corsets .... 8 Dress Goods 3 Dry Goods . . . 2y2 * The turnover is obtained by dividing the average inventory at selling prices into the year's sales, or by dividing the average inventory at cost into the year's sales reduced to cost. t The author's opinion is that this is rather high and that the turnover of department stores is from 3 to 5 times. (See following table.) MISCELLANEOUS DATA FOR STORES 625 Embroideries 2 Furniture 2J4 Furs 3 Gloves 3y3 Handkerchiefs ...... 354 Hats (men's and boys') .... 3 Hosiery ....... 4 Infants' Clothing ..... 3^^ Jewelry 2 Jewelry (toilet goods, bags, and belts) . 3^4 Laces 2]/^ Leather Goods 314 Linens 2^/3 Linings 4]/^ Men's Furnishings ..... 4 Millinery .6 MusHn Underwear ..... 3%. Neckwear (women's) .... 5^4 Notions 4y3 Patterns 5 Pianos ....... 3% Ribbons 4 Rugs 2 Shoes (men's, women's, and children's) . 2^4 Silks . 3 Stationery 2^ Suits and Coats (women's and misses') . 81/3 Toilet Goods ...... 3>4 Trunks 35<3 Umbrellas 6 Underwear (knit — men's, women's, and children's) ...... 4 Veilings ....... 3 Wash Goods ...... 3 Waists Sy3 Some department stores, in fact quite a number of them, also have a wholesale department. Whenever this is the case, the audit of the accounts pertaining to the wholesale department will follow the lines laid down un- der ''Wholesale Merchants." (^26 AUDITING Automobile Dealers It is important that the auditor familiarize himself with the terms of the dealer's contract with the manu- facturers. Deposits with the latter are not accounts re- ceivable, but payments on account of cars to be purchased during the contract period, and the amounts so deposited may be deducted pro rata from the price to be paid for each car or from the last shipments. The unapplied bal- ance of such deposits should be confirmed by correspondence with the manufacturers. Interest on these deposits is some- times paid by the manufacturers, and where this is the case its collection should be verified. Deposits by customers with the dealer should appear in separate accounts, as they are not current accounts pay- able. If any interest is to be allowed on such deposits, the auditor should ascertain that proper entries for the accrued portion thereof have been made. Cars on hand should be physically examined and their numbers compared with the daily car record. The owner- ship of cars in the possession of others for alterations or other purposes should be confirmed by correspondence. The invoices for unsold new cars should be used to verify the prices at which they are taken into the inventory, and the second-hand cars should be appraised, but in no case should the appraised values exceed the allowances made to the customers for the cars plus the cost of overhauling them. Usually the dealer incurs a loss on the sale of second-hand cars, and this fact must be considered in passing upon their value for balance sheet purposes. Statements of accounts receivable balances, after being stamped with request to communicate directly with the auditors if not correct, should be sent to all customers. Liberal allowance should be made for the probable loss on any old or disputed accounts. AUTOMOBILE DEALERS 627 All accounts with manufacturers should be checked against statements received from them. This is important, as allowances are often made to satisfy customers and charged to the manufacturers, but for which the latter will not pass credit to the dealer. The inventories should be carefully examined, all ob- solete parts eliminated, and allowance made for probable loss by falling off in demand for parts of cars manufac- tured prior to the audit year. In some cases manufacturers agree to keep a certain quantity of parts on hand at the dealers' repair shops. The value of such consignments should either be deducted from the inventory or be shown in a separate ledger account. The correctness of the cost of work in progress in the dealer's repair shop should be tested by examination of the shop cards. All of the cars, both new and second-hand, on hand at the beginning of, and purchased during, the audit period should be accounted for as charged against some customer or as still on hand at the close of the period. Tests should be made of the deliveries from stock to ascertain that parts and supplies are paid for in cash, charged to customers either directly or on shop or road repair cards, or are properly used to repair demonstrating cars and sec- ond-hand cars taken in exchange. Charges for shop and road repair work should also be checked. Time reports of workmen in repair shop and the prep- aration of pay-rolls should be investigated to ascertain that actual work only is paid for, and that it is charged on shop or road repair cards. Office, demonstrating, and general expenses should be vouched and compared with prior pe- riods. Contracts with salesmen should be examined and commissions paid to them verified. A liberal reserve should be made for free repairs to sold cars, which are usually necessary during the year sub- 628 AUDITING sequent to car sales in order to retain the good will of cus- tomers, but the cost of which will probably not be collected from the manufacturers. Branch Accounts The close relation which exists between a branch house and the parent concern presupposes the existence of com- plete records or reports at the head office; but it will be necessary for the auditor to ascertain definitely how com- plete the branch records are and by what system they are reflected in the general books. Some branches keep a full set of books and furnish regular returns as required by the home office. In such case the latter will have but a current account with the branch in the general books, which will be a controlling account, and will represent the branch's capital, composed of the assets at the branch less the liabiHties. Usually such assets will be represented by cash, stock on hand, and ac- counts receivable, and in preparing the final or consolidated balance sheet, the branch balances must be divided into the various classes of assets of which they are made up. They should never be treated simply as an account receiv- able. Where a branch is not visited by the auditor, com- plete reports or returns should be furnished him, properly certified, and so far as may be necessary he should check them into the head office books. All cash remittances in- cluded in the branch report, as well as all cash sent from the head office, should be vouched in the general books. A reconciliation of the account between the branch and the head office should be made, either at a particular date during the audit or as of some date within the period un- der review. The only items affecting such reconciliation will be the cash or invoices in transit, and these should BRANCH ACCOUNTS 629 subsequently be vouched to determine the absolute harmony between the two sets of books. Some concerns allot a permanent cash fund to each branch, and require that all receipts be deposited to the credit of the home office. In such cases it will be necessary to see that the moneys received at the branch appear on the bank statement or pass-books as deposited. When an auditor accepts the certificate of officials or other persons for the verification of assets at branches, he should limit his responsibility by a statement to that effect in his report. He should, however, satisfy himself that all quCvStions of principle, such as valuation of stocks, de- preciation, reserve for bad debts, etc., have been properly considered. Some head offices now have on file duplicates of all records prepared by the branch houses. The latter are able to furnish these by the use of typewriters or other mechanical bookkeeping devices adapted for the purpose. By one operation customers ledgers are posted, customers' monthly statements are written, and duplicate ledger sheets are prepared for the head office, while duplicate records of cash receipts and disbursements form a cash book with which it is possible to keep in close touch. The facilities thus afforded, whereby instant reference can be had to branch transactions, make possible a most satisfactory branch-house internal audit at the home office. Goods billed to retail branches by the head office are charged either at cost price, at cost price plus a percentage, or at selling price, inventories in each case being taken on a similar basis. For balance sheet purposes the auditor should see that the values of the stocks in the last two cases have been reduced to cost or market price. Schedules of debtors at the branch should be submitted, duly certified, and the auditor should make certain that all 630 AUDITING branch liabilities not already shown in the head office books have been taken into account. In making up a balance sheet of the concern as a whole, the auditor must not overlook the fact that accounts between branches and the home office included in controlling ac- counts with the ordinary receivables and payables are to be eliminated. In addition to the points mentioned above, the audit of foreign branches involves the question of exchange, and this requires that the conversion of the various items into domestic currency should be checked and that the difference in exchange be ascertained to have been properly handled. In the case of English or French currency, the rate of ex- change is sufficiently stable to warrant the accounts being converted on a fixed basis, and the only difference will then be in connection with remittances. Where exchange fluc- tuates, the value of the fixed assets should be converted into domestic currency at the rate at which actually pur- chased, the current assets and liabilities at the rate prevail- ing at the close of the fiscal period, and remittances during the period at the actual rate at which made. If the con- version results in a loss, it should be charged off; if a profit, it is proper and is sometimes considered desirable to carry it forward as a reserve against possible losses in a succeeding period. CHAPTER XXV SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS (Continued) PUBLIC UTILITIES For a number of years there has been a growing ten- dency toward strict regulation of public service corpora- tions. Wisconsin, the pioneer state in this movement, has for some years had a commission which has done very effective and progressive work in this respect, and New York's Public Service Commissions (there being two, one for the counties of New York, Kings, Queens, and Rich- mond, and the other for the other counties in the state), which were created in 1907, have also performed good ser- vice. Some other states have also created similar commis- sions or have conferred real power on formerly ineffective governmental bodies which were nominally charged with the duty of regulation, but which were without authority in law to enforce their mandates. The powers of the various commissions vary. In some states they have large powers, such as the right to grant or deny franchises, to regulate the issue of stocks, bonds, and other evidences of corporate indebtedness, to regulate rates, to issue mandatory orders with reference to opera- tion, etc. One of the powers with which practically all these newer commissions are vested is that of prescribing imiform systems of accounts for the various classes of pub- lic service corporations coming under their jurisdiction. This is rightly regarded as an important element in the proper regulation of the conduct of public utilities. Classi- 631 632 AUDITING fications of accounts have been promulgated by the commis- sions of a number of states for electric railways, gas com- panies, and electric light, heat, and power companies. These classifications have frequently been prepared after consulta- tion with representatives of such bodies as the American Street and Interurban Railway Accountants' Association and with prominent public accountants and conferences be- tween the commissioners of various states, so that the varia- tions between the classifications prescribed by different states and by the Interstate Commerce Commission (which also exercises jurisdiction over certain classes of public service corporations other than steam railroads) are not material. The principal feature of these classifications which might call for criticism is a tendency toward too minute a subdivision of the operating expenses. To relieve small companies of the burden which would be imposed by re- quiring them to use in complete detail the prescribed classi- fications, the classifications have been condensed somewhat for moderate-sized companies, only the very large com- panies being required to use the classifications in their entirety. The distinction is drawn by making each grade of classification obligatory on companies having gross an- nual revenues within certain limits. The earliest, and still most important, instance of gov- ernmental regulation of public utilities was the creation of the Interstate Commerce Commission in 1887 to supervise steam railroads transacting an interstate business. The Commission early in its existence began to require the sub- mission by the railroads of annual reports prepared on uniform lines. In 1906, a number of very important amend- ments were made to the Interstate Commerce Act. The jurisdiction and powers of the Commission were greatly extended. In addition to steam railroads, all electric rail- ways, express companies, sleeping-car companies, carriers PUBLIC UTILITIES 633 by water (as described in the act), pipe lines (excepting water and gas), and telephone companies whose business activities are not confined within the limits of one state, are subject to the Commission's authority. The Commission now has the power to fix maximum rates — a power most far-reaching in its effects — not only on the corporations subject to its authority, but also on the communities whose ability to maintain their commercial supremacy or equality of advantage is dependent on the fixing of fair rates as compared with those enjoyed by competitive points. An- other notable broadening of its powers was the conferring of the right to prescribe a uniform system of accounts for each class of corporations subject to its authority, and the enforcement thereof by making deviation therefrom a penal offense. This \^;as an important development of the limited power formerly enjoyed of calling for uniform reports. A most important feature of the new classification of accounts for steam railroads promulgated after the enact- ment of the amendments of 1906, is the requirement that periodically entries be made for depreciation of equipment. It may well be expected that in time depreciation charges will also be required to be made for all other parts of the physical property which are subject to depreciation or grad- ual exhaustion. This recognition by a governmental body of a fundamental accounting principle is gratifying to ac- countants, who stood for years practically alone in their advocacy of the need for depreciation charges in the accounts of railroads and all other public utilities. State legislatures can enact, and in some cases already have enacted, laws delegating to commissions or municipali- ties power to fix the rates to be charged by public service corporations operating within the state. Under these cir- cumstances the auditor has responsibilities additional to those which simply consider the stockholders. In a sense 634 AUDITING he stands between the company and the public. Should depreciation allowances and other necessary reserves be omitted from the accounts, the apparent profits shown will be larger than is actually the case and may result in an agitation for a reduction in rates charged to consumers which the real facts in the case do not justify. In the en- suing litigation it will probably be very difficult to convince either judge or jury that depreciation charges, etc., which were not made at the proper time should now be allowed as an element in the cost of operation. On the other hand, if the reserves for depreciation and the like are excessive, the profits will be shown at less than their real figures and the public will be deceived. The importance of this subject was recognized at a national gathering of public accountants* as long ago as 1904, when a paper on the subject was read and a special committee was appointed to consider the matter. This committee later reported as follows : The committee appointed at the Congress of Accountants, held at St. Louis, U. S. A., in September, 1904, to review the paper by Robert H. Montgomery, C.P.A., upon "The Importance of Uniform Practice in Determining the Profits of Public Service Corporations Where Municipalities Have the Power to Regulate Rates," having taken the paper into 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 under- taking from the point of view of the general community and the profits available for dividends from the point of view of a corporation owning such undertaking. The former would be the net earnings from the operation of the undertaking, after providing for all waste or deprecia- tion of capital assets arising directly out of such operation; while the latter would be arrived at only after providing also for any possible loss on capital assets arising from causes not directly incident to such operation and for interest on borrowed money. II. The net earnings of a public utility with which the general community is concerned are determined by the excess of gross earnings over the expenses, defining the latter terms as follows : Gross earnings consist of the charges for all services rendered during the period as PUBLIC UTILITIES 635 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: (1) The direct cost of operation and of maintenance (ordinary repairs), expenses of management, and provi- sions for bad debts, damage claims, and rebates, as well as extraordinary expenses incurred during the period, such as legal charges, etc., but they should not include interest on borrowed money, discounts on bonds issued, or other charges in connection with the promotion or financing of the undertaking. (2) Depreciation: (a) On plant — physical — covering wear and tear, including direct requirements for renewals, etc., arising both from known and probable causes, such as electrolysis, etc. (b) On plant — indirect — due to obsolescence and the like, but not that due to a fall in value from general causes, (c) On other capital assets which are diminishing in value as a direct result of the operation of the property, such as moneys properly expended in acquiring from the local authorities the franchise under which the utility is operated where such franchise is, as is usually the case, terminable after a certain number of years ; or cost of mines, quarries, or other similar properties which are being used up continuously for the purpose of operating the utility. But there should not be included any provision for recouping promoters' profit or other watered capital, or for possible loss by reason of a general fall in values, etc., on the purchase at the end of the franchise of the whole undertaking by the public authorities, i.e., the state or municipality. III. In dealing with the private accounts of a corporation operating the utility, earnings will also embrace miscellaneous receipts, if any, not connected with the actual operations of the undertaking, and the following additional expenses should be allowed for before arriving at a bafeitee available for distribution : (1) Depreciation: An additional amount to cover any excess of the book value of good-will, franchise, and plant over that provided for under section 2, subsection (c) above, or over the sum it may be expected to realize on the expiry of the franchise. (2) Interest: On bonds or other funded or floating debt. IV. In determining the rates which should be charged to the pub- lic, regard must be had (a) to the profit ascertainable under section II, and (b) to further charges specified under section III, which would have to be borne by the corporation out of such profits. For instance, if 8 per cent per annum on the capital invested is considered a reason- able rate for a corporation to earn, taking into consideration the risks in section III, then the rates should be fixed so as to allow of a profit of 8 per cent calculated as laid down in section II, and out of this 536 • AUDITING • profit the corporation would have to provide for the risks and expenses stated in section III. A. Lowes Dickinson Ernest Reckitt Elijah W. Sells John B. Niven Harvey S. Chase Robert H. Montgomery, Chairman One of the most vital questions confronting the audi- tor of public utility accounts is the separation of all ex- penditures into the two classes of capital and revenue, or — as they are more often termed in practice — construction and maintenance. Frequently expenditures are of such a nature that it is open to debate as to whether they belong in the one class or the other. A factor which contributes to make the distinction diffi- cult is that most public service corporations, particularly railways and light and power plants, do not have any but very extensive additions to plant made by outside contrac- tors. The work is done, under the direction of their own engineers, by their own workmen. As these same forces also do the current maintenance work and use the same kinds of materials for construction as for maintenance pur- poses, it is practically impossible to determine merely from the nature of the labor and material expenditures whether they are capital or revenue charges. The only satisfactory solution of the problem is for the company to keep such cost accounts of its construction work as will relate the expenditures to the thing done or ac- complished. It is then possible for the auditor to satisfy himself by conference with the company's engineer, as well as by his experience with other engagements in the same field, whether or not the capital charges are proper. Un- fortunately, many companies do not keep such construction cost records, though all should. Where they are lacking, one of the best things for the auditor to do is to have the engineering department submit a statement of the construe- PUBLIC UTILITIES ^Z7 tion work done during the period under review and the legitimate cost of each part thereof. Such a statement will usually be of material assistance in passing on expenditures which have been charged to Capital account. The best- managed companies have a system of ''Construction Au- thorizations" which are prepared by the engineering staff and approved by the board of directors or executive com- mittee. These authorizations form the best basis for con- struction cost accounts. Charges for additional equipment are usually more easily traced, and there is not, as a rule, much difficulty in coming to a conclusion as to whether the charges should go to capital or revenue. While it is advisable that in cases of doubt the decision be in favor of the conservative policy of charging the items in doubt to maintenance, yet excessively conservative prac- tice must also be avoided, as it increases the apparent cost of service rendered and consequently is unjust to the con- sumers. There is no question but that the cost of the original plant and all extensions and additions are proper capital charges. Reconstruction expenditures frequently give oc- casion to much doubt as to their proper apportionment. If the reconstruction has resulted in increased capacity, some portion thereof is properly chargeable to capital. The most equitable plan is to charge to capital the reconstruction cost, and eliminate therefrom the cost of the construction work or equipment which has been replaced. The result is that the plant always stands on the books at the last cost, i.e., the cost of the plant as it stands at the present time. In cases involving the determination of rates which are equitable to the consumers and yet at the same time yield a fair return on the actual investment, it is certainly most satisfactory to have the investment in plant appearing at 638 AUDITING the cost of the present plant, and not at the cost of the plant as it was at some earlier date. In considering the question of a proper charge for de- preciation of plant, which is an element in the cost of serv- ice rendered (see section II, subsection 2 (a) of the report supra), it would seem that it should be based on the cost of the plant in operation. This would necessarily include the last cost of any parts of the plant which might have been reconstructed or replaced since its original construction. The Supreme Court of Idaho made a legal definition of depreciation in a decision handed down in the case of Murray v. The Public Utilities Commission of the State of Idaho. In handing down its decision, the court said : So far as the question of depreciation is Goncerned, we think de- duction should be made only for actual tangible depreciation and not for theoretical depreciation, sometimes called "accrued depreciation." In other words, if it be demonstrated that the plant is in good operating condition and giving as good service as a new plant, then the question of depreciation may be entirely disregarded. This decision was rendered in a case where an endeavor was made to show that accrued depreciation should be de- ducted from original cost before arriving at the value of the plant for the purpose of fixing rates. In a decision the Public Service Commission for the First District of New York said : The cost of moving a track from one location to another, and installing new ties, rails, etc., is necessarily an element of operating expense, whether incurred in consequence of wear and tear, or of obsolescence and inadequacy. It is so treated in the accounting systems of this Commission and the Interstate Commerce Commission. Every well-managed corporation, before ascertaining profits and declaring dividends, sets aside some portion of its revenue to provide for extraordinary replacements that are not properly charged to the operating expenses of a single year. In a recent case the United States Supreme Court ren- PUBLIC UTILITIES 639 dered a unanimous judgment in which it held (thereby affirming the Commerce Court) that the Interstate Com- merce Commission has authority to require interstate rail- ways to charge to operating expenses portions of the cost of providing enlarged facilities necessary to meet the re- quirements of increased traffic. The occasion for this decision was a suit by the Kansas City Southern Railway to obtain relief from an interpretation of one of the gen- eral accounting orders of the Commission, the substantial requirements of which are as follows : 1. When property is abandoned and not replaced in kind, the estimated cost of replacing it must be deducted from the cost of property carried in the balance sheet and charged to profit and loss. I 2. When property is abandoned as an incident of im- provements and replaced by more efficient property of like kind, only so much of the cost of providing the improve- ments can be added to the item in the balance sheet which represents cost of property, as may remain after deducting from the actual cost the estimated replacement cost of the property abandoned, and the latter must be charged to cost of operation. A leading financial writer commented thereon as follows : "If a six-story building is torn down to be replaced by a twenty-story building, the cost of the new property in- cludes the cost of the old building as well as that of the land on which it stands, and if the twenty-story building is in turn replaced by one of fifty stories, both its prede- cessors are represented in the cost of the last. *' Without such replacements there could be no progress ; their cost is the cost of progress. This being the economic fact, it is plain that any regulations of the Interstate Com- merce Commission that are in conflict therewith must have one of two consequences : they must either (first) prevent 640 AUDITING the progress that ought to take place, or (second) they must become dead-letters. Neither result is desired nor desirable. The plain necessity of the situation resulting from Monday's decision is that the Interstate Commerce Commission should reconsider its accounting rules and sub- stitute a more liberal and constructive regulation for that in question/* While there is necessarily a different classification of accounts for each of the various classes of public utilities, the general principles underlying all of them are the same. A committee of the American Association of Public Ac- countants submitted to the 1907 convention of the Asso- ciation the following: 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 PUBLIC UTILITIES 641 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 Municipality 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 (Public Plants) Total Disposition of Available Income. Credit (or Debit) balance transferable to "Sur- plus" $. Note : The various items in this condensed statement (particularly expense items 1, 2, and 3) should be supported by detailed schedules. 642 AUDITING This is a condensed form suitable for any form of pub- lic utility — railway, gas, electric light and power, water works, or telephone — and would be accompanied by sched- ules giving the details pertaining to the particular utility for which used. It would be especially useful in compar- ing the operations of different undertakings, as it brings out quite distinctly those items whose treatment is a mat- ter of judgment, such as depreciation, or which for any other reason may be considered as "variables." The exhaustive report of the National Civic Federation on "Municipal and Private Operation of Public Utilities," issued in 1907, will be of both interest and value to the accountant who wishes to devote especial attention to the accounts of public service corporations. Rate Regulation The tendency of legislation for the regulation of rates to be charged by public service corporations is to limit them to such rates as will not yield more than a moderate return on the capital actually invested. As the accounts of but very few companies have been kept in such a way as to exhibit clearly or conclusively the cost of the plant, not to mention proper allowances for depreciation, one of the first steps when fixing of rates, renewals of franchises, or similar negotiations are under consideration, is to have the property appraised. In a decision of the New Jersey Board of Public Utility Commissioners, appears the following: The general principles which underlie all just valuations for rate-making purposes are simple. These great general underlying principles are two in number. The first aims at securing for con- sumers generally a prompt and adequate supply at reasonable rates, of those services which they require of public utility companies. To insure this end a sufficient incentive must be held out to enterprises and investors. Such an incentive is the assured prospect of a sufficient PUBLIC UTILITIES 643 return upon outlay in supplying service. The first general principle is prospective in its reach; it looks to the future. It is comprehensive in its aim, it is bent on obtaining the adequate supply of community wants. The second general underlying principle seeks to conserve the legitimate value of investments in public utility enterprises. It regards the past rather than the present, the individual investors rather than the community of consumers. It is perfectly consonant with the first general principle enunciated. For unless the legitimate value of past investments is preserved by rate-making decisions, the effective incen- tive for individuals to take similar risks in the future is impaired or extinguished. In the Kings County Lighting Co. case decided by the New York Court of Appeals March 24, 1915, the court said: The public is entitled to reasonable rates and the company to a fair return on its property; and in determining what is a fair return there must be taken into account the cost of developing the business after it was started and of building it up and placing it on a paying basis. If it received a fair return on its investment from the start, or if in later years it received more than a fair return and made up for the lean years, then, the Court says, that is the end of the matter so far as "going value" is concerned. But if it did not receive a fair return in the early years and the deficiency has not been made up, and it was due to losses or expenses which were reasonable, necessary and proper in developing efficiency and economy of operation and in establishing the business, then the item of "going value" comes in and must be considered in fixing the rate; otherwise the rate would be confiscatory. In determining what is "going value" and how it is to be appraised, Judge Miller points out that it takes time to put a new enterprise of any magnitude on its feet after the construction work has been finished. Mistakes of construction have to be corrected. Substitu- tions have to be made. Economics have to be studied. Experiments have to be made, which sometimes turn out to be useless. An organi- zation has to be perfected. Business has to be solicited and advertised for. In the case of a gas company, gratuitous work has to be done, such as selling appliances at less than a fair profit and demonstrating new devices to induce consumption of gas and to educate the public up to the maximum point of consumption. None of those things is reflected in the value of the physical property, unless, of course, 644 AUDITING exchange value be taken, which is not admissible in a rate case. The company starts out with the "bare bones" of the plant — to borrow Justice Lurton's phrase in the Omaha Water-Works case. By the expenditure of time, labor, and money it co-ordinates those bones into an efficient working organism and acquires a paying business. The proper and reasonable cost of doing that, whether included in operat- ing expenses or not, is as much a part of the investment of the com- pany as the cost of the physical property. The investors in a new enterprise have to be satisfied as a rule with meager or no returns while the business is being built up. In a business subject only to the natural laws of trade they expect to make up for the early lean years by large profits later. In a business classified among public callings, the rate making power must allow for the losses during the lean years or their rate will be confiscatory, and, of course, will drive investors from the field. In the former case the value of the established business is a part of the "good-will" and may be determined by taking a given number of years' purchase of the profits, or exchange value may be considered. In the latter case a different rule must be adopted. To view the matter in another aspect, take the case of a public service corporation with a plant constructed just ready to serve the public. It is going to take time and cost money to develop the highest efficiency of the plant and to establish the business. Three courses seem to be open with respect to rate making, viz.: (1) to charge rates from the start sufficient to make a fair return to the investor and to pay the development expenses from earnings — a course likely to result in prohibitive rates, except under rare and favorable circumstances; (2) to treat the development ex- penses as a loss to be recouped out of earnings, but to be spread over a number of years, in other words, as a debt to be amortized ; that involves complications, but would seem to be fairer to the public and certainly more practical than the first; (3) to treat the development expenses, whether paid from earnings or not, as a part of the capital account for the purpose of fixing the charge to the public. The last course would seem to be fairest to both the public and the company, as well as the most practical. Obviously the most satisfactory method is to show the actual experience of the company, the original investment, its earnings from the start, the time actually required and expenses incurred in build- ing up the business, all expenditures not reflected by the present condition of the physical property, the extent to which bad manage- ment or other causes prevented or depleted earnings, and any other facts bearing on the question, keeping in mind that the ultimate fact to be determined is not the amount of the expenditures, but the deficiency in the fair return to the investors due to the causes under PUBLIC UTILITIES 643 consideration. The business in this case was twenty years old, the books of the old company were not available, and it is of course problematical whether, if produced, they would have shown the neces- sary facts. The question, therefore, had to be determined, as all questions of fact have to be, by the best evidence available. A gas and electric light company in its application to the Wisconsin Railroad Commission for authority to in- crease its rates, added 12 per cent to the cost of land, buildings, and equipment for engineering superintendence, interest during construction, contingencies, etc. The Com- mission allowed the 12 per cent addition for purposes of arriving at a valuation of the plant. Appraisals of Public Utilities Congress amended the Interstate Commerce Commis- sion Act in March, 1913, so as to provide for a valuation of the several classes of property of interstate carriers and to secure information concerning their stocks, bonds, and other securities. The amendment provides that: The Commission shall make an inventory which shall list the property of every common carrier subject to the provisions of this Act in detail, and show the value thereof as hereinafter provided, and shall classify the physical property, as nearly as practicable, in con- formity with the classification of expenditures for road and equipment as prescribed by the Interstate Commerce Commission. First: In such investigation said Commission shall ascertain and report in detail as to each piece of property owned or used by said common carrier for its purposes as a common carrier, the original cost to date, the cost of reproduction new, the cost of reproduction less depreciation, and an analysis of the methods by which these several costs are obtained, and the reason for their differences, if any. The Commission shall in like manner ascertain and report separately other values, and elements of value, if any, of the property of such common carrier and an analysis of the methods of valuation employed, and of the reasons for any differences between any such value and each of the foregoing cost values. Second : Such investigation and report shall state in detail and separately from improvements, the original cost of all lands, rights of way, and terminals owned or used for the purposes of a common 646 AUDITING carrier and ascertained as of the time of dedication lo public use and the present value of the same, and separately the original and present cost of condemnation and damages or of purchase in excess of such original cost or present value. Third: Such investigation and report shall show separately the property held for purposes other than those of a common carrier and the original cost and present value of the same together with an analysis of the methods of valuation employed. Fourth : In ascertaining the original cost to date of the property of such common carrier, the Commission in addition to such other elements as it may deem necessary, shall investigate and report upon the history and organization of the present and of any previous corporation operating such property; upon any increases or decreases of stocks, bonds, or other securities, in any reorganization, upon moneys re- ceived by any such corporation by reason of any issues of stocks, bonds, or other securities ; upon the syndicating, banking, and other financial arrangements under which such issues were made and the expense thereof; and upon the net and gross earnings of such cor- porations; and shall also ascertain and report in such detail as may be determined by the Commission upon the expenditure of all moneys and the purposes for which the same were expended. Fifth: The Commission shall ascertain and report the amount and value of any aid, gift, grant of right of way, or donation made to any such common carrier, or to any previous corporation operating such property, by the government of the United States or by any state, county, or municipal government, or by individuals, associations, or corporations; and it shall also ascertain and report the grants of land to any such common carrier or any previous corporation operating such property by the government of the United States, or by any state, county, or municipal government and the amount of money derived from the sale of any portion of such grants and the value of the unsold portion thereof at the time acquired and at the present time, also the amount and value of any concession and allowance made by such common carrier to the government of the United States, or to any state, county, or municipal government in consideration of such aid, gift, grant, or donation. The amendment further provides that in making their report, the Commission shall show the value of the prop- erty of every common carrier as a whole, and separately the value in each of the several states and territories. Also that the Commission shall, after completing the valuation, keep itself informed of all extensions and improvements PUBLIC UTILITIES 647 or other changes in the condition and value of the prop- erty of all common carriers, and shall ascertain the value thereof and revise and correct its valuation. The following suggestions for the making of such an appraisal are quoted from Henry Floy's book on "The Valuation of Public Utility Properties." Suggested Procedure: A valuation, to be complete in the fullest sense, must take into consideration not alone the original cost, present value, or cost of reproduction of the physical plant, but also the in- tangible and non-physical values, the limitations of franchise, as well as the market quotation of securities. To complete a valuation of such broad scope, the following method of procedure is suggested : (a) Obtain from the proper officials of the company data, draw- ings, and specifications covering original construction as well as later additions, also lists of material and supplies, and if available, a com- plete inventory of all existing physical property. Where inventories are incomplete, as is usually the case, they must be completed by field inspection, and in every case verified and checked. How thoroughly and with what detail inspection may be necessary depends on the thorough- ness of the appraisal being made. For example, test holes may have to be sunk in order to verify information as to excavation, foundations, buried pipes, duct lines, or other subsurface structures. The size, quantity and condition of all physical property must be determined. (b) Obtain available data as to costs and prices by examination of corporation vouchers, not only for the period in which the appraisal is being made, but covering also original cost. Classify the cost to dif- ferent materials and labor, in accordance with that method which will enable a convenient and easy comparison for the appraisal work in hand. Particular attention should be given to expenditures during the early history of the company covering items that may properly be quali- fied as "Development Expenses," such as interest, taxes, and similar expenses during construction, checking the cost as ascertained from vouchers with the book cost. The two are not likely to agree, due to destruction of old records, accidentally or otherwise, and the fact that expenditures may have been made and no vouchers received therefor. (c) Examine the record books of the corporation, ascertaining therefrom all information as to the issuance of stocks, bonds, or other forms of indebtedness, the cash received therefrom, records of transac- tions of the officials in authorizing contracts, and the prices thereof. (d) A personal inspection and examination must be made of a 648 AUDITING physical property by the individual in charge of the appraisal work, and a more or less detailed acquaintance had with the plant and the con- ditions under which it is operating, even though the working out of detailed information is left to one's subordinates. (e) Determine the unit prices to be used and the percentages to be allowed in connection therewith; the fixing of unit prices and per- centages to be added depends upon the basis adopted for the prices themselves. (f) Using the completed inventory, the unit prices determined upon are to be applied and the work carefully checked to avoid errors. Two inventories and two sets of unit prices may be necessary if both the original cost and the cost of reproduction are being determined. To the totals obtained from applying the unit prices to the inventory should be added the percentages for engineering, contingencies, and administration or superintendence during construction, etc., in order to obtain the cost of the physical plant. (g) If the depreciated or present value is desired, the amount of depreciation must be determined in accordance with the principles laid down in the chapter on "Depreciation" and this sum deducted from the cost, giving the present value of the physical plant. (h) Investigate the actual operating conditions, method of serving the public, rates charged, system of providing for depreciation, and maintenance of the property. (i) Ascertain the limiting conditions in the articles of incorpora- tion, charters, franchises, municipal contracts, or other governing obli- gations, determine whether local conditions are such as to promise fair treatment and a bright future for the corporation, or whether its busi- ness is likely to be interfered with, either through competition or popular opposition. (j) Development expenses are determined from a consideration of the time necessarily consumed in building the plant under consideration, the rate of interest, taxes, and other such expenses, with proper allow- ance for remuneration to the original promoters of the enterprise. (k) Consideration should be had as to whether good-will, fran- chise, or going value should be allowed for, and if so, the amount may be determined from a consideration of the matters set forth in another chapter. (1) The sum of the physical plant value plus the development ex- penses, plus the value of franchise, good-will, going value, or contracts, if any, will result in a sum representing one fair value. The items to be determined in making a valuation to ascertain the total fair value of a utility property may be diagrammatically sum- marized as follows: PUBLIC UTILITIES 649 Net cost of physical plant Contractor's profit Engineering Contingencies, etc. Expenses preliminary to beginning plant construction Overhead expenses during construction Working capital Superseded plant Franchises Good-will doing value Contracts Structural value Development expenses Intangible value - Total value Steam Railroads Taken as a whole, railroad accounting has probably reached a higher degree of standardization of accounting than any other branch of industry or commerce. The uni- form reports called for by the Interstate Commerce Com- mission for the past twenty-five years, and the authority which the Commission has exercised for the past nine years of not only prescribing uniform reports, but the accounts to be kept, and forbidding any deviation from the pre- scribed classifications, have undoubtedly contributed to a considerable extent to this result. On the other hand, it is to be noted that some of the Commission's instructions have not been based on sound accounting principles. For instance, the classification of construction expenditures, which was in effect for many years, permitted bond dis- count to be capitalized and charged to construction. The latest classification, however, recognizes the force of the accountant's contention that discount is nothing else than in- terest paid in advance and consequently cannot properly be permanently capitalized, and the present classification forbids the capitalizing of discount on bonds. It is gen- erally admitted that the classifications now in force are based on sound accounting principles. 650 AUDITING In England one requirement of the Railways Act is that before a dividend can be paid auditors must certify the semiannual accounts. In recent years the number of American railroads having their accounts audited by public accountants has considerably increased. In time, no doubt, stockholders will insist more firmly on an independent verifi- cation of the accounts submitted by the management, but progress in this direction is very slow indeed. As with all public service corporations, one of the most vital points in auditing railroad accounts is to establish the correctness, or otherwise, of the apportionment of ex- penditures as between capital and income, or, as it is also termed, construction and maintenance. The true condition of a company's operations and finances has probably been more often concealed by either manipulation or lack of good judgment in making charges to capital accounts than in any other one way. In the case of many large railroads the auditor's problem of satisfying himself that the appor- tionment of expenditures as between construction and main- tenance has been correctly made, while by no means en- tirely solved, is somewhat simplified by the fact that construction work is usually done under a department other than the one charged with ordinary maintenance work. The prime consideration in connection with the veri- fication of income, and the one in which an audit of rail- road accounts dififers from an ordinary audit, is the audit of the trafiic earnings. These fall into two general classes, viz., freight and passenger. The principal data from which the trafiic earning accounts are built up are the periodical reports from station agents of freight received and for- warded, tickets sold, etc. Also of importance are reports from "foreign" (other) roads, train conductors' reports of cash fares collected, car records showing the movement of cars out on foreign lines or foreign cars on the com- STEAM RAILROADS 651 pany's own lines. From the last-named records are cal- culated the charge against or credits accruing to foreign roads for equipment ''away from home." An important item of indirect income, i.e., a refund of expenses paid out, consists of the charges to other roads for repairs made to their cars while in temporary use by the company whose accounts are being audited. Shop reports are the usual basis for these charges. In the case of large railroad systems it is manifestly impossible for the professional auditor to examine in any reasonable length of time all the original reports and other data which form the basis of the traffic earning accounts. Also in view of the fact that almost every road has a highly organized auditing department whose duty it is to conduct a continuous internal audit, it is not necessary or even desirable that he should attempt to do so. The sys- tem in force should be carefully studied to make sure that by its use an effective check on the station agents, ticket offices, and others handling funds for the company's account is maintained. Sufficient tests should also be .made by com- parison of original reports with the summaries into which their various totals are carried, etc., to assure the auditor that the system is being faithfully carried out. Reports from station agents, in addition to forming the basis of the traffic earning accounts, are of service in cer- tifying that asset appearing in the balance sheet as "Due from Agents." Every agent makes a report, at least monthly, of the account between the company and himself, showing thereon inter alia the uncollected freight bills and the balance due the company for collections made but not yet remitted. The balance due from each agent per the company's books should be verified by reference to the agent's last report. Frequently the two will not be in exact agreement owing to remittances in transit, suspense items, 652 AUDITING etc. A reconcilement of the book balance with the report should, however, be in evidence. The importance of verifying the balances purporting to be due from agents cannot be better emphasized than by referring to a case which received wide attention in the newspapers a few years ago. The treasurer of a constituent company of one of the largest systems in the country con- fessed to having embezzled over $500,000. While a full explanation of the manner in which the funds were ab- stracted and the defalcation concealed for a period of years was never made public, it was stated in general terms that the treasurer had tampered with the agents' accounts. It would certainly seem that if the internal audit of the agents' accounts had been intelligently and faithfully conducted, the theft could not have been concealed for any considerable length of time. Had the accounts been periodically audited by professional accountants, the embezzlement would in all likelihood either never have begun or would have been detected before the amount had reached large proportions. With reference to depreciation charges, it may be stated that the Interstate Commerce Commission has made them compulsory for equipment, but not for track or structures. It is still optional with the railroad management whether or not any depreciation at all shall be charged for accruing renewals or obsolescence of track and structures. The Pennsylvania Railroad Company sets aside for de- preciation, renewals, and obsolescence, 3 per cent on freight cars and 4 per cent upon passenger cars and locomotives. While the railroad audit includes many other points, some of them of extreme importance, they are not suffi- ciently different from those obtaining in other lines of busi- ness to call for special treatment at this time. Valuable papers on steam railroad accounts were pre- sented by Professor Henry C. Adams (connected with the SHIPPING COMPANIES 653 Interstate Commerce Commission) and Arthur W. Teele, C.P.A., to the Atlantic City convention of the American Association of Public Accountants. They are to be found in the Association's 1908 "Year Book." The following extract from an article in a financial paper summarizes a number of the important points to be covered in auditing railroad accounts : No one doubts that the Bahimore and Ohio of today is a magnifi- cent property. But that is all the more reason why it should seem very strange that some of those who are still in the board should ap- parently have forgotten the experience of sixteen years ago. Early in September of 1896, despite the profit and loss surplus of $23,737,000 then existing, Stephen Little was employed to go over the old Baltimore and Ohio's books. Before the end of that month the announcement that a receiver had been appointed for the company came like a bolt out of the blue. In his report Mr. Little gave the following causes for the Baltimore and Ohio's trouble: 1. The inflation or overstatement of net income. 2. The mischarge of worn-out equipment to profit and loss. 3. The capitalization of charges to income. 4. The capitalization of so-called improvements and betterments of leased lines. 5. The payment of unearned dividends. 6. The understatement of liabilities, etc. Shipping Companies Previous to 191 1 there was no recognized uniform classi- fication of accounts for shipping companies. The Interstate Commerce Commission now provides very comprehensive classifications of accounts for carriers by water under its jurisdiction. Shipping company accounts do not differ materially from those used in ordinary commercial undertakings. However, there are some points in connection with shipping accounts which are of interest. It is customary to arrange them so that the income and expenses of each trip can be stated separately. To each voyage, therefore, its fair share of 654 AUDITING shore expenses must be allocated, besides a proportion of such expenses applying directly to specific vessels but which cover periods longer than a single voyage. The ascertain- ment of such amounts often involves considerable detail. Some shipping companies do business entirely with ves- sels chartered from their owners. The many forms of these hire-agreements, or "charter-parties," as they are called, make it imperative that the auditor should carefully examine such agreements as may still be in force at the time of the audit. The auditor should ascertain that all revenues from freight traffic and passenger service have been accounted for, also all moneys due from the government for mail service and from express companies; that all maintenance expenses have been charged as such, and not included in the cost of vessels; that proper provision has been made for depreciation; that all liabilities have been provided for, also any unearned income; that returns of insurance pre- miums due on account of the ''laying up" of any vessel have been obtained. The Interstate Commerce Commission regulations dis- tinctly require that provisions for depreciation of vessels shall be made. In many cases in the past it was customary not to make provision for depreciation. This was especially so with owners of single ships. The minimum allowance for depreciation should be 4 per cent per annum on freight boats and ordinary pas- senger steamers. On modern boats of high speed and expensive equipment, 5 per cent per annum should be allowed. It will be noted that these rates do not mean a life of 25 years and 20 years respectively, but in the former case 161/2 years and in the latter case 14 years, based on the investment of the depreciation fund to yield 5 per cent per ! SHIPPING COMPANIES 655 annum. As the shipping companies' own bonds are usually available at this rate, it is a fair one to use. Another custom which has become quite general is that of a company's providing its own insurance fund instead of placing all its insurance with underwriting companies. In such cases the amounts which would be paid to the in- surance companies are set aside and a fund created to take care of losses and damages. It is advisable that these amounts should be segregated from other funds and in- vested in securities which have a ready market. All re- pairs and replacements which were the result of perils of the sea and the vessels' proportion of general averages would be paid from this fund. It is quite obvious that only such companies as own a large number of vessels, and can consequently distribute the risk, are really warranted in carrying any part of their own insurance. Even in such cases it is universally rec- ognized that at least a part of each risk should be placed with outside underwriters. Even when the risk is well distributed, it sometimes happens that the total loss of a large vessel in excess of the outside insurance carried will be greater than the amount accumulated in the company's own insurance fund. In such cases the question arises whether it is proper to carry the debit balance of the insurance fund into the balance sheet as an asset. It is sometimes argued that this is legitimate, especially if the amount is not so large as to preclude the possibility of its being eliminated by future credits within a reasonably short period of time. Such an argument is fallacious, however, as the overdraft on the insurance fund has absolutely no value at the date of the balance sheet and in no way benefits future operations, which would be the only justification for entering among the assets an item which has no present value. If it is desired to preserve 656 AUDITING the identity of the insurance fund, even though it has been exhausted, the proper procedure would be to show the debit balance thereof in the balance sheet as a distinct item, but deducting it *'in short" from the Surplus or Profit and Loss account with an appropriate explanation. Electric Railways One of the earliest attempts by an unofficial organiza- tion to secure the adoption of a uniform system of accounts for any industry was made in 1898, when a committee of the Street Railway Accountants' Association of America (now known as the American Electric Railway Accountants' Association) prepared a standard classification of accounts for street railways. Many street railway companies adopted this classification, and it was also prescribed by the railroad commissioners of a number of states for use in preparing reports submitted by railways under their jurisdiction. Several years ago the Interstate Commerce Commission issued a more elaborate classification. As this classifica- tion was devised in consultation with the Railway Account- ants' Association, and has since also been made the basis of classifications promulgated by state commissions, it is largely taking the place of the earlier classification, which had done good service. It should be borne in mind that, excepting in those states in which commissions having authority to prescribe accounting systems for public utilities have adopted the Interstate Commerce Commission's classi- fication, adoption of the latter's classification is obligatory only on such railways as do an interstate business. Even in those classifications which differ from that of the Interstate Commerce Commission, it will be found that the differences are more frequently in details than in any essentials. The grouping of the detailed accounts is well nigh universal into the general classes of: ELECTRIC RAILWAYS 657 Maintenance : Way and structures Equipment Conducting Transportation : Power Operation of Cars General and Miscellaneous The auditor will naturally familiarize himself with the classification in use before beginning his audit. The revenue of an electric railway is largely on a cash basis, the principal exceptions being sales of tickets to city departments or the post-office department or isolated cases of very large ticket users having recognized financial stand- ing, advertising in cars, sales of scrap and other old mate- rial, and, in the case of railways carrying freight, accounts with large shippers having good credit. Traffic sheets are made up for each day showing the different runs and the amount of cash fares, tickets, and passes turned in by each conductor. The totals of these sheets should be traced into the cash book. The traffic sheets themselves should be tested by comparing therewith conductors' reports for days in different parts of the period under review. A further test, which is of a reciprocal nature, is to compare the names of conductors on the pay-roll with the names on the traffic sheets to see that some amount is entered on the latter for each conductor appearing on the pay-roll. While this comparison does not establish the correctness of the amounts entered on the traffic sheets, it would re- sult in the detection of the total omission of the receipts of any conductor. On the other hand, it would reveal any padding of the pay-roll as far as conductors are concerned. Indirectly, it also places a check on the number of motor- men on the pay-roll, as these two classes of carmen should, 658 AUDITING of course, be in a proper proportion to each other. Traffic receipts should be in evidence for every day in the year. Receipts from ticket sales can frequently be verified in total by reference to the serial numbers of the first and last tickets sold during the period. Complications in the shape of tickets in the hands of conductors at beginning and end of the period w^ill sometimes be encountered, but these will usually not interfere with verifying the ticket sales, at least approximately. The earnings from advertising in cars and waiting- rooms are to be verified. Usually this is not a difficult matter. More often than not, a contract for the entire advertising space is made with an agency for a fixed sum per annum. Under such circumstances the verification of the income from this source is exceedingly simple. Miscellaneous receipts from sales of scrap and simi- lar sources will need to receive careful attention. As they are received at irregular times, failure to account for them could more easily escape attention than in the case of regu- lar traffic receipts. All receipts of whatsoever nature should be deposited in bank. No railway with a well-devised ac- counting system permits payments to be made from traffic or other receipts. The treatment of ticket sales in the accounts should receive attention. Theoretically the proceeds of tickets sold may properly be included among the traffic earnings only when the tickets have been collected. Until that time they should appear to the credit of an unearned or deferred income account, which is to be included among the lia- bilities in stating the balance sheets. As the tickets are sold, the receipts therefrom are credited to the liability account referred to, and at regular intervals, say, monthly, transfers are made therefrom to the credit of earnings for the value of the tickets collected. ELECTRIC RAILWAYS 659 In cases where the ticket sales form a very small pro- portion of the total traffic receipts, the outstanding tickets would be a negligible quantity and no great harm will be done if tickets are treated as earnings when sold. With many companies, however, the outstanding tickets aggre- gate large amounts, and it is certainly not correct account- ing to include among the earnings cash received for service which has not yet been rendered to the company's patrons. Attention is also called to the fact that inaccuracies in the gross earnings, due to the inclusion therein of ticket sales before the tickets have been used, are greatest for some time after forms of tickets or methods of selling them have been changed or when special tickets are sold for a limited period. As is naturally to be expected, the most important single feature of the audit of the expenditures is the verification of the apportionment between capital and income. This is frequently a most difficult matter, owing to the fact that the nature of many of the expenditures is identical, whether they be for extensions or for maintenance, i.e., they will be for materials and labor, and the items on their face do not indicate conclusively in which category they properly fall. If a system of recording construction and equipment costs is in use, the auditor will be able to satisfy himself as to the propriety of the construction charges much more readily than when such records are lacking. Unfortunately many companies — probably a majority — do not have such records. The keeping of them does not, as a rule, entail an undue amount of work, and, where not already in use, the auditor should recommend their installation. The es- sentials are that a separate account, usually in a subsidiary ledger, be opened for each distinctive piece of construction work undertaken and for each addition made to the equip- 66o AUDITING ment. All construction charges should find their way into this ledger. In the general ledger the expenditures, store- room charges, etc., would be debited to a controlling ac- count called, say, "Construction in Progress." As a specific piece of construction work is completed, the total shown in the account therefor in the subsidiary ledger would be transferred by journal entry (from the Construction in Progress account to the appropriate account or accounts in the classification of construction accounts in the general books. Under this plan the entries for charges to con- struction accounts show what they are really for and what additions to the company's roadway, structures, or equip- ment have really been made. The total of the expenditures made on uncompleted construction work appears on the general ledger in the Construction in Progress account, and the details may be referred to in the construction cost ledger. Where construction records have not been kept, the audi- tor will find it necessary to consult with the company's engineer and use such other means as are available to get definite information as to just what has been accomplished by the expenditures charged to capital accounts. Having supplemented in this way the data furnished by the books, he will then have to decide whether the company was war- ranted in charging the expenditures against capital rather than against earnings. Depreciation of plant — or, if the word "depreciation" has an unpleasant sound, the term "accruing renewals and replacements" may be substituted — is a most important sub- ject in connection with electric railways. Up to a few years ago railway operators, and especially promoters, would not admit that there was any necessity whatever for the inclusion of depreciation charges in the operating accounts. Their stock argument was that the franchises increased in ELECTRIC RAILWAYS 66 1 value more rapidly than the physical property deteriorated, and consequently there was no depreciation in the property as a whole. The fact that the increase in franchise values would not produce funds wherewith to make replacements when they were finally needed was ignored. Since the re- peated puncturing of this fallacy by the bankruptcy of com- panies which proceeded on such an unsound basis, railway operators have reluctantly come to admit the necessity for taking account of depreciation, until at the present time practically all engineers of high standing consider it as an item of operating expense. It is a satisfaction that the correctness of a principle for which at one time almost no one but accountants contended has at last been recognized. In cases where companies have not made any allowance for accruing depreciation, the auditor is not warranted in giv- ing a certificate unless it contains a qualification plainly calling attention to the omission of depreciation allowances. Fortunately, qualified certificates are becoming unpopular. So-called reconstruction expenditures, when no depre- ciation reserve has been provided against which they can be charged, sometimes present a perplexing problem. Fre- quently they are the result of the omission over a period of years to make renewals as they are needed, and thus, when extensive expenditures for the rehabilitation of the property are finally imperative, they really represent an ac- cumulation of long-deferred maintenance charges. It is manifestly unfair to charge the entire amount of the ex- penditures against the operations of the particular year in which they happen to be made. On the other hand, if they are but accumulated maintenance charges, the mere size thereof does not justify capitalizing them. Then, too, the problem is usually complicated by the fact that the expendi- tures usually result in some increase in the carrying capacity of the road. The worn-out rolling stock is replaced with 662 AUDITING larger units, heavier rails are laid, and power-plant equip- ment of increased capacity is installed. The proper treatment of reconstruction charges is to charge to capital such part thereof as represents an in- creased value in the reconstructed part of the property over the original cost of the property replaced; such part of the expenditure as represents a fair or normal annual main- tenance charge should be debited to operating; and such part as represents the making good of neglected mainte- nance applying to prior years should be treated as a special charge against profit and loss. When such reconstruction expenditures are made by a company after the purchase of a dilapidated property, it is assumed that in fixing the purchase price allowance was made for the expenditures required to be made to place the property in good operating condition. Consequently, under such circumstances the entire amount of the reconstruction expenditures is considered to be a proper capital charge. It is to be borne in mind that especially under such circum- stances it is essential that depreciation allowances be in- cluded in the accounts. Otherwise, with the abnormally low maintenance expenditures which will naturally follow during the first few years after extensive reconstruction, the showing of net earnings will be misleading. It should be borne in mind that there is danger in capi- talizing charges for betterments which do not increase earn- ings nor decrease operating expenses. On the other hand, in view of rate regulation it is not safe to wipe off all such expenditures. The situation can perhaps best be met by capitalizing the charges and segregating a liberal propor- tion of the surplus to prevent the payment of unwarranted dividends. The liability for unsettled damages to persons and prop- erty always needs to be thoroughly investigated. In prac- ELECTRIC RAILWAYS 663 tically all cases some suits will be found to be under way or threatened, and in addition, consideration should be given to all accidents for which releases have not yet been obtained, even though suit has not been entered. Large companies have a special claim department, from which the desired information can be obtained, and for smaller com- panies a letter from the company's attorney should be ob- tained stating all unadjusted claims and the probable cost of settlement. Many companies create an accident reserve by crediting to such an account and charging to operating expenses a certain percentage of the gross earnings. Payments in settlement of claims are charged against the reserve. This plan is preferable to that of charging accident payments directly to operating expenses, as it equalizes the charge to successive fiscal periods and, if the charge is ample, creates a reserve for those claims which are unsettled at the end of each period. The plan must be intelligently used. Some companies use too low a percentage and carry the resulting debit balance in the reserve account along from one period to another as a deferred charge to operations. Obviously, payments for accidents occurring in one period are not of the slightest benefit to the operations of a future period, and if a debit balance develops in an accident reserve account, it should be forthwith written off. Such a condition is some- times due to an unusually serious and costly accident, which is not likely to occur again soon, and it may not be necessary to raise the percentage of gross earnings credited to the accident reserve. As already stated, however, the overdraft in the reserve account should be immediately written off, as it is not an asset in any sense of the word. The New York Railways Company sets aside between 7 and 8 per cent of the passenger revenue for injury and damage claims and expenses of litigation. The company 664 AUDITING has come to the conclusion that it usually takes five years to liquidate and extinguish completely all liability for acci- dents in a given year. The extensive development of the interurban electric railway field during the past decade has resulted in condi- tions which in some respects are perhaps even more analo- gous to those of steam railroads than to those of the city electric railway. With considerable mileage, a large freight and express business, graduated rates of fare for passenger traffic, etc., an efficient auditing department as a part of the company's organization is a necessity. This department will naturally audit the details of the company's operations, and the professional auditor's duty with respect to this part of the work will ordinarily be limited to such tests and in- vestigation as will satisfy him that the prescribed system is being followed and that the client's interests are safe- g^iarded in every way possible. Taxicab Companies In auditing a taxicab company, the procedure would be much the same as for an ordinary manufacturing com- pany, excepting the verification of its chief source of income — the charges for service rendered. The taxicabs, as the name indicates, are equipped with taximeters. These show both the total mileage and the revenue miles, i.e., the mileage run during the time the cab is carrying passengers. Most companies keep what is called a master's sheet or some record showing the car number, the time out and in, and the reading of the meter, both as to revenue and total miles. When the cab leaves the garage, the reading is entered on the sheet, and on its return, the reading is again taken and entered alongside of the first or "out" reading. The difference in the revenue miles reading represents the TAXICAB COMPANIES 66s revenue miles run and has to be accounted for by the driver of the cab, either in cash or by proper evidence of having carried a charge customer. With the larger companies most of the calls originate at some hotel or at a stand where there is a starter employed by the company. It is the starter's duty to determine whether or not the customer has an account, and if so, he signs a ticket which is given to the driver, so that the driver turns in either cash or tickets for all fares. By most companies any shortages are deducted from the drivers' wages. Each driver is provided with a daily card, which should show the same mileage as the master's sheet, but in addition gives the details of the call. The cash received from this source is entered in a cash-fares column in the cash book and the charges are posted from the tickets to the customers ledgers, the total being posted through a journal to the general ledger. In some cases these charges are written up on sheets, or a journal, and posted to the ledgers there- from. It would not be practicable for the auditor to check the accuracy of all of the entries, but a thorough test should be made for a certain period. The total cash fares and charges should be checked with the drivers' cards. The mileage shown by the drivers' cards should be checked with the master's sheets, and the ''out" readings of the mileage should be compared with the *'in" readings of the previous day. The latter is important, as it would be an easy matter, if collusion existed, for the starter at the garage to add several miles to the *'out" readings or to deduct several miles from the "in" readings, which, if the driver used the same figures on his card, w^ould give him less mileage to account for. Many companies keep mileage records. Where this is not done, it w^ould be well, in connection with the checking of 566 AUDITING the master's sheets, to make a hst of the mileage, both revenue and total, and compare the ratio of the one to the other for the period investigated. There are many expenses which should vary directly as the mileage. Tires sometimes are rented on a mileage basis. Using the mile as the unit and stating the earnings and expenses per mile, especially when such results can be compared with the results of another period, enables the auditor to uncover many dis- crepancies. In the verification of the pay-rolls, disbursements, pur- chases, sundry sales of gasoline and supplies, storage, etc., the procedure should be the same as in any other business. Depreciation is an important item, but it should be borne in mind that a good taxicab can be renewed in large part, and where tires and motors and other repairs are being charged against operations, a reserve of only 15 to 20 per cent is sufficient to cover all depreciation in a going concern. As an illustration of the accounts to be found in a taxi- cab company, the following form of balance sheet and state- ment of earnings and expenses is presented : The Taxicab Company Statement of Earnings and Expenses For the Month of June, 1915, and for the Six Months Ended June 30, 1915 Earnings Six Months Month of Ended June, 1915 June 30, 1915 Motor Car Earnings $. Miscellaneous Earnings $. I TAXICAB COMPANIES 667 Deductions : Refunds and Allowances. Net Earnings $ $. Expenses Vehicle Operation $ $. Garage Operation Maintenance Rent and Insurance Taximeters Hired Equipment Licenses Commissions Free Riding General Expenses % $. Reserves : Motor Cars Equipment Repair Stock Injuries and Damages. Bad Debts Chauffeurs' Clothing. . . Total Expenses $ $. Current Operating Profit: Motor Department $ $. Additions to Income : Interest on Deposits Discounts Earned Total Income $ $. Deductions from Income: Interest on Bonds $ $. Interest on Notes Discount on Bonds Organization Expenses Total Deductions $ $. Net Profit $ $. 668 AUDITING ^4 ^»o ^^ .i «^ ^ ^Q m- w-[[ <«■ <«-[|<«- w- <4- ' ' ' ^ w- w- m (A ca (U .O O 1^ 1> o c 3 Q^ Cfl 4* C E c ^z; c/5 w P S -O • -5 c O o ^m c - o - • » - c« t« (X, t— 1 3 ^ (I> p >» ii ' < n • • a, o X tf) W «5 • >, E CO 1-1 - €«■''* <«- (A m- infO . o\ w « Bank $. shier (Receipts Not Deposited) tty Cash Funds £6& u CO C 43 3 OS to C 3 3 H U c/3 1^ U ft ft 3 O ■*-> c > o U u S 3 ^ .. o c ^^ I Q TAXICAB COMPANIES 669 CO <^ s ^ ^ 'o o o *. ^ H So C/3 U 5 t O • • 2 to 'O t ^ rt bo 5^ • "J •^ -t-> rt o O rt c/) P4 O H s I <3 1^ OJ C/J • • • • C ^-t * Oi ii V < ^ TJ 5 :: s 3 !l So< •^ fi bo ct S *^ 2 o« t. to II (U (A V (A c CO 4; X T, u J (^ H W P to a u .. O C rt rt H «-. u. g.O c^ O W Vh u c +J X s (U 582 AUDITING Total Debit Date Paid Amount Paid Rental Toll and Messenger Rebate The toll and messenger charges should be divided at the end of the month, as well as the rebate for poor service and the bad debts written off. Two colors of ink are usually employed to mark the distinction in the items. Depreciation The Railroad Commission of Wisconsin has issued a text-book on a system of accounting for telephone com- panies, which should be consulted by those interested in telephone accounting. ' Depreciation is covered by the fol- lowing instructions : Depreciation Reserve. This account shows the balance set aside for depreciation available for the replacing and rebuilding of the plant. There is a certain wear and tear taking place in a plant which cannot be made good by ordinary current repair, and it is against this that the reserve for depreciation is made. The reserve shruld be made at such a rate as will entirely wipe out the asset over the period of its probable life. It has been held that in a moderately large exchange an allowance of 7 per cent per annum is sufficient to take care of all depreciations, but in a small exchange an allowance of from 8 to 10 per cent should be made. If depreciation is not taken care of by means of a reserve fund, then the cost of renewing or reconstructing must be charged to operating expense as that work is done, which has the effect of not providing proper comparisons of one year with another. The years in which little reconstruction work is done show profits in excess of the actual profit, since no provision has been made for the depreciation or deterioration of the plant which actually took place during these years, and, on the other hand, the years in which a great amount of reconstruction work is required to be done show profits greatly short of the actual profits, since the depreciation and deteriora- tion of the plant which took place in earning the profits shown in previous years has been burdened on to them. It is thus to show the TELEPHONE COMPANIES 683 accurate result of the operations that this account is established, and its operation is as follows : At the close of each month this account is credited and Account No. 76 debited with one-twelfth of the yearly amount of depreciation, which is based upon a fixed percentage of the amount invested in the plant. This account now being set up so that it will exactly represent the amount of the investment in the plant when the plant has been worn out, it is proper to charge against it the net cost of such renewals, replacements, and extraordinary repairs as will increase the life of the plant. The net cost of any such item is arrived at as follows : The original cost of labor and material in the part replaced, The cost of removing same. Less the scrap value of the parts removed, this amount being charged to Depreciation Reserve Account No. 42 and credited to the relative accounts as explained under Account No. 6. The cost of the new work is charged directly to the appropriate plant account. Such ordinary current repairs as do not necessarily increase the life of the plant should be charged to Maintenance. The depreciation account is not designed to take care of such con- tingencies as extraordinary destruction by storms, and the cost of repairing such damages is chargeable as follows : All charges in connection with repairing the damage may be charged to Account No. 31 and the scrap value of all salvage will be credited to this account. When completed, an inventory of the actual value of the new line should be made, together with the original value of the line rebuilt. Then Account No. 31 should be debited with the amount by which the original value exceeds the rebuilt value and Plant Account credited, or if the rebuilt value is greater than the original value, then Plant Account should be debited and Account No. 31 credited with the amount of the increase. An examination should then be made of the Depreciation Reserve Account and such sum as may have been set aside as depreciation on the line rebuilt, after deducting any amounts which may have been charged to Depreciation Reserve Account for renewals on the rebuilt line, should be charged to Depreciation Reserve Account and credited to Account No. 31. When this has been done, Account No. 31 will show the exact loss from the storm and this amount can then be charged off to Account No. 11, either in one sum or in equal monthly instalments, covering such period as may be decided upon. 684 AUDITING The agitation for appraisals of public utility companies has made it necessary for telephone companies to keep more detailed records of construction items. In addition there has been a close scrutiny of construction and expense charges. The following figures prepared by an expert for the New York Telephone Company as of June 30, 1914, illus- trate some of the items which would be included by this company in its appraisal : Telephone Plant (as per Tax Records revised) $73,889,507 Plant in Service, but Bills Not Rendered to the Telephone Company 300,000 Liability Insurance 621,000 Telephone Directories, Library, Working Records, etc 773,068 Working Cash Capital 3,000,000 Total $78,583,575 Overhead Charges (Executive Administration, Engineering, Interest, Taxes, etc.) 14,785,000 Contingencies and Omissions 3,694,475 Training Operators 678,340 Selling Service 2,184,544 Total in New York (exclusive of "Non-Physical Values" and of the Empire City Subway Company) $99,925,934 CHAPTER XXVI I J I SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS (Continued) MUNICIPAL Before outlining the procedure which an auditor should follow in auditing the accounts of a municipality, it will be well to outline briefly the methods by which cities are financed and to say a word about municipal organization. Preparation of Budget A time-honored custom of municipalities and other gov- ernmental bodies is that no money may be spent for any purpose whatsoever unless the expenditure has been first authorized. This means that revenues or other funds must be appropriated for specific purposes by the proper authori- ties. The method of authorizing expenditures and appro- priating funds is usually provided for in the city's charter or by state laws. The usual procedure in appropriating revenues is somewhat as follows : Some time before the beginning of the fiscal year the mayor or chief financial officer requests the head of each department, bureau, or office to prepare a detailed estimate of the amounts of money that he will require to meet the expenditure of his depart- ment for the ensuing year. These estimates are usually collated by the chief financial officer. In some cities they are examined by comparison with departmental records, as they should be, but in most cases they are not. The financial officer also prepares an estimate of the revenues from sources other than general taxes that will probably be 685 586 AUDITING received during the ensuing year, basing the estimate on the experience of previous years. These estimates of expendi- tures and revenues which constitute what is coming to be called the "tentative budget" are then submitted to the council, board of commissioners, or other authorizing body for action. Fixing the Tax Rate After the amount which is to be authorized for expendi- ture has been determined upon, the amount of estimated revenues is deducted therefrom in order to ascertain what amount must be raised by general taxation. This amount, divided by the total assessed valuation of property, gives the tax rate. Authorization of Expenditures These facts having been determined, they are embodied in an ordinance, usually called the budget ordinance or appropriation bill, which is voted by the appropriating body. The charters of most cities provide that the ordinance shall be approved by the mayor. The funds thus appropriated usually provide only for meeting the current operating and maintenance expenses of the city. Funds for permanent improvements and other property which has a continuing value are generally raised by selling bonds which in most cases run for a long term of years. These bond issues must be authorized by the appro- priating body, and sometimes action by the state legislature is necessary. Funds so raised must also be appropriated for specific purposes. All amounts appropriated are represented by accounts in the books of account, and all amounts payable therefrom are charged to them. The auditor should have a copy of the city charter at hand, and before proceeding with the audit MUNICIPAL 587 should acquaint himself with the provisions relating to finances and accounts. Business Departments of a City All cities except the very small ones have a finance de- partment and a treasury department, which together handle the general financial business of the city as a whole. The most important of these is the finance department. This is, or should be, the central ofifice of financial and accounting control. The official in charge is sometimes called comp- troller, sometimes auditor. In commission cities he is called the commissioner of finance, and in the very small cities the functions of the office are performed by the city clerk. He keeps all the general accounts of the city, audits all claims against the city for payment, and performs such other duties pertaining to the finances of the city as may be specified in the city charter. He is usually an elected officer. The treasurer is sometimes elected, but more frequently he is appointed by the mayor or the council. He is custodian of the city funds, receives all revenues, and pays all claims against the city on the order or warrant of the chief financial officer. His accounts should be under the accounting con- trol of the finance officer, although in some instances this control exists in name only. In very small municipalities the treasurer frequently keeps all of the books. The various operating departments are managed by offi- cers, usually called either commissioners or directors, ap- pointed in most cities by the mayor. Those common to nearly all cities are the health, public safety, public works, and public charities departments. There are frequently de- partments for other functions according to circumstances. The bulk of expenditures is incurred by these departments. Usually each has its own purchasing agent, although a few cities have central purchasing departments. Most cities en- 588 AUDITING deavor to make their purchases chiefly by letting contracts, though in practice it is found necessary to make many pur- chases in the open market. Invoices and pay-rolls are usually prepared for payment on vouchers which are certified by department heads and their subordinates and submitted to the financial officer for audit and payment. Sources of Revenue The chief sources of revenue of cities are the general taxes levied annually on the taxable real and personal prop- erty within the city. There are many other sources of revenue, among which may be mentioned the following: Water rates Excise taxes and liquor licenses Franchises Licenses Permits Privileges Rents Market fees Market rents Tolls Fees Court fines and penalties Court costs and fees Sale of old material Interest Control of Receipts and Expenditures The general theory of control over city revenue is that for all moneys paid into the city treasury there shall be an independent report made by the collecting office to the finan- cial officer, from which he can build up a record of cash receipts for the purpose of establishing a controlling account MUNICIPAL 689 against the treasurer. The means of control over cash pay- ments made by the treasurer originate with the financial officer, since it is only upon the order or warrant of the latter that the treasurer can pay out money. The treasurer's cash account can be reconciled with the comptroller's cash account by taking account of the warrants not yet paid by the treasurer's cheques. In many cases, however, the treas- urer draws cheques on the same day on which the warrants are drawn, so that his cash account is, or should be, always in agreement with the financial officer's account. Few cities have adopted methods by which control may be established over the amount of revenues that should ac- crue. This can be done absolutely only by the use of con- trolled financial stationery* issued to collecting offices by the chief financial officer. This stationery should be so man- ufactured as to be difficult to imitate, and should be num- bered and charged to the collecting agents, who must account for it either in money or unused forms. A system should provide for daily and monthly reports of collection, the daily reports to the financial officer to be accompanied by skeleton carbon copies prepared at the time the original document is issued. At the same time daily reports of collections are made to the treasurer, who, after making the necessary entries in his books, acknowledges the receipt of the cash on the reports and transmits them to the finance officer. The latter audits the treasurer's reports by means of the collecting agents' reports and the carbon copies above referred to, thus establishing a current control over the accuracy and completeness of revenue returns. The accounting methods of most municipalities are crude and archaic, few of them having kept pace with the modern •This is similar in form to the money orders used by the post-office department. The cutting of the dollars and cents on the margin controls the amount to be accounted for by the receiving clerk. The unused portion of each piece of stationery is preserved as a voucher. 690 AUDITING improvements in accounting practice. Their bookkeeping consists mainly of accounts showing the condition of appro- priation accounts and the inflow and outgo of cash. Ac- counts on the basis of revenue accrued and expenses incurred are the exception, and accounts showing assets such as taxes and other revenue receivable, stores, equipment, and other permanent properties, are either not understood or con- sidered wholly superfluous by all but a few cities. Periodical Examinations The following extract from "Short Talks on Municipal Accounting and Reporting," issued by the Metz Fund, August 15, 1912, is of interest: As a means of insuring continuous conformity to the authorized procedure, it is a good plan to have the accounts audited and the pro- cedure inspected periodically, once or twice a year, by a competent representative of the comptroller's office, or, if necessary, by an outside accountant. In addition to establishing the integrity of the accounts (if they are correct), such an inspection will determine not only whether the procedure is being scrupulously followed, but will afford the examining accountant an opportunity to suggest modifications or improvements which may be needed as conditions change with the lapse of time. In this relation it may be of interest to quote from a letter received by the Metz Fund from the comptroller of a large New England city. He writes : "We are having an audit conducted in this city of the comptroller's records and of other department records in so far as they relate to the comptroller's records. Some criticism has arisen as to the need of such a step, some maintaining that it is an audit of the auditor and that there should be no need for such a proceeding. While I do not expect you to decide a controversy, yet I consider that a talk on such a subject would be of interest to citizens and officials throughout the country." It is true that many persons not concerned with the active manage- ment of business do not see the necessity of an independent audit made by an outsider. But the experience of thousands of enterprises has so conclusively demonstrated the wisdom of such a procedure that the subject is no longer debatable. A large proportion of well-conducted private concerns, even though their regular office staff includes an MUNICIPAL 691 auditor or a comptroller, have periodical examinations of their accounts made by professional auditors, and the proportion is constantly increas- ing. They have learned that the moral effect of an audit on the office staff is salutary; that many a man who, if left to his own devices, might misappropriate funds and falsify the accounts to conceal the misappropriation, would absolutely be deterred from so doing if he knew that an audit of the accounts would be made which would mean exposure. Even the employee who does not have the handling of funds will do his work better if he knows that he may be criticised by an outsider. The inside auditor, from too close contact, loses his ability as well as his disposition to criticise, hence the outside auditor is needed to supply this deficiency. The professional accountant, moreover, by reason of his contact with the affairs and problems of many widely different concerns, is in a position to make valuable suggestions as to the accounting methods, organization, and business policies of his client, and such service has frequently bridged the gap between failure and success. The need for independent audits is even greater in public business, where tenures of office are frequently of short duration and where there are not the same influences at work which make for strict accountability in private business. There is no reason why systematic audits of municipal accounts should not be made by a properly equipped state department. Audit of Revenue The auditor should carefully examine the method of control over the revenues, and if it is adequate in principle, he should make tests to satisfy himself that all the revenue to which the city is entitled has been accounted for. If the method of internal check does not sufficiently safeguard the city's interests, his judgment must be guided by circum- stances. He must adopt such a procedure as will be neces- sary to satisfy himself that the cash turned in is the amount collected, and that the amount collected is the amount to which the city is entitled. Taxes As general taxes constitute the major portion of the revenues, he should pay particular attention to the method of accounting for them. He should ascertain whether the 692 AUDITING uncollected taxes recorded on the tax rolls agree with the summary or controlling account in the general ledger. He should see that abatements made are authorized and should make tests to ascertain that the proper amount of interest and penalties has been collected on past-due taxes. He should notice whether alterations have been made in tax assessments in the tax roll and should make sure that all alterations are authorized. The laws of most states provide that when taxes are in arrears a certain length of time, the tax liens (in some cases the property itself) shall be sold by the city to indemnify it for the taxes unpaid. The auditor should make a note of all taxes in arrears in respect of which the city has not availed itself of its prerogative thus to indemnify itself. Assessments Assessments due the city for improvements, such as sewers, grading and paving streets, etc., benefiting particu- lar properties, should also receive attention. In most cases the city undertakes these improvements, financing them by borrowing on public improvement or assessment bonds and then assessing the property benefited to recover the amount spent. Frequently the city bears a percentage of the cost. The auditor should look into the condition of assessments levied to see that they are accounted for in cash or accounts due, and whether the conditions attaching to the assessments are being complied with, such as the payment of principal within a stated period, interest, penalties, etc. Rents and Franchises The auditor should see that rents for all properties of which the city is lessor are accounted for, and that the in- come from all franchises granted by the city has been accounted for. MUNICIPAL 693 Audit of Outstanding Accounts The general theory of verifying accounts receivable by sending confirmatory statements to debtors may properly be applied in the audit of municipal accounts. Such a plan would be particularly useful in verifying unpaid taxes, and in many cases would probably be fruitful of results, al- though there will probably be somewhat more difficulty in reaching persons so indebted than ordinary trade debtors. Audit of Property and Equipment The auditor should not neglect to audit the property and equipment held by the municipality. In many cities inven- tories are kept of the property and equipment, and it is a simple matter to see that the additions are properly recorded and also to ascertain whether the deductions represent prop- erty sold, junked, or condemned. It has been said that in a large Eastern city a steam yacht worth $10,000 was stolen and never recovered; in another city an automobile disappeared mysteriously. Where the city property is not completely inventoried it is the auditor's duty to see that no time is lost in doing so. Audit of Expenditures The method of internal audit of claims against the city should be carefully inspected. All vouchers should be ap- proved by the heads of departments in which they originate and should be certified by the subordinates who have knowl- edge of the facts as .to delivery of goods or performance of services, quality, prices, correctness of calculations, etc. If vouchers are by law required to be approved by the council or a council committee, the auditor should see that this rule has been complied with. Payments of an unusual character, such as judgments, damage claims, etc., should be carefully scrutinized. Particular attention should be paid to pay-roll 694 AUDITING vouchers to see that they are not ''padded." Usually the salaries and number of incumbents of all positions other than those of laborers are fixed by the council. Tests may be made by reference to the council's resolutions relating to these matters. Payments of bonds and bond interest should be carefully scrutinized and audited by reference to can- celed coupons and bonds, or, in the case of interest on registered bonds, to the record of bonds outstanding. Tests of prices paid for supplies, particularly those used in large quantities, such as coal, forage, etc., will often reveal improper methods of administration. For example, it will sometimes be found that one department buys coal at one price and that another department pays the same con- tractor considerably more for the same kind of coal at the same season of the year. The charters or ordinances of most cities fix the maximum amount which may be purchased on open order, requiring that purchases exceeding this limit be made by public letting of contracts. This rule is frequently violated by "splitting" orders among favored dealers, keeping each order within the lawful limit, the result of which is that the city pays very much higher prices than it would have to pay if it obtained competitive bids. Since expenditures can be made only from appropriated funds, the auditor should see that claims have been charged to the proper appropriation accounts. He should report all appropriations which have been overdrawn. Sinking Funds The adequacy of sinking fund provisions should have careful consideration. It is astonishing how many cities fail to lay aside regularly money which will accumulate and be sufficient and available to pay off bond obligations at maturity. In order that the burdens growing out of the acquirement of properties of a more or less permanent char- MUNICIPAL 695 acter may be to some extent distributed over a period of years, cities finance these acquisitions by issuing long-term bonds, the plan being to raise by taxation and set aside each year in a sinking fund an amount which, with interest accretions, will be sufficient to retire the bonds at maturity. Rarely are these yearly sinking fund instalments computed correctly; indeed, in some instances they are not raised at all. In some states the amounts which cities are required to pay into sinking funds yearly are fixed by law, a certain percentage of the total issue of bonds being specified, while the charters of some cities provide that revenues from cer- tain sources shall be turned into the sinking fund. Some- times this causes the sinking funds to be in excess of re- quirements, which means that taxpayers are bearing a heavier burden than is necessary. Sinking fund require- ments should be computed on the basis of actuarial tables, and a reserve should be built up by additions each year, which will at all times show what should be in the sinking funds to date. The auditor should ascertain whether the amounts in the sinking funds in cash and securities equal the actuarial reserve. If there is a deficit he should call particular attention to the fact. Financial Statements The financial condition of a municipality is more easily understood if its transactions are summarized according to the several groups into which they naturally fall and finan- cial statements prepared accordingly. The accounts growing out of the raising of current revenues and the incurring of liabilities to meet current operating and maintenance expenses constitute the general account, or the general fund, as it is frequently called. At the end of the fiscal period these transactions are reflected 696 AUDITING in a balance sheet of the general account and a statement of revenues and expenses. The assets and liabilities of the general account may thus be related to a statement of revenues and expenses as in any private business. The principal items of assets are cash, taxes, and miscellaneous revenues receivable, stores, v^ork in progress, and prepaid expenses. The principal liabilities are invoices and pay- rolls payable, vouchers and warrants payable, and temporary loans made in anticipation of the collection of taxes and other revenues. The second natural division or group has to do with the permanent properties and equipment of a city, construction and improvements in progress, including assessments levied against property owners who are benefited by improvements. The liabilities relating to this group are invoices and pay- rolls payable, assessment or special improvement bonds, and funded debt. These constitute the capital account balance sheet. The third natural division has to do with the funds and properties held in trust by the city, such as intestate estates, bequests, security deposits, pension funds, etc. The condi- tion of these trusts is shown in a trust fund balance sheet. The fourth group comprises the appropriation fund ac- counts, which are set forth in a fund balance sheet. These show the condition of appropriated funds and the contingent liabilities of the city on contracts and open orders, the latter being charges or encumbrances against appropriated funds which have not yet become actual liabilities. Opposed to these items are shown the resources, present and prospective, which are looked to for the liquidation of the liabilities. These several detail balance sheets are brought together in a summary consolidated balance sheet in order to give in a single statement a complete view of the city's finances. MUNICIPAL 697 General Account Balance Sheet (Exhibit 2, page 706) Accounts Receivable — Unpaid Taxes. This is supported by the uncollected items in the tax rolls, or tax duplicate, as it is sometimes called. Provision for uncollectable taxes should be made currently by including in the annual budget of expenses a percentage of the tax levy sufficient to cover the estimated loss in collection. The product of taxes levied in the year will thus be sufficient to meet all expenses author- ized for the year. Miscellaneous Revenues Receivable. This account is supported by the revenues receivable ledger and includes various uncollected charges. Due from Other Funds. This account is charged with cash temporarily loaned to the capital account or to trust funds. It is credited when cash is returned or when cash is borrowed from these funds. Stores (which should be supported by stores ledgers). Are shown in the general account balance sheet and not in the capital account balance sheet, since in the main they are used for meeting current operating and maintenance ex- penses. If any stores are used for construction purposes, a charge for them is made to the Capital account the same as if cash were advanced. The reserve for stores among the liabilities is merely a device to keep them from being represented in the surplus. Stores and other prepaid items are not available for meeting contingent liabilities which may exist or which may be incurred against appropriated funds, and hence, to find the balance of assets available for further appropriation, they are excluded from the surplus. Temporary Loans in Anticipation of Taxes. Many cities are obliged to borrow money for short periods, pending the collection of taxes and other revenues. In consequence, temporary loans are made which are a lien against these 698 AUDITING revenues. They should be paid off when the collections are made. Capital Account Balance Sheet (Exhibit 4, page 708) Cash. Is held exclusively for meeting liabilities incurred in the acquisition of property having a continuing value, such as lands, buildings, equipment and improvements. It is obtained by issuing long-term bonds and by the collection of assessments. Assessments Receivable. The amounts due from prop- erty owners whose property has been benefited by local improvements, such as the paving of streets, the building of new sewers, etc. They are frequently made payable in instalments. This item is supported by individual accounts in the assessment rolls or assessment ledger. Local Improvements in Progress. Represent current expenditures for grading and paving new streets, building sewers, etc., the cost thereof being assessable against prop- erty deemed benefited when the improvements are completed, at which time this account is credited and Assessments Re- ceivable debited. Coincident with this entry. Permanent Improvements account is charged and Capital Account Sur- plus is credited. It frequently happens that the city is obliged to stand some portion of the cost of the improve- ments. This is the case when city property is benefited by them or when the city at the outset agrees to bear a per- centage of the cost. When the city's share is determined, long-term bonds are usually issued to meet it. At the time Permanent Improvements account is charged as noted above, Capital Surplus is credited for the amount assessed against taxpayers only. Local Improvements in Progress being credited with the amount to be borne by the city. Other Accounts. When among the assets, will be readily understood by their titles. These items should be supported MUNICIPAL 699 by detail ledgers showing the various individual properties owned by the city. The rule in regard to depreciation of assets may be applied in municipal accounts as in the accounts of private concerns, with one exception. The best authorities suggest that instead of creating a depreciation reserve by a mere bookkeeping entry, the depreciation charges should be in- cluded in the annual budget of expenses and the cash raised and invested in a fund. At the end of the period estimated to be the life of the property, this fund would contain an amount sufficient to replace it, and the property would thus be automatically perpetuated. The argument advanced against this practice is that it entails a double charge against taxpayers, namely, the annual depreciation charge and the annual sinking fund instalments provided for the retirement of the bonds sold to purchase the properties. In some cases at least, it is a question whether, when a public work has outlived its usefulness and an entire reconstruction is in order, there should not be a new issue of bonds for the rebuilding. In this way the cost of the improvement may be spread over its life, and each generation of taxpayers made to bear the burden of the improvements it enjoys by a single charge for the annual sinking fund instalments. As a matter of actual practice, however, depreciation of municipal properties is seldom provided for. Assessment or Special Improvement Bonds. Represent the bonds issued to finance assessable improvements. They are shown under a separate head so that they may be con- trasted with assessments receivable which are available for meeting them. Bonded Debt. Instead of showing sinking fund cash and investments among the assets of the Capital account, they are shown as a deduction from bonded debt. This admits yOQ AUDITING of Stating them In a supplementary statement (sinking fund balance sheet, Exhibit 5, page 709) in relation to the "Re- serve Required to Meet Bonded Debt at Maturity." As has been previously pointed out, the most important fact to be set forth in connection with sinking funds is the amount that should be on hand in cash and investments at any given date. This can be done only by building up a reserve on an actuarial basis, adding to it each year an amount equivalent to the amount of cash that should be provided each year, which, accumulated to the maturity date of the bonds, plus interest accretions, will yield an amount equal to the amount of bonds to be paid off. If an amount of cash commensurate with the yearly reserve (allowing for interest accretions) is not provided each year, the inadequacy of the sinking funds will be disclosed by the excess of the reserve account. In other words, there will be a deficit in the sinking funds. Trust Fund Balance Sheet (Exhibit 8, page 710) Cash, Securities, and Investments. Are supported by detail ledger accounts showing how the trust funds are in- vested. The assets are not necessarily earmarked according to the several trusts represented, though they may be. Obviously the character of the securities is of importance. It might be advisable to list them on the balance sheet. Invoices Payable, Vouchers and Pay- Rolls Payable, Warrants Payable. Are the current liabilities of the trust accounts. The number of separate general ledger accounts to be kept will depend somewhat upon the precise methods employed for handling transactions. Reserve for Public and Private Trusts. Under this head are summarized the various trusts assumed by the city. Each individual trust is represented by an account, and if there are many of them, as is usually the case in large cities, these accounts should be carried in a subsidiary trust fund ledger. MUNICIPAL 701 Current Operation and Surplus Account ( Exhibit 3, page 707) As an adjunct of the general account balance sheet it is necessary to show ( 1 ) the revenues and expenses for the fiscal period, and (2) the present condition of the surplus of the general account. Revenues should be summarized according to sources, and expenses according to purposes. For the latter, it is suggested that the functional classifica- tion adopted by the United States Census Bureau be em- ployed. This classification divides the expenditures of a city under the following significant headings, viz., general government, protection to persons and property, conserva- tion of health, sanitation, highways, charities, correction, education, recreation, interest, and miscellaneous. The financial statements thus far discussed represent what may be called the proprietary relations of a city, that is, what the city owns and what it owes and the results of current operation. These statements are in every respect analogous to those employed in private business. We shall now discuss the statements that show the funding relations of a city, namely, those which have to do with the restric- tions placed upon public officers in the expenditure bf funds. There are two main categories of funds — those de- rived from taxation and those obtained from the sale of long-term bonds. A statement of the former is an adjunct of the general account balance sheet, whereas a statement of the latter is an adjunct of the capital account balance sheet. Fund Balance Sheet— General Account (Exhibit 6, page 709) An analysis of the items appearing on the credit side of this statement will facilitate the understanding of it. When the appropriating body authorizes the amounts which may be expended (budget), it is necessary to establish accounts ^02 AUDITING in the books so that officers may know at any time the amount of authorized funds available for expenditure and so that they may know when they have reached the limit of expenditure. An entry is therefore made in the general ledger crediting "Appropriations" or ''Authorizations to Incur Liabilities" for the amount authorized. Detailed ac- counts showing the various purposes of expenditure are opened in a subsidiary ledger. Under the rules of double- entry bookkeeping some account must be charged, and since the appropriations are predicated upon revenues which are expected to accrue, an account is established on the debit side entitled "Estimated Revenues from Taxes and Miscellaneous Receipts Needed to Meet Budget Authorizations." This gives not only a proper equation, but lays the foundation for currently obtaining two distinct items of information, as will presently be shown. Some accountants attempt to treat appropriations as lia- bilities and include them among the liabilities in the balance sheet. This is obviously improper, since the act of appro- priating money for expenditures does not make the city a debtor. The argument in favor of treating appropriations as a liability is, that while a mere appropriation is not a liability, yet if taxes have been levied to provide for pay- ment of the municipality's expenses for a whole year and the uncollected part of such levy is included in its entirety among the assets, the omission from the liabilities of the appropriations for which the levy was made shows a surplus which is likely to mislead (at least during the early part of the year) as to the municipality's financial condition. It is quite feasible, however, by means of the fund balance sheet to show the exact condition of affairs without thus doing violence to the accepted meaning of terms. When contracts are awarded and orders are issued, con- tingent liabilities are created and appropriations are encum- MUNICIPAL 703 bered. These must be recognized in any statement of a city's financial condition. The details relating to unen- cumbered appropriations and contingent liabilities on con- tracts and orders are shown by the appropriation ledger over which these general ledger accounts operate as a con- trol. The details of contracts in the appropriation ledger are further supported by the contract ledger. In order to maintain a distinct accounting action within the fund group of accounts, it is necessary to introduce two other debit accounts, namely, "Available Balance" and "Un- applied Balance." In doing this, valuable information is currently produced which otherwise could not be obtained without analysis. The Unapplied Balance is identical with cash less demand liabilities shown in the general account balance sheet, and as such it shows what amount of cash is available for meeting contingent liabilities on contracts and orders already incurred, or to be incurred, against available appropriations. It appears only in the general ledger and is not supported by subsidiary accounts. Available Balance is identical with accounts receivable in the assets. It is built up by credits to the account "Estimated Revenues from Taxes and Miscellaneous Receipts Needed to Meet Budget Authorizations." It is likewise not supported by subsidiary accounts. Action in both of these accounts is produced by entries secondary or collateral to those which affect assets, liabilities, revenues, and expenses. For example, when cash is received in payment of taxes, Cash is debited and Taxes Receivable is credited. At the time this entry is made, a secondary entry must be made in the fund group of accounts debiting Unapplied Balance and crediting Available Bal- ance. The item on the credit side entitled "Reserve for Re- tirement of Loans in Anticipation of Collection of Taxes" represents the item in the general account balance sheet en- 704 AUDITING M- «»••»• 4I9- *9- M 0) > l-i V S °° li^ (^ ^ ae=«l c S O JS rt tS'" .2 c«" C .2 Ul H *-M §« - g » a. t/5 : 2 2l < ^ H J m 2 < 0« ^ 8-3 6 S > a; ^ 4) t)'-' < a; Q 13 •2 d o C3 z .6 >< ■•+J t^ 1 p< C/) uU^ X < < S '^ t> rt C/i "J ^- ««• >■ M- «I9- «»■ W- ««■««■ «^ ««- . -o c o CO -J (O '3 4> CO • C cnpq g n> j3 O Ss-^ « 1. Ji " ^ . CO VS Ph o o ■ CO - S O Ij < .« C -i-i ^ ClJ I ^ S n « ^1 g o rt SsSo- MUNICIPAL 705 M- «» M- V*- W- Vi- ^ ^ lij mis '5 « p SJ to « C.&w O > o "J^ ««^ « w 3 " w 7o6 AUDITING 5 •J • -I • s •< o\ CO to J-O > 1^3 ^ e ^ Ota .H O . 6 o^ O rt '^ .. tn^ to C to "^ '" " S5 S ^ -ax**- «'-' =5 s a 9 C/} «» «»- ^ .^ ^ . O +> >». — r< " I- C g 4> 4) « CO***** 4> D C ^ « . I s ^ M « « 1. 'S o ^3 « h rt > i-i • S Q .^t^s • •r; « « c4 O coS O -2 eio p "< Q O >-. o o ■" w to.^ to jg«« C8 4) •n H .S 3 J3 O MUNICIPAL 707 CO IS I H 12; t) O U u < H M U E ^* W ON Q -I o PL. m Q < !25 O M H Pu. o P^ g ss I- u o > ..So B> 3 «, 5 « 4> C > O ..o • 01 ? m u •- c 2 e o r .. (U ^_^o u C ^ to OT 4> S « MO 3 o M Q U rt o St H CO 7o8 AUDITING H O u u < < H < H W W U < < PQ s > o u 0^ I— I c C/3 c •« -a 03 to « O 3 '^ Si ,< en ■M c X PQ ^ *- H Q .. V) Ph»q W 5 -I rt c .(u ^ . cS 3 ca o > ■3.C ^B rt w V - /^ s CPU ^. I o O rt kS 3 •■»l MUNICIPAL 709 J:, > u t/) c ^ rt ^'Ipi; >«( X c C/3 VO On g .-oO . O cn = o ••g • 2 N • * «|J5 i > 1' S wJi 4> «JS!7^ '^'^pq 4> ^►'t > c — W

1 -Si- o o "rt 13 ^^-^ o ^s^^l 4> > H >< c S «S* Wi ^Prt« s P « 00 C/3 Q ^ . H ID ^ I [^ in w u pq CO C ... 3 u o c .« ."^ ■*2 o S u J3 3 en u MUNICIPAL 711 titled "Temporary Loans in Anticipation of Taxes." It is not supported by any subsidiary accounts. For further information regarding the bookkeeping pro- cedure relating to the treatment of these accounts, the reader is referred to ''Handbook of Municipal Accounting," pre- pared by the Metz Fund for Promoting Efficient Municipal Accounting and Reporting. Fund Balance Sheet — Capital Account (Exhibit 7, page 710) A similar group of accounts is kept to show the condi- tion of funds raised by issuing bonds, and the condition of these funds is shown in a fund balance sheet of the capital account (Exhibit 7). One of the items on the credit side of this statement needs to be explained, namely, ''Reserve for Retirement of Assessment Bonds." As assessments are collected Assessments Receivable is credited and cash is debited. At the same time a secondary entry must be made in the fund accounts debiting Unapplied Balance and credit- ing this reserve. The latter serves to show the cash that should be held available for paying off the assessment bonds by which the assessable improvements were financed. Summary Consolidated Balance Sheet (Exhibit 1, page 704) We come now to the summary consolidated balance sheet, which comprises the several detail balance sheets and fund statements already described, and gives in a single statement a comprehensive view of a city's financial condi- tion. It is in two sections, the first dealing with assets, liabilities, and surplus ; the second section showing estimated revenues, appropriations, and reserves. It will be noted that the accounts "Available Balance" and "Unapplied Bal- ance" are eliminated from this consolidated balance sheet, ^12 AUDITING the assets, which they represent in a detached statement, taking their place. In the second section the excess of assets is added to the balance of "Estimated Revenues from Taxes and Miscellaneous Receipts," for the reason that appropria- tions which were predicated on such estimated revenues are stated against them. As any balance of the estimated rev- enues not accrued (or collected) at the end of the fiscal year will have to be provided for in the following year, it must be regarded as at least a potential asset. The excess of assets and estimated revenues over liabilities, appropriations, and reserves is the amount which is available for further appropriations ; in other words, the free surplus. CHAPTER XXVII SPECIAL POINTS IN DIFFERENT CLASSES OF AUDITS (Continued) EXECUTORS AND TRUSTEES An audit of the accounts of executors or trustees prop- erly begins with a careful reading of the will or deed of trust, as the provisions of these documents will have an important bearing on the actions of the executors or trustees as reflected in their accounts. While the apportionment of receipts and payments between capital and income should always receive attention in the auditing of trusts, it becomes extremely important under some wills and trust deeds. Having examined the documents from which the trustees derive their power, the auditor should next compare a cer- tified copy of the inventory of the estate, which was filed with a court of probate, with the trustees' books, to see that all the assets scheduled in the inventory have been entered in the books and at the appraised values. Should the trust have already been in existence for a considerable time and the audit not go back to its inception, it is desirable that the examination start with the date with which the most recent account approved by the court closed. The income from securities should be verified in detail. This can usually be very satisfactorily done; even if the securities are not listed on a stock exchange, information as to dividends or interest paid thereon can in almost all cases be obtained without much difficulty. Overdue interest on mortgages should be investigated. When examining the securities, which work is an im- 713 ^14 AUDITING portant feature of the audit, the auditor should see that they are registered in the names of all the trustees, if there are more than one. If real estate has been committed to the care of the trustees, or if the will gives the executors the custody and disposition of the testator's real estate, the rentals therefrom will need to be verified and taxes and other realty expenses vouched. Vouchers should be submitted to the auditor for all pay- ments. In verifying the correctness of the credits taken by the executors or trustees, the commissions paid or claimed should be carefully scrutinized. Their arithmetical correct- ness can usually be verified in total, but it is also important to see that the basis on which they were calculated is a proper one. Particularly must duplications of commissions be guarded against. If an executor becomes trustee of an estate after being discharged as executor, he will receive but one commission on the principal of the estate. Further- more, a commission is not ordinarily allowed on changes of investments, though it is usually allowed on the net increase, if any, in the principal caused by such changes. The average rates of commission allowed executors and trustees of de- cedents' estates are 2j4 or 3 per cent on the principal and 5 per cent on the income handled; but rates vary, and in some states a sliding scale of commissions is in force. In the case of large estates, however, a different rate or a fixed amount of compensation is sometimes named in the will (frequently, no doubt, in pursuance of an agreement be- tween the executor to be and the testator during the latter's lifetime), and by accepting the trust the executor binds him- self to limit his commission in accordance with the stipula- tion in the will. Presumably, however, if the executor de- clined to serve and no one could be found who would be willing to accept the trust for the stipulated compensation, EXECUTORS AND TRUSTEES 715 the probate court could appoint an administrator who would not be bound by this stipulation of the will, but would be allowed the ordinary rate of commission. The commissions allowed in New York State are as follows : on the principal for receiving and paying out all sums of money not exceeding $1,000, at the rate of 5 per cent ; for receiving and paying out any additional sums not in excess of $10,000, 2^/2 per cent; and for all amounts above $11,000, 1 per cent. The annual charge on income is at the same rate. In a complete audit of the accounts of a trust estate, the investments made by the trustees should also be reviewed from the standpoint of whether they were legitimate at the time they were made. The character of investments which are legal for trust funds vary in different states; generally they are first mortgages on real estate, government (federal, state, county, and municipal) bonds, and the first mortgage bonds of railroads having an established dividend record. The importance of a correct apportionment of all re- ceipts and payments between principal and income has al- ready been mentioned. In this connection it should be borne in mind that interest and rents accrued to the date of the testator's decease are part of the corpus or principal of the estate ; that profits realized or losses sustained on the liqui- dation of legitimate investments are added to or deducted from the principal; that expenses during the period of the executorship are paid out of principal and not from income, excepting expenses connected with improved real estate which are chargeable against the income derived therefrom ; that losses on unauthorized or illegal investments are charge- able to the trustees personally, with such interest (usually at the rate of 6 per cent per annum without compounding) as may be directed by the court ; that a trustee is similarly chargeable with interest on funds actively applied to his 7i6 AUDITING own use or indirectly so applied by merging them with his own funds, even though he may have balances on deposit to his personal credit in excess of the trust funds for which he is responsible; that, even when investments of a wasting nature are specifically authorized, or form the original prin- cipal of the estate, a life tenant does not necessarily receive the entire gross income. When the instrument creating the trust provides that the life tenant and the remainderman shall benefit equally from such investments, it is usual to treat such part of the receipts from the investment as equals, say, 5 per cent on the appraised value of the investment at the time the trust was created, as income for the life tenant, and to capitalize the amount received in excess thereof. The proceeds from the sale of rights given to stock- holders to subscribe for new stock at less than its market value belong to the principal. The additions to the principal from such sales are generally offset by a reduction in the value of the old stock. The terms of the will or trust deed may, however, modify any of the foregoing rules, and hence the importance of the auditor studying carefully the conditions of the trust. With regard to premiums paid on securities purchased by the estate, the usual rule is that they come out of the principal of the estate. Discounts on bonds purchased inure to the benefit of the principal. As probably the great ma- jority of investments which are legal for trust funds sell at a premium rather than at a discount, one does not offset the other. From an accounting standpoint, premiums paid on bonds purchased should be amortized over the life of the bonds, and a portion of each interest payment retained to refund the premium advanced from the principal of the estate, and only the actual income yield on the investment paid over to the life tenant. The accountant must, however, in this as in all matters pertaining to trust estates, be guided EXECUTORS AND TRUSTEES 717 by the rules laid down by the court, which are not uniform in the different states. It is to be hoped that the courts will in time give effect to a more logical treatment of premiums on bonds than they have in the past. The division or partition of an estate is frequently quite a complex proceeding. An estate is sometimes left in trust for the children of a family, each to receive his or her re- spective share of the principal on attaining a specified age. Until such time each beneficiary receives only his or her share of the income. As the specified event would not occur simultaneously in the case of all the beneficiaries, they would not all become entitled to their respective shares at the same time. As soon, however, as any one became entitled to re- ceive his share, he could demand it without having to wait for such time as all the heirs could receive their respective shares of the principal, and, excepting by consent, the estate would have to be forthwith divided. Should the estate con- sist of securities which are readily divisible, no serious diffi- culty is encountered, as the beneficiary may then be given his proportion of each of the estate's investments. Should the estate, however, consist of real estate or other non-divisible assets, resort must be had to some other method of deter- mining the beneficiary's share and delivering it to him. Were all the beneficiaries of age, a mutual agreement could be made, but if any one of the beneficiaries is a minor, he or she cannot give binding consent to such an agreement. The only course left open is to apply to the courts for an order to "partition" the estate ; the final order of the court confirming the share determined to be payable to the bene- ficiary entitled to the partition will be a protection to all parties interested. The payment of his share to the retiring beneficiary forthwith terminates his interest in the estate, and he is not concerned in any fluctuations in the value of the trust investments which may subsequently take place. 7i8 AUDITING Such fluctuations would affect only the remaining benefi- ciaries, for whose benefit the balance of the estate would be administered. A principle of law which should not be overlooked is that no beneficiary who is under age has power to consent to any changes in the terms of a trust. INSTITUTIONAL Educational Institutions As the greater portion of the income of educational in- stitutions is usually derived from tuition fees, dormitory rents, and board, any failure of the records to control ade- quately the collection of such income should be reported, and detailed tests should be made (if these records are kept by single entry) to ascertain that all such income is being received and accounted for. Particular attention should be given to cases where no tuition fees, or fees at reduced rates, are received, to ascertain that proper authority therefor has been granted. The collection of extra charges for diplomas, special examinations, laboratory or school supplies, etc., should be given careful attention. The examination of securities and the verification of the income therefrom are important. The records should show clearly the total amounts of all special funds, the invested and uninvested portion thereof, and, in addition, should en- able the auditor to ascertain that the income therefrom has been applied to the purpose designated by the donors. The annual report will be of material assistance to the auditor in the verification of income from tuition and dona- tions, as the names of students and donors (and the nature and amount of donations) are usually detailed therein. If the report is not published until after the audit, it is desir- CHARITABLE ORGANIZATIONS 719 able for the auditor to verify the proof sheets of the annual report prior to the final printing thereof. The accounts of most educational institutions are kept only on a cash basis, and uncollected income and outstand- ing liabilities are usually ignored in stating their financial operations. It would be well for the auditor to recommend changes in the accounting records which will enable accurate statements of operations, as well as of assets and liabilities, to be prepared periodically. These statements will be valu- able to the executive officers and trustees and should form part of the annual report. Charitable Organizations This class of institutions includes hospitals, asylums, or- phanages, relief societies, and all organizations whose aim is to relieve suffering and distress. That respect in which the accounts of charitable organizations especially differ from ordinary commercial accounts is the receipt of volun- tary subscriptions and contributions. The receipts or ac- knowledgments sent to contributors should be consecutively numbered, and preferably so designed that a carbon copy will remain on file. Entries should be found in the cash book for all donations appearing on the copies of acknowl- edgments to contributors. The only practical way of in- suring an accounting for all contributions received is to in- clude in the annual report a list showing both the names of contributors and the amounts of their donations; then if any donations have not been accounted for, the donors may call attention to the omission of their donations from the pub- lished list. In hospitals, asylums, and like institutions considerable income is received from pay patients. This should be thoroughly verified. Keeping a controlling account in the ^20 AUDITING general ledger for the patients' accounts will aid materially in verifying the correctness of the income from patients. Patients' accounts are similar in theory to those of hotel guests. There is a patients register in which are recorded the arrival and departure of patients, and the books can be so arranged as to permit of a conclusive audit. Another item of income is from appropriations made by the state. These are sometimes in round sums and in other cases are based on the number of patients cared for at a fixed amount per patient. In some states the accounts of charitable institutions re- ceiving state aid are subject to audit by representatives of a state bureau. These official audits are usually restricted to an inquiry into the expenditure of the state appropriation and do not embrace the verification of other items of income and expenditure. Some states also prescribe a classification of expenses which institutions receiving state aid must fol- low, but these classifications have not as a rule been planned with the thoroughness characteristic of the classifications prescribed for public service corporations. In the great majority of cases the accounts of charitable institutions are kept on a purely cash basis. The need for keeping and stating the accounts on a true income and ex- pense basis so that actual results of operations may be seen, is just as great in the case of charitable institutions as in business houses. As every accountant knows, a cash state- ment does not necessarily show the real cost of conducting an institution, and a large deficit may be accruing of which the published reports give no intimation. In auditing the disbursements, the actual cost of opera- tion should be ascertained as closely as feasible and the per capita cost determined. This will furnish data for com- parison with the operations of other institutions of like nature ; such comparisons make for increased efficiency. CHARITABLE ORGANIZATIONS 721 The use made of trust funds devised to an institution for specific purposes should receive the auditor's attention. If the income from the funds is not being applied to the objects designated by the donors, or if the principal of funds has been encroached upon when only the income w2ls to have been used, it is clearly the auditor's duty to call attention to the matter. These organizations frequently take care of persons sent to them by cities, counties, etc., in which cases the cities, counties, etc., pay a stipulated amount. In other cases charitable organizations have special accommodations for persons who have sufficient means to pay for them. The auditor should ascertain that the rates charged in such spe- cial cases are based on the cost of such services. Charitable institutions have in some instances been known to handle these special cases at a loss because of the lack of proper records. The Subscriptions Investigations Committee of the Chi- cago Association of Commerce in a report on their investi- gations of charitable and philanthropic institutions said in part : The Committee regards it as of fundamental importance that every charity receiving indorsement should have its accounts audited by a public accountant. During the past year fifty organizations have had their accounts so audited for the first time in their history. The audit report contains detailed information relative to source of income, purpose for which funds are expended, assets and liabili- ties, together with a statement made by the auditor as to whether the methods employed in the system of accounting are satisfactory and up to date. The audit also covers questions as to the status of in- surance matters and as to whether the premiums have been fully met. The experience of the Committee with regard to a public ac- countant's audit has strengthened the conviction that the audit is ab- solutely necessary. Lax methods have been discovered and frankly called to the attention of the boards of directors of institutions concerned. 722 AUDITING The Comptroller of the City of New York requires charitable institutions which receive public aid to keep uni- form accounts, and to submit to him periodical reports, using the following forms : Comparative Balance Sheet and Summary of Income AND Expenses Of For Six Months Periods Ending 19. . . . Balance Sheet Assets Cash on Hand and in Bank . . Due from City of New York . Other Accounts Receivable . Investments Accrued Income on Investments . Inventory of SuppHes . . . . Special Funds Real Estate and Buildings, Do- nated Real Estate and Buildings, Pur- chased Equipment Prepaid Items Total Assets . . . . . Six Months Six Months Ended. . . . Ended. . . . Increase Decrease $ $ $ Liabilities Accounts Payable Loans Payable . Accrued Items Mortgages Payable . Bonds Outstanding. . . Due. ^ $ $ $ Total Liabilities $. CHARITABLE ORGANIZATIONS I^Z Six Months Six Months Ended .... Ended .... Increase Decrease Excess of Assets Over Liabilities $ $ $ $. Surplus and Reserves Surplus at Beginning . . Income . Total Less : Maintenance Expenses . Non-Maintenance Expenses Total Surplus at End Reserves, for Special Funds . Surplus and Reserves . ? ? $ ? $.... .. $.... .. $.... • . $ $.... .. $.... .. $ $.... .. $.... .. $.... .. $ $.... .. $.... .. $.... .. $ $.... .. $.... .. $.... .. $ Statement of Income and Expenses Income New York City for Maintenance New York City for Education Donations, Gifts, etc., for Gen eral Purposes Donations, Gifts, etc., for Special Purposes . . . Collections Fairs, Entertainments, etc. Sales of Manufactured Products Legacies, Bequests, etc. — General " " " — Special Income on Investments Interest on Trust Funds . . Rents Miscellaneous Total Income . . . Six Months Six Months Ended Ended. . . . Increase Decrease $ «p "P «p «p...... ■ . I - ==== 724 AUDITING Expenses Six Months Six Months Ended Ended. . . . Increase Decrease Maintenance Expenses: Repairs and Renewals to Plant and Equipment $. . Repairs and Renewals to Fur- niture and Fixtures Foodstuflfs Supplies — General ... Clothes Linen and Bedding . . . Fuel Light Salaries and Wages . . . Forage and Care of Animals Telephone Printing, Stationery, and Ad vertising Postage, Telegrams, Magazines, and Newspapers Professional Services . . Miscellaneous Expenses Boarded-Out Children : Board of Children . Salaries Traveling Expenses Clothes Professional Services . . Miscellaneous .... $ $ $. Total Maintenance Expenses $ $ $ $. Non-Maintenance Expenses : Interest on Mortgage Interest on Loans . . Rent Insurance .... Taxes . $ $ $ $ Total Non-Maintenance Ex- penses $ Total Expenses . . . . $ $ $. $... $ $... CHURCHES 725 Six Months Six Months Ended Ended Increase Decrease Weekly Cost $ $ $ $ I Excess of Income over Expenses $ $ $ $. ! Surplus brought forward Surplus $ $ $ $ Churches In the majority of cases the audit of church accounts is unsatisfactory to the auditor. One reason is that the church treasurer frequently is not only the custodian of all the church funds, but is tacitly empowered to disburse the same at will. There is usually a total lack of effective internal supervision. At times large sums pass through a treasurer's hands without any proper check being kept upon his dealings. It is the auditor's duty to check whatever he can, and at the same time to urge upon his clients, judiciously but impressively, the necessity for ordinary commercial caution. He should see that all receipts are deposited in bank, and if a balance appears to be on hand, that also should be de- posited. This is preferable to an actual count of cash, as in the latter case the church official might exhibit his own funds without any intention of having them reach the church's bank account. A certificate from the bank direct to the auditor should be obtained, this certificate indicating the balance in bank belonging to the church at a stated time. In some churches a collection register is kept in which are entered the collections as made, the aggregate amount subsequently being transferred to a cash book. The entries in the collection register should, if possible, be verified and initialed by some one other than the church treasurer. Spe- cial collections should be vouched for in a similar manner. Where pews are rented, the pew-rent register should be 726 AUDITING compared with the cash book. If special funds have been devised to the church, the securities held for such funds should be examined. Vouchers should be in evidence for all payments ; these are to be compared with the minutes of that board or committee of the church whose duty it is to supervise its finances. In at least one denomination the sentiment has been ex- pressed that the accounts of a church whose treasurer handles moneys in excess of a stated amount annually should be audited by a Certified Public Accountant. When this sentiment becomes general we shall see a decided improve- ment in the manner of keeping church accounts, as well as added safety in the use and care of church funds. Clubs In auditing clubs, particular attention should be given to the collection of income, and it will frequently be found that improvements can be made in this feature of their account- ing systems. Since the members are the club's proprietors, their co-operation can usually be obtained, if necessary, in safeguarding the club from being defrauded by its em- ployees or others. Members should be requested to pay by cheque to the order of the club for all dues, house, restaurant, and other charges. Where peculations have occurred they have usu- ally been from currency receipts, as the chance of detection is comparatively small if there is no adequate system of check on those handling the currency. Consecutively numbered receipt forms, charge slips, and bills should be used wherever practicable, as the office copies thereof are valuable for auditing purposes. The collection of dues can usually be verified by exam- ination of the membership register. If necessary, the latter CLUBS 727 can, in turn, be verified by comparing it with the member- ship record at the close of the preceding audit, and exam- ining the minutes for names of new members and of those resigned, suspended, or expelled. Wherever feasible, registers should be used as a basis for room charges. A good additional check thereon, which is valuable for auditing purposes, is to have the housekeeper make a daily record in a suitably ruled bound book of occu- pancies and vacancies of rentable rooms. Consecutively numbered daily reports to the office should form the basis of other house charges. Members' signatures are usually required on orders re- ceived in the restaurant and bar. In some clubs where it is the practice to return such orders to the members monthly upon payment of their accounts, duplicate orders are ob- tained by the use of carbon sheets. If these orders are filed chronologically, they may be used in connection with the verification of the deliveries from stock of wines and liquors. If members can be induced to use consecutively numbered ticket books, either to be paid for in advance or charged for in total, the bookkeeping will be entirely elimi- nated (in the first instance) or materially reduced (in the second) from that necessary when each order must be charged to the personal account of some member. There usually are, or ought to be, in hotels and clubs, miscellaneous receipts from the sale of bones, fat, and other like sources. The practice, which still exists in some clubs, of allowing the chef to retain the proceeds from the sale of kitchen refuse, should be discouraged, as the pay-roll should show the entire compensation of all employees. Under the best of conditions it is difficult to be certain that all such receipts have been accounted for, and comparisons should be made of the receipts during the period audited with simi- lar previous periods, and, in instances where no such receipts 728 AUDITING are recorded, investigation as to the disposal of the offal and scrap should be made. Care should be taken to ascertain that proper allowance has been made for depreciation of china, glass, silverware, linen, and other furnishings. Either of two methods for doing this may be used : charge original cost of furnishings to asset accounts and all renewals to expense accounts, or reappraise the entire stock at least once annually. Many clubrooms are from to time lavishly redecorated and re- furnished, and it would be well, instead of charging the entire usually heavy costs of this nature to one year's opera- tions, to distribute the expenditures equally over a period of several years. It is important that all expenses be properly apportioned among the various activities of the club so that it may be definitely known whether those departments which are in the nature of business activities are in fact yielding sufficient revenue to defray all the expenses (including a proportion of the general expenses) properly chargeable to such activi- ties. Otherwise it may be that departments which are sup- posed to be self-supporting, and which may on the face of the figures appear to be so, are, if all expenses chargeable thereto are taken into consideration, operating at a loss, which is being made up out of members' dues. PROFESSIONAL Architects The accounts of architects are not usually so voluminous as to preclude making a detailed audit. Owing to the fact that men who are professionally very able do not always have a keen business sense, it is important that the auditor exert every means to safeguard the financial affairs of his client and protect him from loss. ARCHITECTS 729 All payments should be carefully scrutinized. This is particularly necessary because some of the expenditures will be recoverable from clients and the auditor should see to it that all such payments have been duly charged to accounts w^ith the clients. A very important part of the audit is the verification of the commissions and fees charged to clients. Fees of speci- fied amount are sometimes agreed upon, or are charged in the case of preliminary work (such as sketches, etc.) done in cases where the proposed undertaking is abandoned. Usually, however, the architect's compensation is based on an agreed percentage on the cost of the building and its equipment where the latter comes under the architect's su- pervision. This makes it necessary for the architect to keep a record of contracts let and payments made thereon. The auditor should refer to this record as a means of verifying the charges to cHents. Such a record of contracts is, of course, also a necessary part of an architect's records for the purpose of having a basis on which to issue certificates of the amounts which are to be paid by the owners for work done by contractors. Another method which is frequently used is to consider 60 per cent of the commission as being earned when the contract is let, and the balance of 40 per cent when the pay- ments to contractors are made by owners on the architects' certificates. As there is almost invariably considerable work unfin- ished at the end of a fiscal period, a basis of valuing it must be found. The author's experience is that a quite satis- factory basis is the amount of contracts let, a part of the agreed rate of commission being taken up on the amount of all contracts awarded, and the remaining part of the com- mission on the amount of payments made on the contracts. There will be some engagements on which the work has y^Q AUDITING not .yet advanced to the point of awarding construction con- tracts. Valuations of such work will be made by the archi- tect himself, frequently in round sums, and the auditor should see to it that the estimated valuations are, if any- thing, ultraconservative. When the work is only in the preliminary stage there is frequently a possibiHty of the project being abandoned or indefinitely postponed, and in such cases the architect is not always able to secure re- muneration commensurate with the work actually done. Doctors The absence of a uniform system of bookkeeping on the part of medical men, and their failure, in most instances, to realize the value or desirability of keeping accurate ac- counts with patients, renders it difficult in the space here available to offer definite useful hints as to the method of audit. Assuming, however, that there is a patients ledger, it may be suggested that to go behind the charges therein is not necessary. In fact, in many instances it would not be possible to do so, as the charges may or may not repre- sent a stated number of visits, as frequently a lump sum is charged for a case. The auditor should endeavor to introduce some efficient system of recording visits so that the client may have before him all the facts when making his charges. It would be especially satisfactory for purposes of subsequent reference if this record gave in the case of a family the particular name of the patient visited, though the ledger account might ap- pear in the name of the family head. All credits on the patients ledger should be carefully checked by the auditor in order that all moneys credited to patients may be properly accounted for. Any allowances that have been made should be particularly noted. Many LAWYERS 731 practitioners employ one or more assistants who are author- ized to receive money. Where this is so, the importance of following ordinary commercial precautions agiinst fraud is apparent. Occasionally payments are made on account of patients for medicines, consultation fees, or other objects. It is im- portant that the auditor determine that such charges have been charged up and duly collected. Where practitioners supply their patients with medicines and drugs it is neces- sary that the accounts of druggists, etc., should be carefully checked, and at balancing time an allowance will have to be made for the value of drugs in stock. Horses and carriages or automobiles that are the prop- erty of the practitioner should be depreciated at the rate of 15 to 30 per cent per annum. If these are rented it is equally important to include cost of hire to the date of balancing, or, in case of payment in advance, to carry a proportionate part forward as a deferred asset. Lawyers The nature of a lawyer's work, together with a general tendency on the part of professional men toward laxity along bookkeeping lines, makes a complete, detailed audit a neces- sity if it is to be effective. A difficulty which frequently confronts an auditor going over a lawyer's books is that they are the stock forms sold by law stationers. These are designed with a view to sav- ing time rather than for any other purpose. An important requirement is to make certain that the amount included in the balance sheet for outstanding charges represents the actual sum included in bills to clients. Every item of costs charged a client might profitably be compared with a copy of the bill rendered to make sure that all amounts ^^2 AUDITING chargeable have been properly debited. Care should be taken to note amounts that may have been paid on account. Retainers may not be so considered. A not uncommon practice among lawyers is a failure to distinguish between personal funds and those of a client. This very condition emphasizes the necessity and importance of proper accounts being kept by those attorneys who wish to avoid any possible reflection upon their manner of deal- ing with moneys intrusted to them by clients. This separa- tion of money materially simplifies the keeping of accounts. Each large estate should have its own bank account and separate books, entirely independent of the books of the firm. A "Clients' Accounts" in the cash book should show all money received in trust for clients, and if there is but one bank account, it would be advisable to recommend separate columns, so that the ''clients' " accounts may be distinct from the "general" bank account. It is a common occurrence for a practitioner to make pay- ments on behalf of a client who may not have a credit bal- ance upon the books. It is especially desirable, therefore, that provision be made for charges to be so entered that ref- erence to any account will reflect its true condition and lead to its settlement. An important advantage in keeping large estates quite separate from the f -^-^^ral accounts is that the cost of keep- ing them, and of 1. ' g them audited, may then frequently be charged, together with other costs, against the estate. It will be possible, also, to submit these accounts to clients or their representatives without disclosing any other transac- tion. If they be so examined at regular intervals, it may not be necessary to have them' also audited by the lawyer's auditors. In this way a further saving of expense may be effected. CONTRACTORS y^^ MISCELLANEOUS Contractors The accounts of contracting companies, erectors, build- ers, engineers, and others engaged mostly in work carried out under contract may be included under this caption. In nearly every instance separate accounts are kept for the cost of each contract, or, if the work under one contract is very large, for each of several sections of a contract, which are later combined when each part is completed. Obviously, the value of such a system of cost accounts to the client depends upon the efficiency with which it is carried out. The auditor should examine it carefully to ascertain that it is based upon good accounting theory and that the results shown are in harmony with those shown on the general books. The system of preparing the pay-roll and of accounting for materials purchased and handled through the storeroom should be carefully investigated to ascertain that all reason- able safeguards against fraud and loss are provided. Wages should be paid by office employees not connected with the preparation of the pay-roll. The value of work done on uncompleted contracts is shown on the balance sheet under the head of "Uncompleted Contracts" or "Work in Progress." The auditor should request a certified schedule of the ^pfnenditures on each of the contracts included in this accc^, ,^1^^ The schedule may readily be verified in cases where correct cost accounts have been kept, but in other instances the auditor may be obliged to accept the schedule upon the certificate of the engineers, superintendents, or -other proper officials, after investigating unusual items and satisfying himself that every effort has been made to prepare the schedule correctly. As a matter of fact, there is almost always some check ^24 AUDITING on the amount of work completed. As the work progresses under the supervision of architects or engineers, certificates are secured from them testifying to the quantity and qual- ity of work done and authorizing partial payments on account. The auditor may not see these certificates unless he asks for them. Contractors are usually more optimistic about the proportion completed than is the architect (unless the two are working together against the owner), so that his estimate as to the part completed at a given time should be verified in every possible way. The cash receipts are also a clue to the amounts certi- fied to. The stipulated payments are on a basis of 90 per cent of the work completed, sometimes more and sometimes less. The contracts themselves, which must always be open to the inspection of the auditor, and which should be called for, will indicate the percentage reserved until after com- pletion and acceptance. It is important to note whether or not any profit has been taken on uncompleted contracts. The profit on each contract to any date can readily be ascertained in instances where cost accounts have been kept, by preparing a memo- randum Profit and Loss account and making the following entries therein : Debit : All Direct Contract Costs. Depreciation of Plant Used on Contract Work. Credit : Value of Work Certified to Date. Value of Work Done, but Not .Yet Certified. Stores and Materials Charged to Contract, but Still Unused. CONTRACTORS 735 The net credit balance of such a Profit and Loss account will represent the estimated profit to date; a net debit balance will represent the loss to date. If a contract is nearly completed, the estimated profit upon completion may be ascertained by deducting from the contract price the combined cost of work to date and the estimated cost of completion. The most conservative method is to ignore entirely profits which may have accrued on uncompleted contracts. It could, however, hardly be claimed to be improper to take at least some part of the profit on the work already done on, say, a large building contract extending over several fiscal periods, provided the percentage of the work completed has been estimated on a conservative basis and a liberal allow- ance has been made for contingencies. Whenever such profits are taken, it is the auditor's duty to satisfy himself that they have been conservatively calculated. The accounts should show clearly the amounts of estimated profits, if any, taken on uncompleted contracts, and the auditor should show them separately in his statements and also call atten- tion thereto in his report, if deemed necessary. Monthly statements should be requested from subcon- tractors, as they may have large claims for work in excess of that called for by their contracts, but for which credits do not appear on the client's books. It may even be found that the client has billed this extra work to the customer, and that credit therefor is entered in the contract account. At times subcontractors may do extra work under an agreement with the general contractor providing for com- pensation only in the event of collection therefor by the general contractor from the customer ; changes in specifica- tions after subcontracts have been let also furnish grounds for subcontractors' claims. Sufficient reserve must be made to cover the probable amount to be paid on such claims prior ^^5 AUDITING to carrying the gross profit from the contract account to profit and loss. Real Estate In auditing the accounts of a client engaged in buying, holding, renting, and seUing real estate, the leases should be examined, and, in the case of office or loft buildings, should be compared with loft plans, and all the rentals accounted for. Actual inspection should be made of properties, or rentable portions thereof, which are recorded on the books as vacant at the time the audit is begun. Prepaid rents, or security deposited by tenants, should be clearly shown, and changes in the latter during the audit period carefully investigated. Balances due for unpaid rentals, power, alterations, etc., can be verified by cor- respondence. All expenses should be vouched and comparisons of the income and expenses of each property and of administration should be made with periods prior to that under review. Extraordinary expenditures for alterations should be called to the attention of the proprietors to ascertain if the tenants should perhaps have been charged therewith. If properties are managed by the client as agent of other owners, the contracts with the latter should be examined and the collection of the commissions verified. Balances due to or by owners may be verified by sending statements to the latter and requesting confirmation thereof. Care should be taken to ascertain that proper allowance has been made for accrued taxes, interest on mortgages, and ground rents. The mortgage interest paid during a full year is a good check on the principal of the mortgages, in addition to which the amount of the latter, as well as the payments on account thereof during the audit period, can be further verified by correspondence with the mortgagees. REAL ESTATE y-^J Prepaid insurance premiums should be verified by calcu- lation. The charges to Land, Buildings, and Equipment accounts should be examined to ascertain that they are all for additional land and construction work or improvements. Accounts covering bonuses which may have been paid for leases purchased, or the cost of improvements on leased ground which will revert to the owners of the latter at the expiration of the ground rent leases, should be reduced at regular intervals. Settlement records may be used in connection with the verification of sales of real estate. In the case of undertakings involving the development of large tracts and the sale of lots therefrom, care should be taken to ascertain (if any profits are calculated prior to the disposal of the entire tract) that the costs of the lots sold have been calculated on a conservative basis. The following illustration of fraud discovered in the accounts of a real estate agency will be of interest: Rent collections were entered in detail in a cash receipt book, footings made each day, and the total deposited to the com- pany's bank account. Th-e footings were verified by the treasurer and agreed with the amounts credited in the pass- books each day. After this verification, the cashier entered additional items covering amounts which he had taken, in order that the collector, who checked up the receipts, would see that all items had been collected. These additional items were not, however, included in the totals. The cashier re- tained currency and cheques in his drawer, which he juggled in order to make up the exact amount of the items he was supposed to be depositing. The main cash book or cash journal (the total of the day's entries being journalized) included all of the items entered in the cash receipt book, and fraudulent footings were made to agree with the bank accounts. 73^ AUDITING All items were eventually posted in the ledger to the credit of the various owners, and the footings and balances, when inked in, were as they should have been had there been no defalcation. The postings were always from two to four months in arrears, and, in order to prepare a trial bal- ance, postings and footings were falsified. Some months later these errors were corrected as stated above. The deficiency was partly concealed by depositing to the company's credit cheques drawn to the order of clients which had been properly charged to their accounts, but the cheques were never sent to the clients. The above-described fraud was practiced few about seven years, and a total of some $26,000 obtained before the omis- sion of an entry for one item of receipt was questioned by the collector and this led to the discovery of the fraud. Land and Development Companies The operations of a typical land development company embrace the purchase of a tract of land, the platting of it into streets and lots, the grading and paving of the streets, the laying of sewers and water mains, the laying of side- walks and curbs, the placing of telephone and light poles, and the selling of the improved lots. Oftentimes there are other features of the plan, such as the building of houses for purchasers, the extension of railway or other transpor- tation facilities to reach the property, and possibly the tem- porary operation of one or more industries. There are many fine points involved in the proper dis- tinction between expenses and. additions to property. Un- like a railroad, the entire cost and expenses up to the time the property is ready to be marketed cannot be charged against the property. Only such part of the expense as really adds to the value of the property, such as the grading and paving of streets, the cost of the water and sewer in- LAND AND DEVELOPMENT COMPANIES 739 stallation, etc., is a proper addition to the capital account. Administrative expenses and any preliminary selling ex- penses, such as advance advertising, publicity work, print- ing, and the preparation of maps, must be segregated and shown on the balance sheet as deferred charges to future operations until such time as revenue begins to come in. The books peculiar to the business are these : Real estate lot ledger Construction ledger Improved real estate cost ledger Improved real estate operating ledger In the lot ledger the lots are carried at cost. Unim- proved tracts should be represented by an account with the tract until such time as the tract is divided into lots, then the total cost of the tract and improvements is spread over the number of lots, the Tract account is credited with the full amount, and an account is opened with each lot. The basis of division of cost is not the number of lots in the tract, but the relative value of each to the whole, depending upon location, size, etc. The construction ledger contains only the cost of build- ings and the carrying charges thereon, and does not include the cost of land. Upon the completion of the building the cost of the same and the cost of the lot are transferred from their respective ledgers to an account in the improved real estate cost ledger representing the building and lot complete. The details of the operation of the property are there- after carried in the improved real estate operating ledger, from which the credit or debit balance is carried at the end of the fiscal period to proper profit and loss accounts. Following are some of the points that should be covered in the audit of a going concern engaged in the development and sale of land : 740 AUDITING Analyze the Property account from the beginning of the development, noting the nature of the charges against this account. Ascertain if there is any record of the prices at which the lots are to be sold and compare selling prices therewith. If no such record exists, see that the sales contracts are approved by one of the principals before being binding upon the client. Obtain from the client the basis for the distribution of expenses between properties in case more than one property is being handled. Then see to it that the proper distribu- tion is made for every expense incurred. The distribution is usually made on the stub of the cheque or directly in the cash book. There is no reason why the cheque stub cannot be dispensed with, and the cheques entered and distributed directly in the cash book. Compare a considerable number of the cashier's contract cards with the ledger, testing the correctness of the interest calculations. Compare contracts entered into during the period under review with the ledgers as to terms, name and address of purchaser, etc. Compare the payments to salesmen for commissions, with the card record of contracts and with the ledgers, not- ing especially that commissions have been charged back on canceled contracts. Compare the sales of lots with map (retained by the auditor), noting on the map the price obtained and investi- gating wide fluctuations. Compare open items in the ''lot book" with the lots unsold at the end of the period per the map. See contract terms regarding taxes, interest, etc. Send out verifications of accounts to all customers, with rubber stamp request to report inaccuracies to auditor. HOTELS 741 Hotels The auditor should analyze the Earnings and Expense accounts, if necessary, and prepare statements of the financial results in each department, which should be carefully gone over with the proprietors. Such departments as show un- satisfactory returns should be especially investigated to the extent of verifying the detail work for a part of the audit period. Hotels at summer resorts usually have more de- partments than do city hotels. Frequently the operations of the former include drug stores, various amusements and excursions for guests, all of which are sources of additional income. Stock accounts of cigars, wines, liquors, etc., should be carefully examined in the event of the results being unsatisfactory in departments where they are handled. The auditor should satisfy himself that all receipts are accounted for, that expense payments are either covered by vouchers or properly approved pay-rolls, and that such as have been made on behalf of' guests have been charged to their accounts and collected. The subsidiary guests' and purchase ledgers should be proven with the balances in their controlling accounts, and all of the entries in the general ledger should be thoroughly checked. Some hotels make their charges for rooms to the guests' controlling account from the daily room report, which is the housekeeper's record of the rooms occupied. The rate of each room is filled in and the sheet totaled. Where this system is used there is a good check on the clerk and book- keeper. The inventories of china, glassware, etc., should be care- fully examined to account for all the equipment on hand at the previous examination and that purchased subsequently, and to ascertain whether the proceeds from the sale of equip- ment which has been discarded have been received. Careful attention should be given to the question of de- y^2. AUDITING preciation of furnishings, such as china, glass, cutlery, silver, linens, etc. These may be reappraised at periods when statements are prepared or depreciated at such times at adequate rates. Another good method is to credit regularly a reserve account and charge against the Profit and Loss account amounts sufficient to cover the estimated actual re- newals and depreciation over a period of years, and then to charge all renewals to this reserve account. Restaurants The accounts of restaurants are somewhat similar to those used in hotels and clubs, although, by reason of restaurants having few^er departments, the records are not so complex. It is a difficult matter to safeguard the pro- prietor against all possible fraud and to discover if any has been perpetrated. The auditor should, however, carefully investigate the manner of serving meals and collecting there- for, and should ascertain that the Earnings and Expense accounts in the general ledger are so classified that the proprietor can form an opinion as to the efficiency of the management. In some restaurants the waiters do not issue checks to guests, the checks being issued by a checker at the kitchen door, who scrutinizes the food or drinks served, and who also charges the waiter's account on a columnar checking sheet, which is used as a check at the end of the meal periods against both the waiters and the cashier. Advertising Agencies It is important for the auditor of an advertising agency to ascertain that the accounting system in use embraces a good internal check on the actual advertising done, on the credits to publishers therefor, and on the charges to the THEATERS 743 clients for the advertising and commissions, and that the system is actually being carried out in practice. A good system will provide for the charges to the clients (for the advertising and commissions), the credits to the publishers (for the value of space occupied in their periodi- cals), and credit to the agency's commission account to be made in one entry from the same original data. If a "Space" account is carried in the agency's general ledger and is used as the medium through which the charges to the clients and the credits to the publishers are made, the auditor should ascertain that the balance therein consists of the aggregate value of specific advertising not yet charged to the clients, but credited to the publishers, and of specific advertising not yet credited to the publishers, but charged to the clients. The -contracts of the agency with the publishers of periodicals and with the clients should be examined, and the rates for advertising and commissions should be com- pared with the agency's records to ascertain that the credits to the publishers for space and the charges to the clients for advertising and commissions are being correctly made. * Theaters The auditor of theatrical accounts must at once recog- nize the fact that a cash system alone prevails and that all persons connected with the financial part of the manage- ment necessarily handle this currency. It is a matter of regret that managers cannot be induced to make payments by cheque more generally, but up to the present representa- tions and arguments presenting the advantages of such a system have not been favorably received. However, the practice is increasing gradually, and in time, it is to be hoped, may become general. J744 AUDITING While nearly all receipts are in currency, it is not usual for the auditor to be expected to verify such receipts; this is a function for the treasurer, who is considered sufficiently responsible for a service that demands integrity, but no great technical knowledge or unusual ability. The methods followed in keeping theater accounts are as follows : About half an hour after the beginning of each performance the treasurer of the theater counts his unsold coupon tickets, making up a ''rough" statement of the cash which should be on hand; to this he adds the proceeds of sales of "hard tickets" (general admission and exchange), and then submits this statement to the treasurer of the company. The two treasurers then count the tickets con- tained in the doortenders' boxes, which, except in stormy weather, agree very closely with the rough statement. Fol- lowing the count the theater treasurer makes out a final statement, which is signed by both treasurers. A "settlement sheet" is made up at the end of each week by the theater treasurer, showing the gross receipts and the share of same due to the theater. Any additional earnings are added thereto, and after deducting the salaries and petty expenses, the treasurer pays the remainder in currency to the manager. The latter usually pays all advertising, bill-posting, light, etc., about Tuesday of each week to cover the previous week. In some theaters the treasurer pays all bills and settles with the manager for the profit or loss shown by the weekly statements only, but this is not a com- mon practice. The treasurer of the theater also prepares a complete weekly statement for the company treasurer and settles therefor. After making these two settlements he would have on hand only the receipts of the "advance ticket" sales, which latter, as elsewhere considered, should be verified. It is well to remember that the object of theater book- THEATERS 745 keeping is to show the result of each week's business in a manner that will determine which attraction pays best. Such items as annual license fee, rent, repairs, etc., should, there- fore, be apportioned weekly on a basis of a season of thirty or thirty-five weeks. The procedure in an audit of theater accounts should be somewhat as follows : Deduct the number of coupon tickets on hand from the total capacity of the house; find how many "hard tickets" were furnished the treasurer at the beginning of season, de- duct number on hand at time of balancing, and the re- mainder should be accounted for in cash. The total result should then agree with the cash and vouchers in the hands of the treasurer. It is necessary to see that all nightly statements of the period under review are signed by the treasurers of the companies. A check on the proper division of receipts may be had by examination of the contracts. These will also enable the auditor to know that the proper shares of extras have been collected from companies. He should also inquire into the manner of preparing pay-rolls, in connection with which reference to an attendance book will be necessary. This book records the names of persons entering the premises by the stage door before a performance, and from it fines for absence or lateness are determined. Proper approval of all pay-rolls should be secured. As both the treasurer and his assistant have access to the same cash, it will readily be seen that a difficulty obtains in dividing this responsibihty ; and a similar difficulty arises in connection with the weekly payments to the manager. After making settlement with him, the cash remaining represents the advance ticket sales, which needs to be verified at the time. However, managers seldom count a large number of tickets, and just here more than one defalcation has been 746 AUDITING covered up or carried along by using advance sales to conceal shortages. Strip tickets used largely by ^Vaudeville" or "continuous performance" houses are, of course, easily counted. Theatrical Companies A treasurer's cash book is the basis of the accounts of a theatrical company; it should be balanced weekly, at least. From it several accounts as here classified (known as "Pro- duction" accounts) are built up. These include: Preliminary Expenses. Incurred during rehearsals, such as salaries of manager, musical director, and orchestra, hall rent, typewriting parts, etc. Properties. Including almost everything used in the stage representation other than scenery, costumes, or elec- trical apparatus, such as furniture, draperies, animals (either papier mache or alive), flowers, etc. Perishable articles should, of course, be absorbed in current expenses and not charged to properties. Costumes. Covering clothing, shoes, wigs, etc. Electrical Apparatus. In this item are included calcium lights and special devices. If the electrical equipment is rented instead of being owned, the rental is chargeable to current expenses. Scenery. The work of building and painting is usually done under contract. The scenery may be built by one firm and painted by different artists. A dif^cult landscape would • probably be done by a high-priced artist, but the painting of a simple interior would be done by a cheaper man. Vouchers representing expenditures for the foregoing items should be examined. In addition, an audit would in- clude the verification of receipts by comparing them with THEATRICAL COMPANIES 747 the nightly statements signed by the house treasurer; and also seeing that the fines imposed by the stage manager are accounted for. The company's earnings statement is made up weekly to agree with the theater accounts. Owing to the unceitainty of the outcome of theatrical productions, definite rules for the treatment of depreciation cannot be stated. The whole cost of an unsuccessful pro- duction should be written off forthwith; on the contrary, the copyright of a successful play does not depreciate rapidly in value. In New York the total cost of production is written off against the first year's business. This is obviously the safest practice. CHAPTER XXVIII THE LIABILITIES OF DIRECTORS It may be thought that the duties and responsibiHties of an auditor are onerous enough without injecting into a treatise of this nature an intimation that a professional auditor is charged with looking after the directors of a cor- poration as well as its officers and clerks. Such is rarely the case, however, because most of the directors in the United States who direct and who perform acts which require review, are officers as well, and the auditor examines their transactions as such and not in their capacity as directors. Board Minutes' Inspection Nevertheless, the auditor may find in reading the minutes of the proceedings of the board of directors or of an executive or other committee, that one or more directors have been intrusted with negotiations to purchase property or with similar commissions. In such cases the auditor should verify the transaction along the usual lines. Directors* Dealings with Company Where a director receives no compensation, except per- haps a small attendance fee, the warning as to participation in meetings is not so pertinent, but it frequently happens that directors are interested in contracts and other transac- tions which are authorized or arranged at meetings in which they participate. If the auditor discovers this state of affairs and is con- vinced of the bona fides of the transactions, he need not 748 THE LIABILITIES OF DIRECTORS 749 criticize, but he can point out the divergence from the law, state the proper procedure, and suggest that at the next meeting of stockholders all such questionable acts of the directors be ratified. Under ordinary circumstances a director is held respon- sible for good faith only, but if the minutes are not full and clear and at some distant day a dissatisfied stockholder or creditor looks sharply for unlawful and unauthorized trans- actions, the director may find himself involved in annoying, if not expensive, litigation. Compensation of Directors Directors usually receive an attendance fee ranging from $5 to $50, and so long as there is nothing in the by- laws to prevent, the auditor can accept as authority therefor a resolution which has been regularly adopted. The minutes should record the names of all directors present at each meeting, which will serve as a check on the amount disbursed for this purpose. Compensation in excess of the attendance fee is rarely paid to a director who is not an officer. If any sum is voted to one or more directors, the auditor should ascertain whether the by-laws permit the payment, and whether the action was taken at a full board meeting or whether any were absent who might have objected. If any director who is benefited votes for the resolution, or if his presence is necessary to make a quorum, the action is voidable and may be attacked. All such transactions should be reported to and ratified by the annual meeting of stock- holders. If no such action has been taken by the stock- holders, the auditor should mention the fact in his report. It has been held by the courts that officers are not en- titled to compensation simply because they occupy office and ^co AUDITING perform the duties incident thereto. Their salaries should be fixed before election as directors, if possible. If this is not feasible, the amounts paid to the directors in compensa- tion for their services should be reported to the annual meeting and be formally approved by the stockholders. As a practical matter, where the officers and directors own all or nearly all of the stock and are acting in good faith, it is not necessary to report salaries nor other matters of detail to the stockholders' meeting. Directors May Inspect Books It is not generally known that a director has an abso- lute right to inspect the books and papers of a corporation of which he is a director. There are a great many men who represent minority interests on a board and who are almost totally ignored in the management of the company. Information with respect to finances or earnings is rarely furnished to them, and is then handed out as if there were no obligation to do so. Auditors are frequently consulted by directors who state that they have tried to secure information without success. The auditor should advise them that their legal right to full access to the books is unquestioned, and that they may be accompanied by a professional auditor if they require assistance. Directors are charged with a knowledge of what is going on, and if they fail to keep informed, they may be held jointly responsible for the acts of others. In all cases, therefore, where they have any doubt as to what is going on, it is nothing more than simple business prudence to employ an auditor who will ascertain exact conditions. The auditor should, as far as possible, report to the board of directors individually, and it is not improper for him so to word his report as to invite personal conferences with any or all of them. THE LIABILITIES OF DIRECTORS 751 A director has a right to inspect all of the books and papers of a company. This includes the auditor's report, and if an auditor has reason to beheve that any director does not receive his report, he should investigate and at least ascertain whether the director is knowingly ignorant or whether he is kept in ignorance of the existence of the auditor's report because the officers or his colleagues have something to conceal. Many directors do not know that under certain conditions they are personally liable for all debts in excess of a certain amount. The auditor should post himself on this and other points so as to be able to make helpful suggestions. Legal Liabilities of Directors It is unquestionably the duty of a professional auditor to warn the directors against the payment of unearned divi- dends, and if it appears that his suggestion is unheeded, the auditor should seek legal advice in order to be sure that his own position is unassailable. The report and certificate will, of course, set forth his position fully. Successful business men might look with more favor upon directorships if they were sure that affairs of the cor- poration would have the periodical supervision of auditors who seek to broaden, rather than to narrow, their responsi- bihties. The auditor's consideration of the possible legal lia- bilities of directors need not extend beyond matters con- nected with the accounts, but wherever accounting ques- tions are involved, the auditor's familiarity therewith should be unquestioned. In the American Malting case, decided in New York in 1904, the court discussed the relation and duties of directors to the accounts. The decision is of suffi- cient interest to v/arrant its reproduction in full : J.2 AUDITING Archibald A. Hutchinson and Victor McElheny, Jr., on Behalf of Themselves and All Other Stockholders of the American Malting Co., Similarly Situated, Plaintiffs, V. Alexander M. Curtiss and The American Malting Co., Defendants. (Supreme Court, New York Special Term, December, 1904.) The statutes of this State allow the recovery, from directors of a foreign corporation, of dividends unauthorized by the laws under which such corporation is organized. It is the foreign statute that makes the dividends unauthorized, but the recovery is to be had under the New York statute. No dividends can be made except from "surplus or net profits." Contracts entered into by a corporation for future deliveries of a product not yet made by it, from raw material not yet purchased, can- not be taken as assets in figuring said surplus or net profits. Divi- dends cannot be made on a mere hope or expectation of profits. Where raw material is bought by weight, and after manufacture is increased in weight and value, the corporation is entitled to treat it as an asset at its increased value. A director who is not present when an unauthorized dividend is 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 dividends in the ab- sence 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, J.: The American Malting Company was organized under the laws of New Jersey, September 28, 1897. It began business on October 11, 1897. On October 15, 1897, it filed a copy of its charter in the office of the Secretary of State of New York to enable it to do business in this State, and received the usual certificate for that purpose. The principal office of the company was situated in the city of New York, THE LIABILITIES OF DIRECTORS 753 at No. 80 Broadway, from its organization until the fall of 1899, and since then it has been situated continuously at East River and Sixty- third Street, New York City. The company has had no plant or property in New Jersey. It has kept no bank account there. It had merely a formal, statutory office in that State. Its capital stock is $30,000,000, divided into 300,000 shares of $100 each, of which 144,400 shares of preferred stock and 145,000 shares of common stock have been issued. The preferred stock is seven per cent cumulative, having a preference as to dividends only. The company is engaged in the manufacture and sale of malt. Its stock was issued to promoters for twenty-one malting establishments, situated in various parts of the United States, on which they had acquired options, and for $2,080,000 cash 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 purchase from the vendors of the various malting plants their stocks of barley and malt, for which the company issued its obligations, amounting to upward of $1,600,000. A little over two months after the company began business, and on December 20, 1897, the board of directors declared a dividend of one and three- fourths per cent to preferred stockholders, 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 outstand- ing obligations amounted to $2,800,000 in notes; that the officers were unable to negotiate further temporary loans; that the company needed additional working capital and that the board authorized the sale of $4,000,000 mortgage bonds of the company. Said bonds, six per cent fifteen-year gold mortgage bonds, were subsequently disposed of at a discount of $400,000. This is an action brought by plaintiffs as stock- holders on behalf of themselves and all other 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 com- pany, it was joined as a party defendant. At first the company put in a defense, but subsequently, its management having changed, it ob- tained leave to file an amended answer admitting the allegations of the complaint and joining in the prayer of the plaintiffs for the relief 7^4 AUDITING 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 director of a New Jersey corporation to recover the amount of dividends de- clared in violation of the laws of that State. Two opinions were handed down, in which the learned justices arrived at the conclusion that the action could be maintained upon different grounds. With each of these opinions a justice concurred. The fifth learned justice concurred in the result. I cite this division of opinion because this court is now called upon to apply the law, as laid down with this practical embarrassment, that while it was the unanimous decision that the action could be maintained, yet the difference in the grounds there- for means a difference of hundreds of thousands of dollars in the judgment I am about to order. As I interpret it that case holds this court has jurisdiction because section twenty-three of the Stock Cor- poration Law of this State provides: "The directors of a stock cor- poration shall not make dividends, except from the surplus profits arising from the business of such corporation; nor divide, withdraw, or in any way pay to the stockholders, or any of them, any part of the capital of such corporation, or reduce its capital stock, except as authorized by law. In case of any violation of the provisions of this section, the directors under whose administration the same may have happened, except those who may have caused their dissent therefrom to be entered at large upon the minutes of such directors at the time, or were not present when the same happened, shall jointly and severally be liable to such corporation and to the creditors thereof to the full amount of the capital of such corporation so divided, withdrawn, pai4 out, or reduced" ; and because section thirty of the General Corpora- tion Law of New Jersey provides : "No corporation shall make divi- dends, except from the surplus or net profits arising from its business, nor divide, withdraw, or in any way pay to the stockholders, or any of them, any part of its capital stock, or reduce its capital stock, except according to this act, and in case of any violation of the provisions of this section the directors under whose administration the same may happen shall be jointly and severally liable at any time within six years after paying such dividends to the corporation and to its creditors in the event of its dissolution or 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 THE LIABILITIES OF DIRECTORS 755 by causing his dissent to be entered at large on the minutes of the directors at the time the same was done, or forthwith after he shall, have notice of the same, and by causing a true copy of said dissent to be published within two weeks after the same shall have been so entered in a newspaper published in the county where the corporation has its principal office"; and because section sixty of the Stock Cor- poration Law of this State provides: "Except as otherwise provided in this chapter the officers, directors, and stockholders of a foreign stock corporation transacting business in this State, except moneyed and railroad corporations, shall be liable under the provisions of this chapter, in the same manner and to the same extent as the officers, directors, and stockholders of a domestic corporation for: I. The making of unauthorized dividends . . . Such liabilities may be en- forced in the courts of this State in the same manner as similar liabilities imposed by law upon the officers, directors, and stockholders of domestic corporations." That is, by virtue of the statutes, this State allows the recovery of dividends unauthorized by the State of New Jersey from directors of a New Jersey corporation in the same manner and to the same extent as the directors of a domestic corpora- tion. That is, it is the New Jersey statute which makes the dividend unauthorized, but the recovery is to be had according to the New York statute. What, then, is unauthorized? "No corporation shall make dividends except from the surplus or net profits arising from its business." Net profits are defined in the Century Dictionary as "what remains as the clear gain of any business after deducting the capital invested in the business, the expenses incurred in its manage- ment, and the losses sustained by its operation." And the controlling question of fact is, were these dividends paid from "net profits"? The twenty-one branches, located in many places and in different States, which were actually engaged in the business of manufacturing the malt from the barley, sent in to the- general office in New York daily, weekly, and monthly statements in great detail of their business. From these statements branch books were made, and from these a general set of books was prepared. All of the books and papers from the general office, which were used in the accounting department, were produced in court, identified, and marked in evidence. The defendant objects to the summaries made up from' these books, and from any and all conclusions of fact to be drawn from said books and said summaries upon the ground that concededly the contracts and the contract books were not produced and were not considered. It was in evidence that malt was always oversold, that contracts for future deliveries, running over many months, were entered into, and the claim is that such contracts were required to be taken into consideration when it came to be determined whether any particular dividend was 756 AUDITING 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 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. So the objec- tion to the books upon that ground is of no weight. From the books certain statements were made up for the aid of the court upon different theories and in different ways. One set of statements was testified to be exactly what the books showed, without the change of a figure. These exhibits are known as 10 P, 10 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 10 R, 10 S, is identical with the foregoing, with the elimination of one entry, which, as a matter of fact, was eliminated by the company itself some months after its entry. There was entered on the books on December 31, 1898, an item of $388,063.36 of the anticipated or estimated future profits on contracts for future deliveries running over many months. This entry, for the reasons stated in regard to the contracts for future deliveries, was unjustifiable. The company subsequently 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 time as they occurred, resulting in double credits, the cancellation or reversal of the entry was absolutely required. On the other hand, I find against the plaintiffs in regard to their conten- tion as to the increase account. Barley is bought by the bushel of forty-eight pounds. Malt, the manufactured article made from barley by steeping, is dealt in by the bushel of thirty-four pounds. The process of manufacture produces about fifteen per cent more of malt by the bushel than the barley measures from which it is produced. The amount of this fifteen per cent excess is reported from each of the manufactories month by month as increase. Of course, this in- crease has a value, as it is sold as malt at malt prices. For the purpose of inventory the company has ascribed to it the value of the barley. This, plaintiffs claim, is error, because that amount has already once THE LIABILITIES OF DIRECTORS 757 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 ascer- tain the actual condition of the company, it must be valued in some way. As it has always been the custom in the malting business to treat it as treated by this company, I am unwilling to disregard that custom. The accounts upon which I based my conclusions treated it as this company did. I find that at the time of the declaration and payment of the third dividend, July, 1898, a deficit was caused thereby of $142,774.59, and from that time to the end of the period under consideration none of the dividends were paid out of net profits, but all were paid out of capital. But it appears that defendant Curtiss was not present at the meeting on February 28, 1899, when the divi- dend paid Aiwil 15, 1899, was authorized. Under the New York statute — under which we are proceeding — a director who was not present when the dividend was declared is not liable. The approval of the minutes at the following June meeting, at which he was present, was only the authentication of the proof of what had happened at the previous meeting. He is, therefore, not to be held liable for that dividend. He is Hable, 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, $252,700— $1,087,074.59, with interest thereon from the several dates of payment. As the highest court of New Jersey, interpreting the law of the State under which this company was incorporated, held, "for the full protection of the company the liability of the directors must be absolute" (Appleton v. Am. Malting Co.), I find against the defendant upon his claim that the accrued profits of the 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 combinations 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 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. As to the second cause of action: While the allegations are profuse as to a "willful, 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 allegations have been where directors have diverted to themselves for their own benefit the property of the company. The damage here flowed out of 758 AUDITING 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 plaintiff seeks to recover. But as I find that this flowed as a damage only from the declaration and payment of the dividends, I am persuaded by the language of Mr. Justice Hatch in Hutchinson V. Stadler, supra, that it does not under the facts of this case constitute a separate cause of action. He says : "In point of fact the statute of the State of New Jersey upon this subject, as well as our own, does little more than lay down a rule of damage to be enforced against directors for breach of duty. At common law a recovery could be had for the waste, but the extent of the recovery would depend upon the damage sustained by the corporation and be the subject of proof. The statute measures the loss sustained, which is usually the correct arnount, and authorizes a recovery therefrom of the individuals who produced that result." It seems to me that any other theory would result in turning the amount recovered for illegal dividends into a penalty. The Court of Errors and Appeals of New Jersey, in this very matter, as well as our Appellate Division, have held : "The liability imposed by the statute is not penal in its character. Its sole purpose is not to punish, but to provide for the making of compensa- tion 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 FEDERAL INCOME TAX* Historical and Introductory In all probability the tax on income will be a permanent source of revenue in the United States, and will be assessed and collected not only by the federal authorities, but by the state authorities as well, and possibly by municipalities. The professional auditor is looked to as an authority on this subject, and a close familiarity with the procedure required in making the statutory returns will add to his prestige and increase his personal income. Professor Edwin R. A. Seligman in his book "The Income Tax" states that everywhere there seems to be a trend towards the income tax. The history of income tax development and legislation is interest- ing and those who desire to familiarize themselves with the subject in all of its aspects should consult Professor Seligman's book. Income taxation has been known in Great Britain since the close of the eighteenth century, and has been in continuous operation there since 1842. In many other countries the principle has been applied with at least fairly satisfactory results; but in the United States there has been a deep-rooted antipathy to the idea of taxing incomes until re- cently. During the last few years there has been a gradual, but dis- tinctly favorable, trend towards this form of taxation. Probably this change of view has arisen out of a rather natural selection of a choice of evils, i.e., the growth of public expenditure with its consequent bur- den upon taxpayers has led to a more careful consideration of the equities involved in the different methods of raising revenue. Indirect taxation has little to recommend it to a thinking people, and income derived under a high protective tariff or from the liquor and other industries, must be in the long run temporary and unsatisfactory. Taxes ♦The limits of this book prevent extended treatment of the entire law In all its technicalities and ramifications, but an attempt is made to discuss all points which arise in the compilation of the returns of investors and business concerns. _ ^ . , .. ^ .^ ,^ The author has freely consulted the "Income Tax Guide" by Walter A. Staub, C.P.A., and the "Income Tax Service" of the Corporation Trust Company, New York City, and hereby expresses his appreciation of the authoritative material contained therein. ^ ^ Information as to details which cannot be touched upon here, Treasury decisions as rendered, and copies of rulings upon specific cases, can be secured through services such as that rendered by the Corporation Trust Company. 759 760 AUDITING levied upon property, including money at interest, bonds, and other forms of indebtedness, inevitably ignore, to a great extent, its income productiveness and may (and frequently do) absorb the entire income. Therefore the gradual decline of the antipathy to an income tax, and the more or less favor in v^^hich it is now held, may be ascribed to the education of the public along economic lines. Adam Smith, in "The Wealth of Nations," has given certain maxims with regard to taxation which have become almost axiomatic in their general adoption. Among various rules which he lays down, are the following, namely, that the subjects of every state ought to contribute towards the support of the government as nearly as possible in propor- tion to their respective abilities, that is, in proportion to the income which they respectively enjoy under the protection of the state; that every tax ought to be levied at the time and in the manner in which it is most likely to be convenient for the contributor to pay it; that every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state. It is probable, as already intimated, that the merits of the^ income tax will lead to its adoption by states and municipalities. In the past, about twenty states have levied taxes on incomes, but their administra- tion of the law has been so inefficient that the lack of success of these laws has led to their repeal or non-enforcement. The few exceptions include Wisconsin, where a systematic and intelligent attempt has been made to enact and enforce an equitable law. The Wisconsin law was passed in 1911 and its administration so far seems to justify a belief that it will be a permanent part of the revenue-producing legislation of that state. In confirmation of this possibility it is of interest to note that on December 15, 1915, an income tax for the State of New York was recommended by three bodies representing practically all of the industry and trade of the City of New York. These bodies are the Chamber of Commerce of the State of New York, the Merchants' Association of New York City, and the Mayor's Committee on Taxation of New York City. Before making this favorable recommendation, these bodies spent many months in the investigation of other methods of raising additional revenues for the State and City of New York. Inquisitorial Features The inquisitorial features are the greatest source of objection to a federal income tax. On this point the report of the Wisconsin Com- mission for 1912 says: FEDERAL INCOME TAX 761 No tax measured by ability to pay can be administered without ask- ing searching questions. The more thoroughly these questions are asked, the more certain honest people can be that the tax dodgers are paying their fair share. If taxation is confined to visible things alone, the assessor can get along without asking questions; but such pro- cedure would exempt from taxation many of the wealthiest and ablest members of the community. When an assessor is trying to ascertain a man's income or the value of his personal property, he must ask either the man himself or the man's neighbors. The second method is ob- noxious. The open way is to put the taxpayer himself on record. This procedure is the honest man's only protection against the tax dodger. The old personal property tax would have been much more in- quisitorial than the income tax if it had been enforced. It failed largely because questions were not asked ; and its failure resulted in great financial burdens being shifted from the shoulders of certain classes of the community onto the shoulders of other classes far less able to bear them. The income tax will be a farce if searching ques- tions are not asked and answers insisted upon. And on the same point the Special Commission on Revenue and Taxation of Nebraska in its report for 1914 says: Another objection to an income tax has always been that it requires taxpayers to reveal information hurtful to their business interests. This objection is held to be unfounded. Nothing is revealed by the records not already known to the credit agencies and to the business world. A man's taxable income and the tax thereon are matters of public record, but that is all. Nothing is known of his exemptions, or his untaxable income, or of his income derived from business transacted without the state, or of his income derived from stocks and bonds taxed directly to the corporations from which received. Application to States and Municipalities In many respects an income tax is more equitable than any other in its possible application to states and municipalities. There is in each community a considerable class of persons who enjoy an income out of all proportion to the taxable property owned. In a city like New York, there are many persons with enormous incomes who pay no taxes whatever except the federal income tax. It may be said that the heavy tax on real estate reaches them through the rent they pay. This, however, is a trifling amount to most of them. As a matter of fact, a great many rich people pay low rents and a great many com- paratively poor people pay high rents. The rich derive much of their income from personal property which is now taxed on its value. From every point of view the income tax is an improvement over the personal property tax. With the removal of this obnoxious tax and a proper scheme of administrative machinery, the income tax can undoubtedly be applied successfully to states and municipalities. y62 AUDITING Importance of Good Administration Of course, we must not rush ahead blindly or else we will find ourselves passing from one bad tax to another. This thought was well expressed by the Nebraska Commission in its 1914 report: In our opinion it would be unwise for Nebraska to undertake so delicate a task as that of administering an income tax law without going through some such period of preparation for it as Wisconsin has gone through. If it is not understood from the beginning that it will be fairly and fully administered by capable officials, an income tax would become as lamentable a failure as the taxation of intangible property it is intended to supersede. Until the state has built up an efficient central control through a permanent commission and that com- mission by its integrity and its efficiency has established itself in the confidence of the people, action looking to an income tax ought to be deferred. It could hardly be made clearer that a tax can be successful only if properly administered, and when administered, made as little burden- some as possible to the honest taxpayers. Income Tax Legislation in the United States Summarizing the history of the income tax in the United States as confined to federal legislation, it is found that at the time of the War of 1812 an income tax was proposed, but was rejected by Con- gress. During the Civil War, however, an income tax was imposed and continued in force until 1872. The Wilson tariff bill, passed in 1894, contained provision for a tax of 2 per cent on incomes in excess of $4,000, but this was declared unconstitutional by the Supreme Court, and no serious effort was made to secure the passage of an income tax between that time and 1909, when the Payne-Aldrich bill became law. It is true that the provision therein contained (taxing corporations upon net income in excess of $5,000) was declared constitutional by the Supreme Court of the United States on the ground that it was an excise and not an income tax within the meaning of the Federal Con- stitution which by clause four of Article 1, section 11, declares that "No capitation or other direct tax shall be laid, unless In proportion to the census or enumeration hereinbefore directed to be taken"; but to all intents and purposes it was an income tax. The law directed that "net income" should be ascertained by deducting from gross income received certain costs, expenses and losses paid, but in the administra- tion of the law its requirements as to income received and expenses paid were ignored and corporations generally paid a tax based on net income as ascertained by commercial practice, i.e., by deducting ex- penses accrued (whether paid or not), from income earned (whether received or not). FEDERAL INCOME TAX 763 Contrary to general expectations, the law met with favor and the opposition from corporations never materialized. This success en- couraged the legislators to propose an amendment to the Federal Con- stitution providing for the necessary authority to Congress to levy a tax on incomes without resorting to the subterfuge of calling it an excise tax. The necessary number of states having signified their con- sent to the amendment to the Constitution, the present income tax law was enacted October 3, 1913. As an indication of the change in public sentiment. Congressman Cordell Hull, who wrote the income tax law and who had studied the subject very thoroughly prior thereto, said in Congress: During recent years there has been a general agitation and demand in almost every state in the union and almost every country in the world for intelligent, fair, and practical reforms and readjustments of their tax systems, to the end that every citizen may be required to contribute to the wants of the state or government in proportion to the revenue he enjoys under its protection. To this end the doctrine of equality of sacrifice or ability to pay is being universally invoked. I shall not consume the time of the committee upon the results of the operation of this tax in the various foreign countries, except to say that the masses everywhere have a deep-seated conviction that it is fair alike to every citizen and is the only effective method of equaliz- ing tax burdens. This tax, in addition to being fair, is productive and responsive to changes in rates, and is cheap of collection. The proposed tax is the outgrowth of centuries of tax legislation throughout the world. Those who have been the victims of our in- tangible and invisible tariff taxes, with all their features of spoliation and plunder, without being able to know the extent thereof, should and will welcome the proposed tax ; the receivers of large incomes and the owners of great wealth should prepare to accept it as a permanent tax, for, in my judgment, it has come to stay. In his message to Congress December 7, 1915, President Wilson, In suggesting a lower exemption and a higher supertax as two of the sources from which the federal government should increase its revenue, said: We should be following an almost universal example of modern governments if we were to draw the greater part or even the whole of the revenues we need from the income taxes. By somewhat lower- ing the present limits of exemption and the figure at which the surtax shall begin to be imposed, and by increasing, step by step throughout the present graduation, the surtax itself, the income taxes as at present apportioned would yield sums sufficient to balance the books of the Treasury at the end of the fiscal year 1917 without anywhere making the burden unreasonably or oppressively heavy. Defects of Present Income Tax Law The income tax law as it stands is by no means perfect. Its many 764 AUDITING complexities and ambiguities have caused dissatisfaction on the part of taxpayers and unnecessary annoyance to its administrators. Further- more, it is felt that the Treasury Department has by reason of some of its interpretations imposed excessive burdens and expense upon those who have had no intention of evading its apparent provisions. It must, however, be realized that an honest official cannot be expected to decide doubtful points against the government, particularly when any ag- grieved party may appeal to the courts for relief. Doubtful points will always arise, but the more glaring defects in the law will no doubt be cured by amendments, and the alleged inequalities arising out of interpretations of officials will disappear as the courts render their decisions. Proceeding upon the assumption that the income tax is here to stay, a discussion of the amendment of unsatisfactory provisions in the pres- ent law is in order. Before making suggestions for amendments, how- ever, one should have the most authoritative data on the general prin- ciples involved in the taxation of incomes. Perhaps the highest au- thority in this country is found in the proceedings of the National Tax Association. Copious extracts therefrom will be found herein, particularly as bearing on the correct theory of taxation. The Committee on the Federal Income Tax of the National Tax Association in its report sub- mitted to the annual meeting in August, 1915, said: There seems to be no demand throughout the country for a repeal of the law. There is, however, a general dissatisfaction with its com- plexity and strong objection to several of its provisions which are con- trary to the principles of just taxation, work unnecessary hardship, and result in unfair discrimination between various classes of taxpayers. While the Committee does not question the propriety of any rulings that have been made, it desires to call attention to the fact that the trouble is frequently to be ascribed to the lack of clearness in the law itself. The language of the law is in need of great improvement. The lack of system in the arrangement of subsections and paragraphs, the long and involved sentences, and the frequent introduction of provisos make the act most difficult to understand. Your Committee desires to express its earnest hope that especial attention will be paid to this point. The recasting of the language of the law should be undertaken by ex- perts qualified to deal with so intricate and complex a task. No con- gressional committee working under pressure of other matters, and with the limited time at its disposal, can be expected to draft and to work out satisfactorily the minute details of arrangement of an act such as this. And it would be of little avail for your Committee to undertake the task. Our first and most important general recommenda- tion therefore is in favor of a complete restatement and clarification of the law. The author was a member of the Committee and indorses this state- ment. FEDERAL INCOME TAX 765 Further comment in the report just referred to is reproduced as of vital interest to all who deem it necessary to be well informed on the subject. General Considerations There are at least four general matters of considerable difficulty in the elaboration of any income tax law. On each of these points there is a wide difference of practice in the various countries; and on some of them there is by no means a complete unanimity among stu- dents of the subject. These four problems are: the general doctrine of income, the double taxation of income, the differentiation of the income tax, and the taxation of corporate income. 1. General Doctrine of Income Although the man in the street uses the term very glibly, the precise meaning of income is still in dispute. There are at least three different concepts of income recognized in important ways, with corresponding variations in the provisions of the income tax laws. One of the chief difficulties is to determine the exact relation of income to capital. Is everything that comes in during the year to be considered income, or are certain items to be regarded as accretions to capital ; and Tnce versa, are certain losses to be deducted from gross income or are they to be considered impairments of capital? A satisfactory treatment of this topic would require much space; and would involve an investigation of such subjects as depreciation, obsolescence, depletion of natural resources, the temporary or permanent character of gains and losses, and the like. While such a study would manifestly be out of place here, we have had occasion in our specific recommendations to call attention to certain glaring departures in the present law from the more obvious and generally recognized distinctions between income and capital. Another question in the theory of income is whether it is to be limited to money or should include what the economists call use or service income, whether measurable in money or not. The chief practical problem here arises in connection with the inclusion of the rental value of a house occupied by the owner. A has invested $100,000 in a house in which he lives ; B has invested a similar amount in 5 per cent bonds, and lives in a rented house. If the rental value of A's house is not included in his income, he pays nothing; while B pays tax on $5,000. Obviously, in order to put them on a strict equality, income should include rental value or money's worth as well as actual money received as income. The same arguments would apply to that part of a farmer's income which consists of the produce con- sumed by him. Yet, if we depart from the conception of money income, the question arises, where shall we stop? Shall we include the rental value of an automobile, of a library, of a picture gallery, of a yacht? Although the income tax laws of the Civil War period pursued at first a somewhat different policy, the present Act does not include any rental value, whether of real estate or of other things. In this respect, it is in harmony with some of the foreign laws. Again, theories of income differ according as they include or exclude the idea of regularity of return. If only that income which is regularly 766 AUDITING received is to be considered as such, gifts, inheritances, and sporadic or occasional and irregular earnings must be excluded. As a matter of fact, few income tax laws include gifts and inheritances in income ; and the federal law here follows the practice of the majority with respect to individual incomes, thus seeming to lean to the conception of regularity or annual recurrency. A further step in the direction of regularity would be to take the average income for a term of years instead of the income for a single year. Here, however, in contradistinction from many of the European laws, the present Act prefers the yearly income and does not permit of the three-year or five-year average. 2. Double Taxation of Income The second general question is that of the double taxation of income or, at all events, that phase of the problem which consists of the simultaneous taxation of the same income by different jurisdictions. Practically, the question is as to the taxation of income earned in this country by persons living abroad, whether aliens or citizens ; and, con- versely, of incomes earned abroad, but received by residents of this country. The general principles involved are in theory simple. Every govern- ment undoubtedly has a right to tax incomes earned within the country, in so far as the income is derived from property situated therein. A strong argument may even be advanced for a similar treatment of in- comes earned within a country, even if they are not derived from prop- erty. On the other hand, it is obvious that a foreigner owes some fiscal obligations to the country of his residence, even though his income is received in the country to which he belongs or where he has some prop- erty or business. It is clear, however, that the above principles are mutually exclusive ; for if every country were to adopt both principles, many an individual would be taxed on his entire income simultaneously by two or more countries, i.e., the country where he lives, the country to which he belongs, and the country or countries in which he owns property or carries on a business. There are two ways out of the difficulty. One is for each country to exempt certain categories of income. The trouble with this method is that the exemptions granted by different countries may either over- lap or be inadequate, so that the individual will be taxed either too little or too much. The other solution consists of a mutual arrangement among the various countries which levy an income tax, with the result that each individual will be taxed upon his entire income only once, each country taking a certain share of the tax. International comity has unfortunately not proceeded very far along this line. Such arrangements exist only between Germany and Austria and between Great Britain and some of her colonies, although there are similar arrangements among various European states affecting the in- heritance tax. The United States has made no effort to enter on this path and has contented itself with very inadequate and lame provisions. According to our law, the income of all residents of the United States is taxable, irrespective of the fact whether that same income is taxed abroad. Furthermore, the law taxes all incomes received or earned within the United States, whether or not the individual resides here. It is to be recalled, however, that one notable exception exists; the FEDERAL INCOME TAX 767 foreign holders of the bonds of American corporations are not taxable on the interest therefrom. The object of this exception was probably to favor the investment of capital in American enterprises by foreigners; just as England in her recent war loans is endeavoring to secure a better market in this country by exempting the holders of government bonds from her income tax. It is to be observed, however, that according to our practice for- eign stockholders are not exempt, at all events as far as the normal tax is concerned, since the corporation pays the tax irrespective of the nationality of its stockholders. On the other hand, it is to be noticed that we exempt foreign bondholders without inquiring whether or not they are taxed on this income by the country of their residence. Finally it must be mentioned that American citizens residing abroad are ac- cording to our law taxable on their entire income, irrespective of whether this income is also taxable in whole or in part by the country where they live. Under our present law, therefore, we have ample opportunity for the double taxation of certain persons and for the non- taxation of others. The situation is clearly unsatisfactory, 3. Differentiation of the Income Tax The third subject of controversy is that of the differentiation of the income tax. We have introduced into our law the policy of gradua- tion, that is, taxing different amounts of income at different rates. But we have not adopted the plan of taxing different kinds of income at different rates. The distinction in question here is the one usually designated as that between funded and unfunded incomes, or between property and labor (or service) incomes. England, for instance, dis- tinguishes between earned and unearned incomes ; Italy between prop- erty incomes, business incomes, and pure labor incomes. Your Committee recognizes that it may be claimed that funded or unearned incomes should be taxed at a higher rate than unfunded or earned incomes ; but in this country the question is complicated by the heavy taxes imposed by our state and local governments. The question of differentiation must therefore be considered not with reference merely to federal taxation, but with reference to our entire system of federal, state, and local taxation. And when so considered, it is quite possible that by the operation of state and local property taxes, a suffi- cient discrimination may already be made between funded and unfunded incomes. We regard it as a fortunate circumstance that the existence of the state and local taxes may thus relieve the federal government from the necessity of differentiating between different kinds of income. Such differentiation greatly complicates the structure of any income tax, and increases the difficulties of administration. If incomes are divided into only two classes, funded and unfunded, an arbitrary distinction usually has to be made between incomes derived by an individual or partnership from the conduct of a business enterprise and the dividends received by stockholders and bondholders in a corporate enterprise engaged in the same line of business. If, to avoid such difficulties in classifying income as funded or unfunded, the law undertakes to recognize three classes of incomes— funded, unfunded, and mixed— the structure of the law becomes extremely complicated, and great difficulties in administra- tion are encountered. As long, therefore, as our commonwealths con- tinue to derive their chief revenue from property taxes, it seems un- 768 AUDITING necessary to differentiate the rates of taxation imposed by the federal government upon different kinds of income. 4. Taxation of Corporate Incomes The last of the general problems is that of the taxation of cor- porate incomes. It is illustrated by a difficulty connected with the limitation upon interest deductions in the present law. The amount of interest paid by a corporation on its indebtedness which may be de- ducted under the third of the enumerated deductions is subject to an arbitrary limitation. This raises the general problem involved in the taxation of corporate incomes. Here at least two points of view are possible. On the one hand, the object of an income tax may be declared to be to tax all incomes in the hands of the ultimate recipients. All income is ultimately received by individuals, and if every individual is taxed upon his entire income, the result will be that all incomes will be reached. From this point of view, any attempt to levy a tax on cor- porate incomes would be incorrect, for it would result either in the same income being taxed twice, once in the hands of the corporation and again in the hand of the ultimate recipient, or it would be neces- sary to introduce some elaborate system of partial exemptions, which would not be likely to work out satisfactorily. Another possible point of view is that the income tax may be regarded to a certain extent also as a business tax, in so far, at all events, as the income is derived from business. Since most corpora- tions are engaged in business they may therefore be said to be liable to such a business tax. Those holding the second view would contend that it is proper for the corporations to pay a tax on their entire income even though the security holders also pay a tax on their entire incomes. And, regardless of these two views, it may be claimed that to exempt corporations entirely from any such taxation would be injudicious from the point of view of fiscal results. The practice of various countries is not in absolute accord with either of these views. Most income tax laws more or less illogically accept a portion of each as a compromise. No country exempts cor- porations entirely. No country taxes both the corporation and the security holder on the entire income. In our law, also, we find a com- promise. Your Committee presents these opposing views without attempting in this report to decide their relative merits, leaving for future dis- cussion the solution of this important problem. As this involves the question of the limitation upon interest deduction, we likewise refrain from present recommendation of change in this respect. From this survey it will be seen how significant and how difficult are some of the still unsolved problems in the theory and the practice of the income tax. Your Committee desires simply to call attention to these general problems in the hope that they will be carefully considered when the time comes for a comprehensive reform of the law. Administration of Income Tax Law The vital element of success in an income tax is efficient administra- tion ; hence everything which interferes with such administratiort. must FEDERAL INCOME TAX 769 be avoided. In the following consideration of the required returns and regulations and decisions covering the procedure imposed upon the tax- payer, particular attention will be given to a comparison of what must now be done with what should be done to insure more efficient administration. In connection with the apparent discrepancies between the law and modern accounting practice, the report to the National Tax Association says : Taxpayers Keeping Books of Account in Accordance with Statutory Requirements or Well Recognized Methods Should be Permitted to Make Their Returns Based Thereon. • The Act permits to individuals the deduction of expenses actually paid, interest paid within the year, taxes paid within the year, and losses actually sustained within the year; to corporations, expenses paid within the year, losses actually sustained ivithin the year, all sums paid within the year for taxes. The law should be amended so as clearly to permit the deduction of any of the items referred to, if the individual or corporation has so entered them on the books as to constitute a liability against the assets. Furthermore, any regulations which tend to impose vexatious adjust- ments of books of account, where the government does not lose any revenue, are unwise and unnecessary. For many years attempts have been made on the part of corporations and partnerships to arrive at a final figure in closing their books, which can be relied upon as the "net profit" of a year's operation. Where this amount is determined by sound business and accounting principles, and where it substantially agrees with the law and regulations, no immaterial adjustments should be required, because it means cor- responding adjustments in subsequent years with the result that the books of account and the returns never agree. For instance, some corporations accrue their taxes, others do not, some partnership accounts (particularly professional vocations) are kept on a "cash" basis ; others, including most commercial concerns, are kept on an accrual basis. Therefore, where a certain system of accounts has been used for a period of years, and where it honestly reflects actual profits or losses, some leeway should be left to the department to obviate the expense and annoyance of an almost complete analysis of a year's transactions. The government would not lose by such procedure. If expenses actually accrued within a year, although not paid until afterwards, are taken credit for in the period when incurred, the most the government would ever lose would be a postponement of a year in collecting the tax, the taxable amount being the same. The attitude of some inspectors in criticizing rates of depreciation and similar deductions is apt to work great harm from an economic point of view. Perhaps most business men are optimists and state results of a year's operations on the most favorable basis possible. Banker^ and other credit grantors have worked very hard to correct this tendency, as it usually leads to business failure. Liberal reserves and provisions for depreciation and other recurring losses, should be encouraged — not discouraged. yyQ AUDITING Business men who have been forced to be conservative and not over- state their profits, take advantage of what to them appears to be official government sanction to low depreciation and other reserves. The government cannot lose any revenue by sanctioning sound accounting policies, but it can and does encourage unsound business method by criticizing conservative procedure. Corporations keeping books according to the rules laid down by the Interstate Commerce Commission, or the public utility commissions of the various states, should not be required to make returns in a form which requires great work and expense in compiling the figures. They should be permitted to file sworn copies of their balance sheets, supple- mented by such explanation as the Treasury Department may find necessary of the items which enter into any particular account. To exact a supplementary statement, as that on the back of the return of net income of corporations for the present year, is a useless exercise of inquisitorial power. The value of the supplementary statements is no greater than that which it supplements. Neither can be checked ex- cept by an examination of the books, and the penalties for false state- ments are no greater because repeated in both. Investigation of Returns by Bureau of Internal Revenue The annual report of the Secretary of the Treasury dated December 6, 1915, says inter alia: Many inaccurate returns are made, some deliberately and some ignorantly, and there are, without doubt, wholesale evasions of the law throughout the country. The remedy for this is to clarify and strengthen the law where needed and to provide a larger and more effective field force for the investigation and checking up of income tax returns and for the discovery of those who are liable for the tax and have failed to make returns. It is absolutely certain, that the government is losing, through in- accurate returns and evasions of the law, a sum many times greater than the cost of the necessary field force to investigate and check the returns and to bring to account those who are failing to make returns as required by law. The report then goes on to state that on the basis of additional assessments arising out of returns examined, there would be assessed on returns not examined, additional taxes to an amount exceeding $25,000,000. Quoting further : I do not, of course, claim that the deductions here made are con- clusive, but they demonstrate that the returns of individuals and cor- porations are inaccurate to such a degree that very much additional tax will be collectable as soon as the returns are investigated and checked by competent men, and that it is in the interest of the govern- ment that a sufficiently large field force shall be created to do this work thoroughly and promptly. . . . Such investigations and accounting have the double effect of edu- cating taxpayers to the law itself and showing them how their accounts FEDERAL INCOME TAX 771 should be kept to enable them to make accurate returns to the Com- missioner of Internal Revenue. It also serves the purpose of putting all taxpayers upon notice that the government has a sufficiently large and competent force in the field to examine the returns. Inspections and investigations will be welcomed by those who have made their returns in good faith, and no sympathy is felt for those who have attempted to evade just taxation. It is, however, to be borne in mind that many of the offhand con- clusions reached by inspectors, on which are based additional assess- ments, are in themselves inaccurate and on appeal are overruled. For this reason taxpayers should familiarize themselves with correct pro- cedure, so that if inspectors, through erroneous conclusions, criticize returns which are properly prepared, they may be in a position to sustain the integrity thereof. OBLIGATIONS IMPOSED UPON INDIVIDUALS BY THE INCOME TAX LAW For convenience the obligations imposed by the income tax law upon individuals and upon corporations will be separately discussed. It will be found, however, that many regulations relating to indi- viduals also affect corporations. Therefore, such points as affect in- dividuals and corporations alike will be dealt with under individuals, and under corporations will be found comments applicable to corpora- tions only. When preparing returns for corporations, therefore, refer- ence should be had to both sections. The index should be freely consulted when special points are under consideration. The obligations of the individual may be summarized as follows : 1. He must submit an annual return to the federal government on or before March 1 of the succeeding year, provided his net income is $3,000 or over for the taxable year, and must pay the tax levied on the net income so reported. 2. He must withhold and pay over to the federal government the income tax on certain kinds of payments which he makes to others (such as rent exceeding $3,000 per annum paid to an individual) and he must make a report to the government of the taxes so withheld. Computing Net Income of Individuals The Internal Revenue Bureau states that "net income" shall consist of the total gains, profits, and income derived from all sources (designated as gross income) less deductions numbered first to sixth, inclusive, specifically enumerated in paragraph B of the act; and fur- ^^2 AUDITING ther states that the "net income" of an individual is represented by the amount opposite item 3 on page 1 of Form 1040 revised. It is there- fore essential that the form should be studied in all of its aspects in order to ascertain who shall and who shall not make a return. The forms of returns now required are not reproduced here, because they are readily obtainable, and no doubt minor changes therein will be made from time to time. It is believed, however, that the general features of the present forms will be retained so that the following dis- cussion will follow the order of the forms. It will be noted, for instance, that an individual who has an income from dividends of, say, $16,000 per annum, plus less than $3,000 from other sources, need make no return at all, because income from divi- dends is not taxable up to $20,000 per annum. An individual having a total net income, inclusive of dividends, of less than $20,000 per annum, may have to make a return because of income from other sources, but need not include the dividends at all in the return. In his report of December 6, .1915, the Commissioner of Internal Revenue recommended that persons liable for the normal tax only shall be required to include in their returns all income derived from divi- dends. This will not increase the tax, but it leaves to the government the determination as to whether the individual is liable for tax and for what amount. An individual having a gross return from a retail business of $50,000 and allowable deductions of $47,500, need make no return at all, because his net income is less than $3,000. In view of the various decisions as to what is and what is not tax- able income, every individual whose gross receipts or income from any source during a calendar year exceed $3,000, should secure a copy of the form, study its requirements, and answer the questions. It may be that the allowable deductions will produce a net income of less than $3,000 (in which case the return need not be made under oath and filed with the collector of internal revenue for the district in which he resides, as is required where the net income exceeds $3,000), but no possible harm can ensue from the preparation of the return. On the other hand, the compilations of data requisite to the answering of the questions should be interesting and beneficial, and if in subsequent years one is fortunate enough to have a gross income so large that the in- clusion of every allowable deduction fails to bring the net income down to $3,000, then the labor of familiarizing oneself with the requirements will not have been in vain. It is also to be expected that at some future time a return will be required from each individual with a gross income of $3,000 and over, although the allowable deductions may reduce his net income to the point of exemption. Such a requirement is reason- able, because the present law leaves the taxpayer to be the judge of FEDERAL INCOME TAX 773 the propriety of deductions which may reduce his net income below the minimum. The government should be the judge of such deductions — not the taxpayer. The Commissioner of Internal Revenue, in his report of December 6, 1915, recommended that the law be amended to provide for a return of gross incomes of $3,000 or over, and whether or not the normal tax liability has been satisfied by withholding at the source. GROSS INCOME The items of taxable income are subdivided here into convenient groups, following generally the classification in the law. These will now be considered in detail. Salaries and Wages Salaries and wages need not be accounted for in the return until payment is made and received. Unquestionably this is the most con- venient method of dealing with salaries and wages. Very few recipients of salaries keep double-entry books, and it would require some such system or its equivalent to attempt to report the salary earned within a calendar year but partly paid prior or subsequent thereto. The procedure, however, is not consistent with that required in the regulation that there must be reported "all income, etc., arising or accruing from all sources whatever in the calendar year for which the return is made" (Art. 4, Reg. 33), and reference to T. D. 2224* indi- cates that the Treasury Department assumes that salaries or wages may have been reported as income before being collected in cash. This decision provides that uncollected wages and salaries will not be al- lowed as deductions from gross income under the item of bad debts, unless the income which they represent has been included in a return of gross income. Of course, anyone keeping books on an accrual basis (that is, entering all income as earned and all expenses as incurred) and so reporting, would hardly be criticized by the collector of internal revenue. If any part of the accrued income so reported becomes uncollectable, T. D. 2224 provides a means whereby credit can be taken therefor as an allowable deduction. The compensation of all officers and employees of a state or any political subdivision thereof, except when such compensation is paid by the United States government, is specifically exempted by the law and is not taxable. This includes public school teachers, etc. When such state officers *The initials T. D. when used in citations refer to official Treasury decisions. yy^ AUDITING or employees are compensated by the United States, they must include such income as taxable. Rent Equivalent Where an individual is furnished living quarters in addition to salary, the rental value of such living quarters is regarded as compen- sation subject to the income tax. (T. D. 2090.) This ruling, in itself, is equitable but the principle involved is not followed in other rulings. For instance, many factory superintendents are permitted to live, rent free, in houses belonging to their employers. Under this ruling they are required to ascertain the rental value thereof and report it as taxable income. If an individual holding a similar position owns his own house, he is not required to report the rental value. Living quarters or parsonages furnished to clergymen are taxable upon a reasonable valuation thereof. Compensation for Services as Trustee A ruling holds that if no determination was made of the amount due the trustee of an estate as compensation for his services over a period of years until the trust was terminated, the amount allowed him should be returned in full, subject to allowable deductions, as income for the year in which paid; and should not be prorated over the length of time during which he served as trustee. This ruling could hardly be sustained if it could be shown that a definite, or an approximately definite, portion of the fee had been earned and had accrued at March 1, 1913. The trustee could not legally be taxed on income which accrued prior to the date the law went into effect. Heat, Light, etc.; Other Taxable Items Amounts received by, or paid for, an officer for heat and light shall be returned as income. (T. D. 2079.) This applies to army officers who receive, in addition to their sal- aries and allowances for rent, a further allowance for heat and light. As the amounts paid are readily ascertainable, it may be assumed that all army officers whose aggregate incomes exceed the exemption pay the tax thereon. There are many other individuals who receive allow- ances of a similar nature who should be taxed thereon. For instance, many corporation officials, particularly those who live near industrial plants, receive or enjoy telephone service, fuel, use of automobiles, and many other perquisites which under the ruling cited are taxable. It is usual for officers of automobile concerns, manufacturers, and dealers, FEDERAL INCOME TAX 775 to have the full use of motor cars for pleasure and business uses. Officials of railroad companies receive passes good over their own and other lines. These are used for personal as well as business pur- poses. An individual, for instance, may use this pass to go to and from his golf club or on pleasure trips. Should emoluments of this kind be reduced to their equivalent in money, and reported as taxable income? The point is really an im- portant one, for the income tax to be successful must be administered impartially and equitably. If army officers^ who are not overpaid, are required to pay the tax on the money equivalent of rent, light, and heat, then other individuals, most of whom are better able to pay, must pay on similar income. "Compensation for personal service of what- ever kind and in whatever form paid" is hardly subject to doubt as to its meaning. The only difficulty which should arise will be the dis- tinction between compensation which takes the form of reduced living expenses (taxable because not allowable as deductions), and the receipt of similar privileges which do not tend to reduce the living expenses of the recipient. For instance, automobiles are frequently furnished to salesmen for exclusive business use. Here, of course, no return would be made. If the salesman is permitted to use the car for personal or family use, then it might be thought that he should ascertain the rental value for the time so used and include such amount as taxable income. In such a case, however, there would be no obligation to make the calculation. It is a fair assumption that if the car were not furnished free of charge, no similar expense would be incurred, and if the item is not the equivalent of a reduction of "personal, living, or family expenses," it is not taxable. If, however, an officer of an automobile concern has the exclusive use of a car, and does use it for other than business purposes, and if it is a fair assumption that he would own and operate a car even if he had to pay for it, then he should ascertain the total cost of operation for a year and prorate such cost equitably, reporting as taxable income the estimated saving of expense arising out of its use and of which he enjoyed the benefit as additional compensation. Of course, he would report on the basis of actual cost, taking the benefit of manufacturers' or wholesale prices, rather than what he might have paid if he had not been in a position to secure such concessions. The Treasury regulations specifically state that "board, lodging or other consideration received in lieu of rental is income equal in amount to the indebtedness in payment of which it is received, and should be included in any return of annual net income its recipient is required to render under the provisions of the income tax law." The answer to these questions and the basis upon which the treat- ment of free rent and other items should be decided, probably depends 77^ AUDITING upon the contractual relation between the one who pays and the recipient. If the rent, fuel, automobile, and similar privileges are part of the employment contracts, express or implied, and thus show on their face that more or less value attaches thereto, then the cash equivalent of the items is taxable. If, however, the privileges are not part of a contract, and are pure gifts and no diminution of compensation results therefrom, then they do not constitute taxable income. Professions and Vocations Where services rendered are of such nature as to be compensated by fee, it would seem that where the service is completed and the fee is due within one year, but not collected until the following year, that such fees should be reported as accrued income. If the fee becomes uncollectable, it may be deducted in a subsequent return. The Treasury decision on this point seems to hold that professional fees need not be reported until collected, although it is somewhat am- biguous. It is as follows : Where a service and payment period is divided by the end of a taxable year, the compensation for the period so divided at the end of the year will be accounted for in the return for the year in which payment is made and received. Where the service is of such nature as to be compensated by fee, or of such nature that no portion of the amount becomes due until the service is completed, then the total amount of the compensation should be included in the return for the year in which the compensation is received. (T. D. 2090.) It may be assumed that this decision permits the postponement of the reporting of all professional fees until they are collected, although it operates to tax cash receipts instead of true income. Where the taxpayer prefers to prepare his return from his cheque book or cash book, no fault will be found therewith. In such cases it is suggested that if the taxpayer's income arises from fees, etc., a cash book with several columns will be most useful. On the receipt side all items of receipts from fees, etc., should be entered in a column reserved for the particular purpose, so that at the end of the year the aggregate of such column will be the proper amount to include in the return. If the tax has been withheld by any other person on any amount included herein, the aggregate for the year should, of course, be separated to accord therewith. Easter offerings, and fees received by clergymen for funerals, masses, marriages, baptisms, etc., are considered income subject to tax. Christ- mas gifts, however, are not considered income within the meaning of the law and should not be included in a return. FEDERAL INCOME TAX yyy Business, Trade, Commerce; Sales or Dealings in Property, Whether Real or Personal Under this head the individual must report the gross income from his business if conducted by him as a sole proprietor. If he is a mem- ber of a firm, his share of the net profits is to be reported elsewhere (see page 783). If books of account are kept according to the double-entry system, it should be possible to compile therefrom, without difficulty, the in- formation required. By reporting under this head the gross profits, under the first item of allowable deductions the administrative and sell- ing expenses (page 789), and under subsequent items of deductions interest, taxes, losses, bad debts, and depreciation, there should be ex- hausted all items shown by the books, except personal withdrawals and capital investments. If rents, interest, royalties, etc., are included in business income, care must be taken to exclude such items under other heads. If an individual has a fiscal year for business other than December 31, he must nevertheless report as of December 31, and do the best he can to reconcile the results shown by his books for the fiscal year with the figures required for a calendar year basis. The adjustments are not easily made, and are both annoying and expensive in time and labor. Furthermore, as no real benefit accrues therefrom to the government, it is hoped that the law will be amended to permit an individual to report for his fiscal year, as can now be done by a corporation and a partnership. If such an amendment is not feasible, then the Treasury Department should be requested to provide, by suitable regulations which are now in its power, for the inclusion, by an individual in his returns as of December 31 for a return of transactions to the end of his fiscal year next preceding December 31. He would, of course, include the transactions of a full twelve months. If a member of a partnership, he can include the figures as shown by the partnership books when closed at the end of the fiscal year, and need not attempt to make a special closing at December 31 for the purpose of the return. (See page 783, et seq.) This convenient method of reporting applies only to certain classes of taxpayers, however. For some mysterious reason those who deal in other things than ordinary merchandise are discriminated against and instead of being permitted to calculate their losses or gains upon the usual and reasonable methods, the government has decreed that those who deal in real estate, securities, etc., must be penalized for so doing to the extent that an accurate book record must be kept of each item (even if these run up into the tens of thousands), its cost and the date, and its sale and the date (even though many years sub- 778 AUDITING sequently), and that the modern and sensible system of inventories must be dispensed with and a very annoying, expensive, and unreason- able system substituted therefor. Of course, most taxpayers have been unable to comply with this regulation, and in time it will have to be modified. On this point the report of the National Tax Association says : Taxpayers Should be Permitted, with the Approval of the Com- missioner OF Internal Revenue, to Adopt the Practice of Deter- mining AND Reporting Gains or Losses by Annual Inventory of Values. In Regulations, No. 33, issued by the .Treasury Department on or about January 5, 1914, provision was made that "in cases wherein there is an annual adjustment of book values of securities, real estate and like assets, and the increases and decreases in values thus indicated are taken up on the books and reflected in the profit and loss account, such readjusted values will be taken into account in making the return of annual net income. . . . The adjustment referred to will comprehend assets which have increased in value as well as those which have decreased." Article 134 also contained a ruling that depreciation in book values must represent an actual shrinkage in values which may be determined to have taken place during the year for which the return is made. Treasury Decision 2005, dated July 8, 1914, reversed the foregoing rulings, which had been in force also under the Corporation Excise Tax Law, and held that a loss to be deductible must be an absolute loss, not "a speculative or fluctuating valuation of continuing invest- ment, but must be an actual loss, actually sustained and ascertained during the tax year for which the deduction is sought to be made ; it must be incurred in trade and be determined and ascertained upon an actual, a completed, a closed transaction." While your Committee concedes that the Treasury Department h'as good authority in the federal courts for its reversal of the former ruling and for its present contention that mere changes in book values do not constitute either loss or gain until there is liquidation, yet the first con- struction placed upon the act greatly added to the convenience of the taxpa3'er in making his return of net income and resulted in substantial justice to the government. A merchant is permitted to make annual inventory of his stock-in- trade and his income is based in part on the difference between the inventories taken at the beginning and at the end of the year. Your Committee sees no reason why the dealer in securities or in real estate or in any other species of property should not justly be per- mitted to determine his income as the merchant does. Nor can it con- ceive of any reason why the investor, whether he be possessed of one piece of property or more, should not come within the same rule. The government is safeguarded, since a marking down of book values in one year will necessarily result in a corresponding increase in future years or when the property is sold, if at the close of the particular transaction there should be a gain. On the other hand, to wait until the transaction is closed for a final accounting burdens the investor with a heavy tax for the year in which FEDERAL INCOME TAX 779 the property is sold, adds to his inconvenience in making returns, and results only in a rough approximation of the amount of tax actually due to the government. To one who deals in any species of property con- stantly, it is difficult to compute with any degree of accuracy the original cost of each item sold and the proportion of carrying charges charged to it. It is all the more difficult when the property was pur- chased many years before the incidence of the tax or when the part sold is only a small part of the original purchase. Real estate purchased in large blocks and thereafter subdivided and sold in small parcels offers difficulties in determining the gain on any particular parcel in accordance with the present rulings of the Treasury Department, but can be determined with ease where it is based on an annual revaluation of the whole property. Since the present method of computing gains on sale of capital assets results in annoyance to the taxpayer and government officials alike and approaches the taxable gain only by mere approximation, while the inventory method is logical, convenient, and fair, your Com- mittee does not hesitate to urge that the law be so amended that in- ventory values may be taken, by those who keep books, as an annual measure of the gain or loss in the value of unsold assets and that returns of net income be accepted on that basis. In order, however, to safeguard the interests of the Treasury in case of reasonable doubt on the part of the authorities, as to the accuracy or good faith of the report, it may be just as well to guard against the possibility of abuse by some proviso. Your Committee would therefore recommend that : "Taxpayers may be allowed reasonably to revalue their assets pro- vided that in case of doubt the administrative authorities may ignore such revaluation and postpone the reckoning of profit or loss until it is actually realized by sale, complete obsolescence, or some similar definite event." For further discussion of this subject, see "Losses on Securities, etc.," page 795. Farmers A farmer is not required to return as income that part of his crops which is consumed as food by himself and his family. To that extent he is receiving an allowance for living expenses. The government has issued a ruling on farm accounting which covers the subject fully and is reproduced in full: The term "Farm" embraces the farm in the ordinarily accepted sense, plantations, ranches, stock-farms, poultry farms, dairy farms, fruit farms, truck farms, and all lands used for similar purposes; and for the purposes of this Decision all persons who cultivate, operate, or manage farms for gain or profit, either as owners or tenants, are designated as "Farmers." All gains, profits, and income derived from the sale or exchange of farm products, whether produced on the farm, or purchased and resold by a farmer, shall be included in the return of income for the year in which the products were actually marketed and sold ; and all allowable deductions, including the legitimate expenses incident to the production of that year, or future years, may be claimed in the 780 AUDITING return of income for the tax year in which the right to such deductions shall arise, although the products to which such expenses and de- ductions are incidental may not have been sold or exchanged for money, or a money equivalent, during the year for which the return is rendered. Rents received in crop shares shall likewise be returned as of the year in which the crop shares are reduced to money or a money equiva- lent, and allowable deductions, likewise, shall be claimed in the return of income for the tax year to which they apply, although expenses and deductions may be incident to products which remained unsold at the end of the year for which the deductions are claimed. When farm products are held for favorable market prices, no deduction on account of shrinkage in weight or physical value, or losses by reason of such shrinkage or deterioration in storage, shall be allowed. Cost of stock purchased for resale is an allowable deduction undei the item of expense, but money expended for stock for breeding pur- poses is regarded as capital invested, and the amounts so expended do not constitute allowable deductions except as hereinafter stated. Where stock has been purchased for any purpose, and afterwards dies from disease or injury, or is killed by order of the authorities of a state, or the United States, and the cost thereof has not been claimed as an item of expense, the actual purchase price of such stock, less any depreciation which may have been previously claimed, may be deducted as a loss. Property destroyed by order of the authorities of a state, or of the United States, may, in a like manner, be claimed as a loss ; but if reimbursement is made by a state, or the United States, in whole or in part, on account of stock killed or property destroyed, the amount received shall be reported as income for the year in which reimbursement is made. The cost of farm machinery is not allowable deduction as an item of expense, but the cost of ordinary tools may be included under this item. Farmers who keep books, according to some approved method of accounting, which clearly show the net income, may prepare their returns from such books although the method of accounting may not be strictly in accordance with the provisions of this Decision. A person cultivating or operating a farm for recreation or pleasure, on a basis other than the recognized principles of commercial farm- ing, the result of which is a continual loss from year to year, is not regarded as a farmer. In such cases, if the expenses incurred in con- nection with the farm are in excess of the receipts therefrom, the entire receipts from sale of products may be ignored in rendering a return of income ; and the expenses incurred being regarded as per- sonal expenses will not constitute allowable deductions in the return of income derived from other sources. Real Estate As heretofore stated, the Department takes the position that an investor cannot deduct losses arising out of dealings in real estate, but that one in the real estate business may deduct losses, if incurred. An individual, however, must report gains in both instances. There- fore, unless there is some special reason for so doing, it is not advisable to add interest as a carrying charge. FEDERAL INCOME TAX 781 Interest is an allowable deduction year by year for the full amount paid, and by claiming the deduction the tax is lowered. If added to the book value of real estate, the annual deduction, of course, cannot be claimed. When sold subsequently, if at a loss, and if the individual does not claim or is not permitted to claim the loss as a deduction, then the entire amount of interest which has been added, and which increases the loss to that extent, has lost its identity as interest and the benefit which would have been realized if claimed annually is lost. The Treasury decision on this point is as follows : The entire profits realized by individuals or corporations from the sale of real estate will be taxable except where the property in connec- tion with which the profit is obtained was acquired prior to March 1, 1913, in the case of individuals, or prior to January 1, 1909, in the case of corporations; and then and in such event the profit will be pro- rated over the whole time the property was held, and that part of the whole profit apportioned to the taxable period will be reported in annual returns of income. In prorating, fractional parts of years will not be considered. For income tax purposes, where there is an actual sale and transfer, profit will be considered as realized even though payment is to be made in instalments, as notes for deferred payments are secured by the title to the property, and presumably bear interest and are held to be worth, in cash, their face value. In case of default on instalment payments there may be charged off as bad debts the amount of such unpaid instalments less the salvage value of the real estate repossessed, (T. D, 2090,) Rents If books of account are kept, there should be reported all rents collected in cash as well as those accrued and which are believed to be collectable. Any items found to be uncollectable can be deducted as losses in subsequent returns. If this is not practicable or convenient, it will be sufficient to report all rents received during the calendar year. Interest All interest is to be reported whether on notes, bank deposits, securities, bonds, mortgages or deeds of trust, or other similar obliga- tions of domestic corporations, joint-stock companies or associations, and insurance companies, bonds issued in foreign countries or upon foreign mortgages or like obligations (not payable in the United States), and also dividends upon the stock or interest upon the obligations of foreign corporations, associations, and insurance com- panies engaged in business in foreign countries. Interest on Bank Deposits Interest on bank deposits or on certificates of deposit, whether paid or accrued and unpaid, must be included in the annual income 782 AUDITING return of the person entitled to receive such interest, whether on open account or on the certificate of deposit. (Art. 67, Reg. 33.) This, no doubt, is on the assumption that the interest is credited promptly and in fact forms part of the individual's cash account prior to December 31. If, however, the taxpayer does not receive notice of the interest until after his cash account for the year is closed, and if he is reporting upon a cash as distinguished from an accrual basis, he would not be required to include the interest until the following year. This follows the ruling that interest on notes, ordinary mortgages, and corporate obligations should be entered on the annual return for the year in which such payments are received. Annuities A ruling has been made that the amount received under a life insur- ance, endowment, or annuity contract is not income when returned to the person making the contract, either upon the maturity or surrender of the contract ; but the amount by which the sum received exceeds the sum paid and coming into the hands of the person making the contract and payment, is income. Perhaps most annuities are gifts, in which case this ruling would not apply. So-called dividends on life insurance policies are not taxable no matter when accrued or received. Non-Taxable Interest The law provides, "That in computing net income under this section there shall be excluded" : Interest upon the obligations of a state or any political subdivision thereof, and upon the obligations of the United States or its possessions. Where a municipality purchases a public utility subject to a mort- gage, the mortgage retains its original character, even though the municipality assumes the mortgage indebtedness and pays the interest thereon. Therefore, the indebtedness secured by such mortgage is not an obligation of the municipality within the meaning of paragraph B of the income tax law. (T. D. 2090.) Special assessment districts created under the laws of the several states for public purposes, such as the improvement of streets and public highways, the provision for sewerage, gas, and light, and the reclama- tion, drainage, or irrigation of bodies of land within such special assessment districts when such districts are for public use, are political subdivisions of the state within the meaning of the above proviso. It is held that the term "political subdivision" includes special as- sessment districts or divisions of a state created by the proper authority of the state acting within its constitutional powers and under its gen- eral laws, for the purpose of carrying out a portion of those functions of the state which by long usage and inherent necessities of government have always been regarded as public. FEDERAL INCOME TAX 783 Levee and school districts, when lawfully created under the authority of the state and which are authorized by the laws of the state to levy a tax to meet the obligations of such districts, are also held to be political subdivisions of a state within the meaning of the income tax law. The income derived from interest upon the obligations of all such public districts shall, therefore, be excluded in computing net income for the income tax. (T. D. 1946.) Partnership Gains and Profits, Whether Distributed or Not The law is that any persons carrying on business in partnership shall be liable for income tax only in their individual capacity, and the share of the profits of a partnership to which any taxable partner would be entitled if the same were divided, whether actually divided or other- wise, shall be returned for taxation and the tax paid, under the pro- visions of this section; and any such firm, when requested by the Commissioner of Internal Revenue, or any district collector, shall for- ward to him a correct statement of such profits and the names of the individuals who would be entitled to the same, if distributed. T. D, 2137 provides that the individual members of a partnership firm shall include in their individual returns of income to be filed on Form 1040 revised, for the calendar year 1914, their respective distributive interests in the partnership's profits ascertained for the business year ending on any date in 1914. The regulations provide : Partnerships, as such, are not subject to the income tax, and are only required to make return when requested to do so by the Com- missioner of Internal Revenue or the collector of internal revenue for the district in which said partnership has its principal place of business ; and when a return is required it shall give a complete and correct statement of the gross income of the said partnership and also a complete statement of the actual expenses of conducting the business of said partnership, and the net profits and the name and address of each member of said partnership, and their respective interest in the net profit thus reported. The net annual profits of a partnership when divided and paid to the members thereof shall be included by each individual partner receiving same in his annual return of net mcome, and the tax shall be paid thereon as required by law. When the annual profits of a partnership are not distributed and paid to the members thereof, the respective interest of each member in said profits shall be ascertained, and the individuals entitled thereto shall include the said amount in their annual return as a part of their gross income, the same as if said profits had been distributed and paid to them. It is clear that a partnership having a fiscal or closing period other than December 31 need not attempt to make an additional closing of the books or ascertainment of profits or losses at December 31 in order 784 AUDITING that the individual members of the partnership may return their share of the net profits or losses of the partnership for the calendar year. It is recognized that it is frequently impossible to close the books of a partnership on December 31 ; in fact, the last day of various other months is usually the most convenient date for ascertaining accurately the financial condition and the gains or losses of a partnership. What the government does want, and should have, from an individ- ual who is a partner in one or more firms, is a full and accurate return of his share of the partnership profits for the twelve months ending at some date during the calendar year. This will obviate the necessity of guessing, or calculating upon incomplete data, on one's income where the fiscal year of the partnership does not end December 31. It makes it convenient and accurate to report the amount shown by the partnership records, and as the income tax has come to stay, the gov- ernment will not lose any possible income through the postponement of the reporting of possible profits realized during the period between the usual closing date and December 31. To illustrate: An individual member of a partnership which closes its fiscal year October 31. if he has no other source of income, will report the aggregate distributive share of the partnership profits to which he was entitled for the fiscal year ended October 31, as shown by the books (and assuming their accuracy), whether drawn out or left in the business. His individual return being made as of December 31. it may be that during the months of November and December the partnership made a profit to a share of which he is entitled, but so long as the books are not closed December 31. and the results of the business ascertained and stated, no report is required of the operations of those two months, because in his next return the individual will report his full distributable share of the profits for the full fiscal year ending October 31, which, of course, will include the results of the operations of the business for the months of November and December in the preceding year. Dividends and Interest Received by Partnerships At least one of the collectors of internal revenue holds that income accruing to a partnership loses its identity, and, as credited or dis- tributed to the partners, is all taxable, although the law expressly ex- empts interest on government bonds, etc., and dividends up to $20,000. The Treasury Department itself does not si'jtain this position so far as interest is concerned. The Deputy Commissioner of Internal Revenue on April 22, 1915, wrote as follows : This office acknowledges receipt of your letter asking whether FEDERAL INCOME TAX 785 partnerships are allowed to deduct from their gross income, in ascer- taining the distributive interests of individual members, the "total amount of interest received upon obligations of a state or political subdivision thereof, and upon the obligations of the United States or its possessions." You point out that this deduction was provided for by item (e), page 1, of office Form 1065. In reply you are advised that partnerships are permitted, in a computation of their net incomes for the purpose of ascertaining the distributable interests of partnership members, to deduct the item quoted by you. There seems to be no justification for the position of the collector, and it is likely to be so decided by the courts. In the meantime, unfortunately a large amount of tax has been paid under his ruling. It would appear to be a compliance with the law for a partner to analyze his share of firm profits and segregate the interest on United States, state, and municipal bonds, etc., and dividends. The interest should be omitted entirely from his returns, and dividends should be entered on the line provided therefor. If it is felt that notice should be given to the government that the return follows the law rather than the regulations, then the amount of such interest and dividends should be stated in short with an ex- planatory note. If the taxpayer is assessed thereon, the tax should be paid under protest. A decision on this point will no doubt be made by the courts and, if the author's position is sustained, a refund can be secured. The Commissioner of Internal Revenue, in his report of December 6, 1915, recommended that partnerships be required to report on the basis now required of corporations. Royalties from Mines, Oil Wells, Patents, Franchises, or Other Legalized Privileges In the case of mines operated by a lessee on a royalty basis, it is held that the lessor in disposing of his ores or natural deposits on the basis of royalties has a measure of profit in every ton of ore disposed of in this way, and that so much of the gross receipts on account o'f royalties as is in excess of depletion, not exceeding 5 per cent of the gross value of the output at the mine, plus any incidental expenses to which the corporation may be subject, is income within the mean- ing of the federal income tax law and should be so returned by the lessor. Other Sources of Income Property Acquired by Gift The value of property acquired by gift is not subject to income tax, but all gains, profits, or income derived therefrom are subject to tax, 786 AUDITING and if the property so acquired is subsequently sold at a price greater than the appraised value at the time the property was acquired by gift, the gain in value is held to be income and subject to tax under the provisions of the federal income tax law. (T. D. 2090.) Proceeds of Sale of Rights to Subscribe to Stock The income tax law levies the tax upon income accruing from all sources and, under these circumstances, it is held by this office that income accruing to an individual who holds stock in a corporation by reason of the sale of his rights to subscribe to new stock in the cor- poration, is such an item of income as should be included in his return of annual net income for the assessment of the tax. (Extract from a letter signed by Deputy Commissioner L. F. Speer and dated February 21, 1915.) Accident Insurance Money paid to the person insured by an accident insurance policy on account of accident sustained, is returnable as gross income by the insured person. The proceeds of accident insurance policies paid to the beneficiaries upon the death of the person insured are to be treated like the proceeds of life insurance policies. Dividends Dividends on stock or from the net earnings of domestic corpora- tions, joint-stock companies, associations, or insurance companies sub- ject to like tax, are not subject to the normal tax. See rules as to reporting page 772. Stock Dividends Stock dividends when required to be included in a return of income should be accounted for at the valuation placed upon the stock by the corporation when said stock dividends were issued. (T. D. 2090.) Stock dividends issued as a bona fide and permanent increase of the capital stock of corporations, etc., without intent to evade the imposi- tion of the personal income tax, are held to represent capital; and are not, therefore, subject to the income tax as gains, profits, and in- come in the hands of the stockholder. If, however, the dividend stock should be surrendered to the cor- poration for cash or its equivalent, or if the assets of the corporation in any manner should be distributed by means of the stock dividend, the amount realized will be considered income for the year when so converted or received, and will be returned as income by the corporation or individual receiving the same. T. D. 2274, dated December 22, 1915, modifies former decisions, and reads as follows : Stock dividends paid from the net earnings or the established sur- FEDERAL INCOME TAX 787 plus or undivided profits of corporations, joint-stock companies or asso- ciations, and insurance companies, are held to be the equivalent of cash, and to constitute taxable income under the same conditions as cash dividends. In view of court decisions in various jurisdictions, it is not likely that the broad rule here laid down will remain unchallenged. Scrip Dividends Inasmuch as scrip dividends arc issued only by corporations unable to pay cash, there is a serious doubt as to whether such scrip is worth its face value in cash and can be taxed on such a basis. Life Insurance Dividends paid on life insurance policies that have not matured, whether such dividends are drawn in cash by the insured or applied to the reduction of the annual premium due, are not considered items of taxable income under the law, and should be excluded from a return of income. The same rule applies to dividends declared on endowment and other policies but not paid to policyholders until the maturity of the contracts. Dividends from paid-up policies, however, are considered income to the recipient, and must be included in the annual return of income whenever the taxpayer's income, including such dividends, is in ex- cess of $20,000. They are considered the same as dividends or net earnings from corporations subject to a like tax, and may therefore be excluded from a return of income in cases where the income is subject to the normal tax of 1 per cent only. Cash Dividends; Time of Receipt Governs, Not When Declared The Bureau of Internal Revenue holds that : Cash dividends, or their equivalent, paid from the net earnings, or the established surplus or undivided profits of corporations, joint-stock companies, or associations and insurance companies, if declared and paid on or after March 1, 1913, constitute taxable income in the hands of shareholders or beneficiaries when received, and should be returned when the total net income of any individual is in excess of $20,000, inclusive of such dividends, and the additional tax should be paid thereon as on income for the year in which such dividends were re- ceived, without regard to the period in which the profits or surplus were earned or the period during which they were carried as surplus or undivided profits in the treasury or on the books of the corpora- tions, etc. Therefore, dividends received by an individual after March 1, 1913, although obviously paid out of earnings prior thereto, are taxable so far ^88 AUDITING as the present rulings apply. On October 19, 1915, it was ruled (in con- nection with a distribution of profits in 1913, accumulated during a period of several years prior thereto) that "the dividends in question, being a distribution in 1913 of corporate profits, had the status of income for income tax purposes to the stockholders of the corporation." And, again, on November 30, 1915, the Commissioner of Internal Revenue, in passing upon the following facts : The X corporation is compelled to liquidate by mandatory statute of the state in which it is incorporated. The major part of its surplus which is thus compelled to be dis- tributed to its stockholders was accumulated prior to March 1, 1913. This distribution is not made as dividends paid by a going concern, but as a pro rata distribution of the assets of the company upon dissolu- tion. The stockholders have remained the same since incorporation. Is the fund accumulated prior to March 1, 1913, thus distributed, subject to income tax to the individuals who receive it? ruled as follows: It is held, under the provisions of Treasury Decision 2163 of Febru- ary 18, 1915, that a surplus representing the net earnings of a corpora- tion, regardless of the period during which earned, is subject to the income tax as dividends when distributed, whether by declaration of dividends or otherwise, if the distribution was authorized on or after March 1, 1913. The government evidently takes the position that "once profit, always profit" and does not recognize the usual differentiation between princi- pal and income. The accountant is as careful to separate one from the other in calculating the profit of an individual as in stating the profit of a corporation, but having made the calculation and stated the accounts, he has always understood that the undivided income or profit merged with the principal or capital and that thereafter the new calculation of income would be upon one principal sum only. Under this theory an individual may, on March 1, 1913, have had capital as shown by his books of $1,000,000, but all of it except a very small part may have been the accumulation of undivided profits over a long period of years. If he took in a partner on March 1, 1913, or if he incorporated his business at that time, surely it would be recognized that the entire $1,000,000 constituted capital and not part capital and mostly income. So with a corporation as to its surplus. At the end of any fixed period its profits or losses are determined. If the profits are not all paid out in dividends but are allowed to accumulate, the net worth of the corporation, composed of capital stock and surplus, is all capital thereafter in every respect, save one, i.e., the corporation laws permit FEDERAL INCOME TAX 789 subsequent declarations of dividends up to the whole of the surplus. This, however, is in the nature of a penalty clause more than anything else. It merely prohibits directors from paying out in dividends any part of the capital stock, and permits the payment of all accumulations irrespective of when earned. The law purports to tax only "gains, profits, and income" after March 1, 1913. Before that date the tax would have been unconstitu- tional. If the earnings of an individual prior thereto became principal on that date, or for any other reason were not taxable, surely the surplus of a corporation on that date was principal as related to gains, profits, and income, and an individual receiving a portion of such fund, all earned prior to March 1, 1913, cannot equitably be taxed thereon on the same basis as income earned subsequently to the date when a tax upon incomes became constitutional. If it can, accountants will have to evolve a new theory of principal and income. In the preparation of returns, attention should be given to the point as to whether or not items theretofore returned as dividends (where the total exceeded $20,000) were subsequently found to be, in fact, out of capital. If so, a deduction should be made in subsequent returns or claim filed for rebate. For a full discussion of this point, see Journal of Accountancy for November, 1915, page 370, et seq. ALLOWABLE DEDUCTIONS TO INDIVIDUALS Most individuals find it easier to recall all of the items of their in- come than of their expenditures, and for this reason it has been found that advantage has not been taken of many allowable deductions. The professional accountant should carefully study the provisions of the law bearing on this point and be prepared to pass on the propriety of including or excluding the various items of expenditure which are found or are known to have been made by clients. Taking up the allowable deductions in their order, the first item is that of expenses. Expenses The provision of the law is as follows : The amount of necessary expenses actually paid within the calendar year for which the return is made, in carrying on any individual business. There must not be included under this head, personal, living, or family expenses, business expenses of partnerships, or cost of mer- chandise. Amounts paid for permanent improvement or betterment of property are not proper expense deductions. Perhaps the best method of determining the items properly applicable 790 AUDITING under this head is to arrive at them negatively, that is, to ascertain the amounts paid for personal, living, or family expenses (items which are not deductible), and stating the balance of one's payments as busi- ness expenses. This method would not find favor with the taxing authorities and is not suggested as a feasible plan to adopt. It is, however, illustrative of one means whereby permissible deductions may be discovered. For instance, T. D. 2137 states that expenses incurred in earning income which is not subject to tax under the income tax law do not constitute allowable deductions in computing net income from other sources which are taxable under the law. This properly indicates that if one's income (salary, or other com- pensation or earning) is taxable, then the expenses incurred in earn- ing it are allowable deductions. For instance, a clerk may receive a salary of $5,000 per annum. The author's interpretation of the law is to apply the query, "what would his personal, living, or family ex- penses be if his income of $5,000 were derived from investments?" If he lives out of town and pays $20 per month railroad fare, he should be permitted to deduct $240 per annum for this item. If in order to earn his salary he must purchase books, attend lectures, and incur sim- ilar expenses, they are proper deductions. If he must belong to a luncheon club and entertain at his own expense prospective or actual customers or clients, the dues and other charges of the club are busi- ness expenses and allowable deductions. It must be remembered that no differentiation of income is found in the law. In other countries an "earned" income is taxable at a lower rate than one derived from investments. Those in receipt of "earned" incomes lose this advantage under our law, but there is no reason at all why they should be placed under the additional disadvantage of having to incur expenses of a business nature (from which they would be free if they were out of business) and then not be permitted to deduct such expenses in arriving at net income. If one is a university professor and must purchase books and incur similar expenses in order to maintain his standing, such items are allowable deductions. Of course one should not split hairs, but inter- preting the law and the regulations from a combined theoretical and reasonable point of view, it is well to know the exact rights thereunder as well as the exact obligations. It was the author's purpose in defining the extreme limit of reportable income, to mention every dollar of taxable income to which the government is entitled, and it naturally follows that every item of allowable deduction should likewise be mentioned. The average citizen of the United States is not given to a close analysis of his personal expenditures. Anything which tends to increase FEDERAL INCOME TAX 791 the number of those who record and thus know where their income goes, will in the long run increase the government's revenue from the income tax, because the almost invariable result of a close watch over one's expenditure is a cutting out of extravagant and foolish items and a consequent increase of savings, and subsequent income from the investment thereof. Therefore it is believed that the Commissioner of Internal Revenue and his successors will not look with disfavor upon certain deductions herein suggested, which in themselves might indicate a purpose to evade taxation. Various items officially passed upon are cited as illustrative of allow- able deductions. So long as good faith is observed in the inclusion of an expense item, it is not likely to be objected to. Professional Expenses Many lawyers, doctors, and other professional men keep fairly accurate records of income, but are not careful to separate personal and living expenses from those incurred in connection with, or necessary to produce, their income. If care is taken to assemble all items of taxable income, then equal care should be given to compile a schedule of allowable deductions from income. Where a medical practitioner has his office apart from his house, the items of expenses are more readily determined, but the principle is the same. The expenses incident to the earning of income are the ones to be ascertained. Thus a physician whose city office is in his house and who also practices from his country house, should deduct part of the depreciation, repairs, etc., of both houses ; all or part of the depreciation and maintenance of automobiles or horses; depreciation of books, instruments, office furniture, etc. In addition thereto, there will be various payments for subscriptions to medical journals, dues of professional societies, and many other items incident to his pro- fessional work and which would not be incurred if he were not in practice. In other words, the law attempts to tax net income only, and every item of expenditure which affects or stimulates or helps earn the income is an allowable deduction. Premium on Fidelity Bond Where an employee is required to furnish bond and pay the premium on such bond, as a necessary incident of his employment, the premium on the bond will constitute an allowable deduction in computing net income. (T. D. 2090.) Commissions Paid Real Estate Agents A commission paid to a real estate agent for collecting rents and 792 AUDITING for management of property is a legitimate business expense and con- stitutes an allowable deduction in computing net income. (T. D. 2090.) Commissions Paid to Salesmen Commissions paid to salesmen as a part of the expense of con- ducting business are allowable deductions to the payer of the commis- sion. (T. D. 2090.) Taxes Paid by a Tenant Taxes paid by a tenant for a landlord are considered as additional payment for rent and are deductible as an expense of carrying on business. (T. D. 2090.) Life and Fire Insurance Premiums Premiums paid for insurance on property which is not occupied by the owner as a dwelling, but is rented or leased to secure an income, constitute allowable deductions in computing net income. Premiums paid on life insurance by the insured do not constitute allowable deductions under the income tax law. (T. D. 2090.) Life Insurance Carried by Partnership on Lives of Individual Members Premiums paid on life insurance taken out by a partnership upon the lives of individual members of such partnership, constitute allow- able deductions in ascertaining the net earnings of the partnership. However, when such policies mature, or upon the death of the insured partner, the amount received as life insurance should be included in the gross income of the partnership. (T. D. 2090.) Rent An application under the British income tax act, by a clergyman for the deduction of the rental value of his study from his income (which was granted), may be cited as an interesting British precedent. (See Murray & Carter's "A Guide to Income Tax Practice," 6th Ed., page 268, London, 1911.) Management Expenses On this point the report to the National Tax Association says : Expenses Incurred by Indiviituals in Making Investments and Managing Property, with Respect to Which the Income is Taxed, Should be Permitted as are Expenses of Carrying on Business. The act allows the deduction of the necessary expenses actually paid in carrying on any business, not including personal, family, or living expenses. This leaves a doubt as to expenses incurred in man- aging property held for investment (insurance, commissions for collect- ing rents, repairs, etc.). Such management is not commonly regarded as carrying on a business; neither, however, are the expenses of man- FEDERAL INCOME TAX 793 agement personal, family, or living expenses. It would be easy to set this matter clear. Management expenses should be treated like business expenses. Interest The next classification of allowable deductions is interest. The law provides for: "All interest paid within the year on personal indebted- ness of taxpayer." The regulations published in 1915 provided that the deduction under this item should be : ''All interest paid within the year on personal indebtedness of the taxpayer incurred in the conduct of business." Note the last six words, which are not found in the law. As the law reads it is perfectly clear. Manifestly it was intended that if an individual should buy a house for $10,000 subject to an $8,000 6 per cent mort- gage, he could claim an allowable deduction of $480 per year. True, such a provision is not equitable as against an individual who pays rent but who cannot include such payment as a deduction. Therefore, the Commissioner, while completely rewriting the law by adding words which changed its meaning, may have endeavored to collect additional revenue from those who should have paid it ; yet by so* doing he com- pletely usurped legislative powers. Later, the regulations were in effect changed by a telegram sent to a firm of lawyers. The lawyers tele- graphed the Commissioner as follows : Article 6 of the Regulations of January 5, 1915, in referring to deductions from individual's income permits the deduction of interest "paid within the year on personal indebtedness of the taxpayer, in- curred in the conduct of business." Do we understand that the De- partment does not allow deduction of interest unless incurred in the conduct of business? . . . The Commissioner replied : Your telegram February 11 received. All interest paid within the year by taxable persons on indebtedness may be deducted in computing net income. It would be interesting to know how much revenue the government collected through this mistaken regulation, and whether any effort was made to advise individuals who may have followed the regulations that they were in error. This is a good illustration of the fallibility of Treasury Department regulations and decisions, and emphasizes the necessity of understand- ing the law and insisting upon its being enforced. If no objection had been made in the case in point it is quite probable that the govern- ment would have continued to collect taxes, to which it was not entitled, from unsuspecting individuals. 794 AUDITING It would seem that a proper and equitable provision in the law would be to permit the deduction of interest payments only where the interest- bearing debt was incurred in the purchase of property or investments for income-producing purposes. Taxes The next item covers taxes. The law provides that there may be deducted : "AH national, state, county, school and municipal taxes paid" within the year (not including those assessed against local benefits). As the taxes paid upon an individual's residence, the rental value of which is not taxable, are an allowable deduction, it would seem to be more equitable if taxes were deductible only when paid in re- spect of income-producing property, or property acquired for income- producing purposes. Taxes paid by citizens or resident aliens of the United States to a foreign country are not allowable deductions in computing net income. The provision of law for the deduction of taxes applies only to taxes paid to the United States, or to some state or political subdivision thereof in the United States. (T. D. 2090.) On this point the report to the National Tax Association says: Individuals Should be Permitted to Deduct Taxes Paid within the Year in Foreign Countries upon the Property or Business from Which the Taxable Income was Derived. The fourth deduction allowed to corporations reads as follows: "(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." Your Committee is of opinion that individuals should be permitted to deduct taxes paid to foreign countries. No good reason occurs to us why the individual engaged in business should be denied the right extended to corporations. In his report of December 6, 1915, the Commissioner of Internal Revenue recommended that foreign taxes be made allowable deductions. It has been ruled that customs duties paid during the year by an individual are allowable deductions as taxes or as part of the cost price if the individual is engaged in the importation of goods and merchandise. Tax Paid on "Tax Free" Bonds Deductible The amount of taxes paid by a corporation in respect of the "tax free" clause in its bonds is not deductible by the corporation, but does constitute an allowable deduction to the individual for whose account the tax is paid. The amount thereof to be deducted is 1 per cent of the FEDERAL INCOME TAX 795 income of this nature reported in column A of the return. When so treated, the individual should add to the amount of interest the tax paid in his behalf. Taxes Paid by Banks on Bank Stock Held by Individuals Taxes assessed against the stockholders of a bank and paid by the bank in behalf of the stockholders do not constitute an allowable de- duction from the gross income of the bank, but do constitute an allow- able deduction in the return of the individual. If such individual is subject to the additional tax on dividends, the amount of taxes so paid should be included in his return as income, the said amount being considered as an additional dividend. Income Tax as an Allowable Deduction For the purpose of claiming as allowable deductions the amounts paid to the collector and the amounts withheld at the source on ac- count of the income tax, it is held that amounts of both classes are paid, within the meaning of the law, in the year in which assessment is made and the tax paid to the collector of internal revenue. Taxes Assessed Against Local Benefits Taxes paid pursuant to assessments levied by special districts, such as irrigation, reclamation, drainage districts, etc., for sidewalks in cities, street extension, grading, paving, etc., are held to be "taxes assessed against local benefits." Such taxes are not allowable deductions in a return of annual net income. (T. D. 2090.) Losses The next item is losses. The law permits the deduction of: Losses actually sustained during the year incurred in trade or arising from fires, storms, or shipwreck, and not compensated by insurance or otherwise. One of the first rulings relating to losses was by Deputy Internal Revenue Commissioner Speer who early in 1914 made the following ruling : Profits and Losses on Securities Purchased Prior to March 1, 1913, TO be Prorated. If securities were purchased prior to March 1, 1913, and disposed of at a profit or loss during 1913, and no annual adjustment is made on the books, the profits or loss as ascertained when sold (that is, the difference between the cost and the selling price), shall be prorated and the proportionate profit or loss from March 1 would be gain or allowable deduction. 796 AUDITING If the stock was purchased after March 1, 1913, and sold at a later date, during that year, the entire profit or loss in the transaction would be considered a gain or an allowable deduction in computing the net income. This ruling was reasonable and equitable and being made soon after the passage of the law would indicate a close relation to what was in the minds of the legislators. Where there is an ambiguity in a law, the courts attempt to ascertain the intention of those who enacted it. Bearing directly on this point, Judge Hull, already referred to as the writer of the income tax bill, was asked in the House of Repre- sentatives whether a person making a profit on one investment and a loss on another would be permitted to offset the loss against the profit. Mr. Hull is quoted as saying in reply that : If he is simply making a casual investment of that kind now and then, or here and there, I think he would report his gains for taxable purposes, and probably would be allowed for his loss. It would not be a trade loss, but set off against the particular gain from the other stock transactions. (Congressional Record for April 26, 1913, page 10.) On this question the report to the National Tax Association says: It is immaterial from a practical point of view whether the owner of a given business is an individual or a corporation. The same deductions should be allowed to each. No reason has occurred to the Committee why an individual should be allowed to deduct losses arising from fires, storms, or shipwreck and not from floods and other calamities. The English law permits the deduction of any loss con- nected with or arising out of the trade. Whether or not that rule be adopted, deductions for losses should be uniformly allowed to all busi- ness enterprises, regardless of the fact that the business may be con- ducted by corporations or by individuals. The law permits the deductions by individuals of losses "incurred in trade." The Treasury Department holds this to mean losses incurred in the business of the taxpayer and to preclude the deduction of losses on isolated investments. On the other hand, gains from isolated investments are taxed. Perhaps no provision of the law has met with more objection than this. Your Committee urges that the law be changed to permit the deduction of losses with respect to any transaction where the gains are taxed. Much argument could be made on the proposition that increase in capital assets is not income in the true sense of the word, but for the purpose of the tax it works substantial justice to tax gains on trans- actions involving exchange of capital assets. To be consistent and just, however, the converse must be recognized and losses should be permitted to offset gains. Your Committee, therefore, recommends that the fourth deduction allowed to individuals should include all losses incurred in the business, trade or profession in which they are engaged and all losses of prop- erty used for investment or speculative purposes where the gain, if any, would be subject to tax. FEDERAL INCOME TAX 79: To the lay mind the words "in trade" have a broad meaning and comprehend all of the transactions involved in the purchase and sale of real estate, securities, etc., as well as similar dealings in other commodities. The Standard Dictionary defines trade as: 1. A business learned or carried on for procuring subsistence or profit. 2. Buying and selling for gain or as a means of live- lihood ; mercantile traffic; commerce; hence any in- dividual bargain. The courts, too, seem to have the same understanding of the words. In May v. Sloan, 101 U. S. 237, the court said : The word "trade" in its broadest signification, includes not only the business of exchanging com- modities by barter, but the business of buying and selling for money, or commerce and traffic generally. Black's Law Dictionary defines trade as "the act or business of exchanging commodities by barter ; or the business of buying and sell- ing for money." Bouvier's Law Dictionary defines it as "any sort of dealings by way of sale or exchange," and according to the National Reporter System it "means the craft or business which a person has learned and which he carries on as a means of livelihood ; a purchase or sale ; a bargain." From the foregoing it would appear to be reasonably certain that when the courts come to pass upon the question it will be decided that if profits on sales of, or dealings in, real estate, securities, etc., are taxable, then losses are allowable deductions. In the meantime taxpayers should take credit for losses in their returns and clearly specify the nature of the items. No doubt the claim will be disallowed and the tax assessed thereon, but the tax should be paid under protest and there is at least a reasonable chance that it will be refunded some day. In order that the position of the Treasury Department in regard to allowable deductions may be understood, copious extracts from de- cisions are reproduced here. It will be noted that the word "trade" is not defined, but one syno- nym is taken and that is defined. Several letters have been received in which inquiry has been made as to whether losses resulting from the sale of real estate by individ- uals are properly deductible from gross income in the returns of annual net income of individuals for the income tax. Under paragraph B of the income tax law it is provided that among the deductions to be allowed shall be: 798 AUDITING "Losses actually sustained during the year, incurred in trade." "Losses actually sustained during the year, incurred in trade are limited by the language of the act itself." "In trade," is synonymous with business. "Business" has been defined as : "That which occupies and engages the time, attention and labor of any one for the purpose of livelihood, profit, or improvement ; that which is his personal concern or interest ; employment, regular occupa- tion, but it is not necessary. that it should be his sole occupation or employment." The doing of a single act incidently or of necessity not pertaining to the particular business of the person doing the same will not be considered engaging in or carrying on the business. It is therefore held that no losses are deductible in a return of income save and only those losses permitted and provided for by the statute, viz., those actually sustained during the year — Which are . . . "incurred in trade." Or which arise from . . . "fires, storms or ship- wreck, and not compensated for by insurance or otherwise." (T. D. 1989.) "Only those losses are deductible which are sustained during the tax year 'in trade.' Loss to be deductible must be an absolute loss, not a speculative or fluctuating valuation of continuing investment, but must be an actual loss, actually sustained and ascertained during the tax year for which the deduction is sought to be made ; it must be incurred in trade and be determined and ascertained upon an actual, a completed, a closed transaction. "The term 'in trade,' as used in the law and in Treasury Decision 2005, is held to mean the trade or trades in which the person making the return is engaged ; that is, in which he has invested money other- wise than for the purpose of being employed in isolated transactions, and to which he devotes at least a part of his time and attention. A person may engage in more than one trade and may deduct losses incurred in all of them, provided, that in each trade the above re- quirements are met. As to losses on stocks, grain, cotton, etc., if these are incurred by a person engaged in trade to which the buying or selling of stock, etc., are incident as a part of the business, as by a rnember of a stock, grain, or cotton exchange, such losses may be deducted. A person can be engaged in more than one business, but it must be clearly shown in such cases that he is actually a dealer, or trader, or manufacturer, or whatever the occupation may be, and is actually engaged in one or more lines of recognized businesses before losses can be claimed with respect to either or more than one line of business, and his status as such dealer must be clearly established." (T. D. 2090.) I regret that it is impossible to change the principle of the other decision to which you refer. The Act of Congress requires that the tax shall be paid "upon the entire net income arising or accruing from all sources," permitting the deduction of certain specified kinds of ex~ penses and losses, one of which is "losses actually sustained during the year, incurred in trade." I have no authority to permit any other losses to be deducted than those which Congress provides for. If Congress had intended that all losses might be deducted, it would doubtless have so drafted the law. Therefore, forbidding the deduction from income tax returns of losses incurred outside the ordinary course of business, but requiring the inclusion of profits made outside the FEDERAL INCOME TAX 799 business, is not the act of the Treasury Department, but of Congress. (Extract from letter to S. C. Mead, Secretary Merchants' Association of New York, signed by Secretary of the Treasury W. G. McAdoo and dated February 27, 1915.) The Secretary fails to produce any affirmative evidence to indicate that Congress actually defined "trade" as appears in the later decisions. It looks as if he arrived at a conclusion for revenue-producing pur- poses and one not warranted from such evidence as is available. An individual member of a partnership should, under this section, claim a deduction for the net loss, if any, borne by him as his share of a partnership loss for the preceding calendar year; or if the partnership fiscal year ended at some other date, then his share of the loss, if any, for a full year ended at the regular fiscal date. Another remarkable decision relates to allowable deductions by those who deal in real estate, securities, etc., and who are permitted by the Treasury Department to deduct losses in connection therewith when incurred. Losses on Securities, etc. As mentioned under reportable income (page 777), it is 1 physical impossibility for dealers in real estate, securities, etc., to keep each item or parcel separate, and common sense would decree that such dealers should be permitted to inventory their property annually as is done by others. The Department, however, does not sanction the prac- tice. Until the question is passed upon by the courts, it would seem advisable to report gains or losses under the inventory method, and, if the practice is objected to, seek the Department's aid for a practical system whereby their peculiar bookkeeping methods can be followed and still permit the dealers to remain in active business. Where it is feasible, and where partnerships desire to have their books accord with the regulations covering the fluctuations in securities, the following method is suggested as one which will permit the ascertainment and book distribution of profits or losses on the inventory or market price method, and provide for a later adjustment upon the sale of the securities. Open a ledger account entitled "Security Fluctuations." At the end of the fiscal year when the books are closed, debit this account and credit partners' special capital accounts with any increase in market prices above cost or book values. Credit this account and debit partners' special capital accounts with any decreases in market prices below cost or book values. Ignore the entries in this account in making up income tax returns of the partnership or of the individual partners. Subsequently when securities are sold, become worthless, or are 8oo AUDITING otherwise disposed of, debit or credit "Security Fluctuations" and part- ners' special capital accounts, reversing the original entries. The actual profit or loss on each sale will, of course, be reflected in turn in the security account itself, in the profit and loss account, and in the part- ners regular capital accounts. The ruling on this point is : Shrinkage in value of securities : Bonds and securities are not sub- ject to wear and tear within the meaning of the federal income tax law, and therefore depreciation does not apply to any shrinkage in their value. Shrinkage in the value of securities as such does not constitute a loss actually sustained within the year, the amount of which is definitely ascertained. Therefore, under the rules of this office and consistent with the provision of the law, a shrinkage in the value of bonds or like securities does not constitute an allowable deduction from gross income either as loss or depreciation. The fact that bonds and similar securities were written off at the direction of the Comptroller of the Currency or the state banking department is not material. A mere book entry does not constitute either a loss or gain for the purpose of the income tax. The fact that bonds were written off does not necessarily imply ihat they are a total loss, nor is this act a conclusive proof that any loss occurred during the year for which the return is made. Losses of this character are only ascertainable when the securities mature, are disposed of, or canceled. Bad Debts The next item of allowable deduction covers: "Debts past due which have been actually ascertained to be worthless and which have been charged off within the year." Debts arising from unpaid wages, salaries, rents, and items of simi- lar taxable income, due and payable on or after March 1, 1913, will not be allowed as general deductions under paragraph B of the income tax law unless the income which they represent has been included in a return of gross inco ne for the year in which the deduction as a bad debt is sought to be made, or in a previous year; and the debts, them- selves, have been actually ascertained to be worthless and charged off. All debts representing amounts that became due and payable prior to March 1, 1913, and not ascertained to be worthless prior to that date, whether representing income or a return of capital, are held to be allowable deductions, under paragraph B of the law, in a return of income for the year in which they are actually ascertained to be worth- less and are charged off. As most persons and most corporations are honest, it would have been better to permit as an allowable deduction accrued losses as well as those finally ascertained to be worthless and charged off within the year. Every individual or corporation keeping books properly, sets up a reserve to meet the losses which have not fully materialized, but FEDERAL INCOME TAX 8oi which, based upon experience, will surely recur. The failure to do so is opposed to sound accounting, and if so reflected in a balance sheet, will in some states subject the person who signs it to severe penalties, including imprisonment, for obtaining credit upon a false financial statement. These laws are the result of many years of hard work on the part of lawyers, credit and business men, and bankers. United States dis- trict attorneys who prosecute fraudulent bankruptcy cases have been particularly interested in securing legislation of this character. It is true that the returns may be made out by ignoring the net results shown in the books ; that is, claim as allowable deductions only debts charged off within the year, and omit the amount set up as a reserve for debts not yet charged off. Many concerns, however, include the full amount of the reserve and thus report as net income the exact amount as shown by the books. Inspectors who discover this method of reporting, usually see to it that an additional tax is assessed although in an old business the amount charged off during a year approximates the reserve. In a new business it would for one year make some difference, but never enough to justify the government aligning itself, as is now the case, with those who try to fool themselves by failing to provide for probable losses and expenses. The law purports to tax net income only. Therefore, an allowance should be claimed for accrued losses, based on actual experience and at an amount fixed in good faith. Without such provision, accounts cannot be properly stated. If the Commissioner of Internal Revenue does not allow the claim, then a restatement may be necessary, based on the accounts charged off within the year. Bonds It has been pointed out that under present rulings losses arising out of the purchase and sale of stocks and bonds are not allowable deductions. It should be noted, however, that bonds are "debts" and if they be- come worthless and can be charged off, the cost thereof can be entered under this head as an allowable deduction. Stocks are not "debts" and credit cannot be claimed therefor as with bonds. Depreciation The next deduction covers the "amount representing a reasonable allowance for the exhaustion, wear and tear of property arising out of its use or employment in business. No deduction shall be made for any 8o2 AUDITING amount of expense of restoring property or making good the exhaustion thereof for which a deduction is claimed elsewhere in this return." The following quotations are from the official regulations, decisions, and instructions of the Commissioner. (It will be noted that some of the rulings refer specifically to corporations, but in all cases, the prin- ciples involved apply to individuals as well, which accounts for the extended quotation at this point.) The deduction for depreciation should be the estimated amount of the loss, accrued during the year to which the return relates, in the value of the property in respect of which such deduction is claimed, that arises from exhaustion, wear and tear, or obsolescence out of the uses to which the property is put, and which loss has not been made good by payments for ordinary maintenance and repairs deducted under the heading of expenses of maintenance and operation. This estimate should be formed upon the assumed life of the property, its cost, and its use. Expenses paid in any one year in making good ex- haustion, wear and tear, or obsolescence in respect of which any de- duction for depreciation is claimed must not be included in the deduc- tion for expense of maintenance and operation of the property, but must be made out of accumulated allowances, deducted for deprecia- tion in current and previous years. The depreciation allowance, to be deductible, must be, as nearly as possible, the measure of the loss due to wear and tear, exhaustion and obsolescence, and should be so entered on the books as to con- stitute a liability against the assets of the company (or individual) and must be reflected in the annual balance sheet. The annual allow- ance deductible on this account. should be such an amount as that the aggregate of the annual allowances deducted during the life of the property, with respect to which it is claimed, will not, when the prop- erty is worn out, exhausted, or obsolete, exceed its original cost. This ruling conforms to correct accounting practice. The chief difficulty in its application has arisen under the refusal of revenue inspectors to allow, in some cases for both repairs and depreciation, on the ground that the former included the latter. It is quite true that an excessive allowance would be claimed if items charged as repairs represented renewals or additions. The Wis- consin law covers the point very well by providing that repairs and depreciation together must not exceed the deterioration of the property. If the amounts claimed in the return accord with the books of account, there will be few cases where excessive depreciation is claimed, or where additions and renewals will be found charged to repairs. Public accountants have been for many years urging upon their clients the importance of ample allowances for depreciation, and the task has not been an easy one. The tendency is towards insufficient rather than excessive depreciation reserves, which means that from most taxpayers the government will collect too much rather than too little. I FEDERAL INCOME TAX 803 It is not gratifying to observe that our federal authorities, whose tendency is paternalistic, have in their interpretations of the corporation excise and the income tax laws, shown a disposition to favor methods of accounting which are most unsafe and which inevitably lead to bank- ruptcy. For instance in one case, a textile manufacturer whose mill must work in double shifts, claimed a depreciation of his textile machinery at the rate of less than 10 per cent per annum. This was equivalent to less than 5 per cent per annum based on ordinary working hours, because where machinery receives no rest it deteriorates more rapidly. The inspector who examined the accounts, however, decided that the rate was too high and upon appeal to Washington the inspector was sustained. It required a further appeal and a special trip to Washington to sustain the claim. In plants where machinery is run "overtime," depreciation must have special consideration. Because of its constant use, there is little oppor- tunity to make proper repairs and supervise its condition and main- tenance. If a double shift is used (and in some cases there are three shifts), the responsibility for the up-keep of the machinery is divided, and with divided responsibility the machinery is sure to suffer. Then, too, in such cases, new workmen and those on night duty are not so efficient as the regular staff, and the machinery suffers accordingly. Of course, much depends on the class of business. If intricate and delicate machinery is in use, it will be injured more than if rough and heavy work alone is involved. But in all cases extra hours of work involve higher rates of depreciation of machinery than will be found necessary for normal conditions. Fortunately for those who are inclined towards safe and sane methods, the courts may be depended upon to sanction proper rates of depreciation, so that individuals ■ or corporations whose practice it has been to set aside adequate allowances rnay continue to do so. Without question their position will be sustained by the courts. If in the meantime inspectors arbitrarily insist on insufficient al- lowances, and additional taxes are assessed, the taxes will of course have to be paid, but if paid under protest the excess paid can be recovered later. Depreciation Must Appear on Books The law does not state that depreciation must be provided for on the books, but the author has no sympathy with anyone who is not willing to have his income tax returns accord with his books ; there- fore the position of the Treasury Department on this point, while it does not follow the law and will not be sustained by the courts, is reasonable from the standpoint of correct accounting. 8o4 AUDITING The regulations provide: In the examination of the books of corporations for the purpose of verifying their returns of annual net income, revenue agents and examining officers have, in many cases, declined to allow deductions on account of depreciation, simply and only because the amounts claimed in the returns on this account were not written off on the books of the companies. This conforms technically with the rules of this office, requiring all deductible items to be evidenced by book entries. However, the law authorizes corporations to deduct from gross income "a reasonable allowance for depreciation, if any." The law does not specifically require that, in order to secure deduction on this account, the amount claimed must be written off. It has nevertheless been consistently held by this office that a de- preciation deduction, in order to be allowable, must be a fair measure of the loss sustained by reason of the wear and tear, exhaustion, or obsolescence of the property, and must be so entered upon the books of the company as to constitute a liability against its assets. Such "reasonable allowance" is to be determined upon the basis of the cost and probable number of years constituting the life of the property with respect to which it is claimed. Because of the fact that the law does not specifically require amounts, otherwise deductible, to be written off, many corporations included in their deductions from gross income reasonable allowances for depreciation of which there was no evidence on their books. It is not the desire of this office to deny, upon purely technical grounds, a deduction which the law authorizes and which conforms, or may be made to conform, to the regulations. Revenue agents and examining officers, in the examination of the books of a corporation, will, therefore, determine whether or not the deduction claimed in its re- turn is a fair and reasonable measure of the loss sustained during the year, and if they find that thfe amount claimed in a return is such fair and reasonable measure of the loss and that it was not written off on the books of the company, they will permit the corporation to reopen its books, if it so desires, and make such entries as will con- stitute the amount, sought to be deducted, a liability against the assets of the company and a charge against the income of the year for which the return is made. Sufficient time to make such correcting entries should be given the corporation before the report of the ex- amination is made to this office, and any recommendations as to addi- tional taxes should be made accordingly. If a corporation refuses or neglects to reopen its books and write off the depreciation claimed in the return, or a reasonable amount measuring the loss sustained on this account, the amount claimed in the return will be disallowed. The correcting entries for each year, if made, must be such as would have been made had they been made at the time the books were closed. The foregoing instructions do not contemplate that a depreciation deduction is to be allowed in every case simply because it is written off. If, upon examination, taking into account the character of the property and the uses to which it is put, it appears that the amount written off and deducted in the return is in excess of a reasonable allowance within the law, the excess should be disallowed. When the amount claimed for depreciation has been written off on FEDERAL INCOME TAX 805 the books of the company, either prior or subsequent to the making of the return, it remains for the revenue agent and the examining officer to determine whether or not this amount is such as, within the meaning of the law and regulations, constitutes an allowable deduction, and, if it does, it should be allowed and report made accordingly. Under the corporation excise tax law the Internal Revenue Com- missioner ruled that depreciation, to be allowed, must be charged ofif as an expense on one side and credited directly to the Property account on the other. This of course disregarded the practice of all well-run concerns. Later the ruling was rescinded and from May 9, 1912, it has been recognized that depreciation can be expressed on the books of account by appropriate reserve accounts. Reserves for Depreciation The Internal Revenue Bureau, however, goes a step further and provides that the reserves must be used for the purposes for which they are created and nothing else. The Commissioner takes the stand that it is a "reasonable requirement that the fund set aside for depreciation should be kept intact." Of course, if applied literally this ruling would be absurd. Assume that a building is expected to last fifty years and 2 per cent per annum is reserved for depreciation. It is not the custom, nor, as is pointed out elsewhere in this book, is it good business to put this 2 per cent in a separate bank account and hold it there intact for fifty years. There is no separate fund to represent it but it is properly accounted for among the assets gen- erally. In a letter to Willard H. Lawton, C. P. A., who took issue with the ruling, the Commissioner in effect said that the depreciation "fund" could be diverted provided that the expenditures thereof were not charged against the reserve for depreciation. As this accords with general practice, it will be noted that the whole subject is of academic interest only, but in view of the importance given to it, the rulings are reproduced at length. Reserves for Depreciation. Depreciation set up on the books and deducted from gross income cannot be used for any purpose other than making good the loss sustained by reason of the wear and tear, exhaustion, or obsolescence of the property with respect to which it was claimed. If it develops that an amount has been reserved or deducted in excess of the loss by depreciation, the excess shall be restored to income and so accounted for. If any portion of the depreciation set up is diverted to any purpose other than making good the loss sustained by reason of depreciation, the income account for the year in which such diversion takes place must be correspondingly increased. The investment of depreciation reserve funds in the concern's own plant in the way of additions and extensions would appear to be such a diversion. Investments in additions and extensions are primarily capital in- 8o6 AUDITING vestments and the fact that the corporation is investing its deprecia- tion funds in additions and betterments or improvements would seem to indicate that the amounts set aside on account of depreciation were in excess of a reasonable allowance which the law contemplates a corporation may deduct from its gross income, and when it shall appear that by reason of the investing of its depreciation funds in additions, betterments, and improvements, it actually adds to the value of its capital assets, it will be insisted upon that the amount by which the assets are increased on this account shall be returned as income and be subject to the income tax. Mr. Lawton's letter, taking issue with this ruling, was answered as follows: The only apparent reason for authorizing a deduction on account of depreciation is to provide a fund out of which the property with respect to which depreciation is claimed may be renewed or replaced, or to restore to the corporation the capital invested in such property, when it is worn out or exhausted. This does not mean that this fund shall be locked up in a vault or that it cannot be used to meet the ordinary demands of the busi- ness, but that it shall be available at any time to meet purposes for which it is set aside. In order that the return may be checked at any time with the books, this fund should be carried as a separate and distinct account as a liability against the assets of the company. The investment of this fund or any part thereof in the concern's own plant in the way of additions or extensions would appear to be a diversion of the fund to a purpose other than the making good depreciation previously sustained. This may be permitted, however, if the property account is charged with the amount of the fund thus used, in which case the depreciation account remains a liability and renewals and replacements when made are charged against it rather than against current income. In any event, the depreciation liability will be reflected in the annual balance sheet. Rates of Depreciation As heretofore stated, the government will be compelled to allow such claims for depreciation as can be sustained as actual or reason- able. For rates of depreciation on various classes of property, and methods of calculating same, see page 401 of this book. So far there has been no standardization of rates and obviously no standards can be established. Rulings relating to rates of depreciation are as follows: This office is in receipt of your letter of the 26th ultimo, in which you state that a representative of this Bureau in making an examina- tion of the books of corporations located in that district for the pur- pose of verifying their returns of annual net income, insists upon a fixed per cent of depreciation to be deducted from gross income of said corporations. The percentages insisted upon, you state, are 5 per cent on machinery of all kinds, 3 per cent on fixtures, 1 per cent on buildings, 7^ per cent on horses and wagons. FEDERAL INCOME TAX 807 In reply to your inquiry, you are informed that this office has fixed no definite rates by which an allowable deduction on account of depreciation in the value of any class of property is to be computed. The rule which this office has established and which is being very generally followed by corporations, contemplates that an allowable depreciation deduction shall be computed upon the basis of the cost of the property and the number of years constituting its life. The life of the property necessarily depends upon its character, the uses to which it is put and the conditions under which it is used. These elements being taken into consideration, corporations should, as a result of experience, very closely approximate the number of years constituting the life of the property and upon this basis determine the rate of depreciation which annually occurs. Depreciation of Patents An allowance for depreciation of patents will be made on the following basis : The deduction claimed for exhaustion of the capital assets as represented by patents to be made in the return of annual net income of a corporation for any given year shall be one-seventeenth of the actual cost of such patents reduced to a cash basis. Where the patent has been secured from the government by a corporation itself, its cost would be represented by the various government fees, cost of drawings, experimental models, attorney's fees, etc. Where the patent has been purchased by the corporation for a cash consideration, the amount would represent the cost. Where the corporation has purchased a patent and made payment therefor in stocks or other securities, the actual cash value of such stocks or other securities at the time of the purchase will represent the cost of the patent to the corporation. With respect to the depreciation of patents, one-seventeenth of the cost is allowable as a proper deduction each year until the cost of the patent has been returned to the corporation. Where the value of a patent has disappeared through obsolescence or any other cause and the fact has been established that the patent is valueless, the unre- turned cash investment remaining in the patent may be claimed as a total loss and be deducted from gross income in the return of annual net income for the year during which the facts as to obsolescence or loss shall be established, such unreturned cash value to be fixed in accordance with the proportion that the number of years which the patent still has to run bears to the full patent period of seventeen years. Depreciation of Good- Will "Good-will" represents the value attached to a business over and above the value of the physical property, and is such an entirely intangible asset that no claim for depreciation in connection therewith can be allowed. Depreciation of Timber Lands Owners of tracts of timber lands, removing therefrom and selling, or otherwise disposing of the timber will be permitted to deduct from 8o8 . AUDITING their gross income on account of depreciation or depletion an amount representing the original cost of such timber, plus any carrying charges that may have been capitalized or not deducted from income. The purpose of the depreciation or depletion deduction is to secure to the corporation, when the timber has been exhausted, an aggregate amount which, plus the salvage value of the land, will equal the capital actually invested in such timber and land. When an amount sufficient to return this capital has been secured through annual depreciation deductions, no further deduction on this account shall be allowed. For the purpose of increasing the deduction on this account no arbitrary increase in values shall be made, unless such increase in value shall be returned as income for the year in which the increase in value was taken up on the books. Unearned Increment as Affecting Depreciation Unearned increment will not be considered in fixing the value on which depreciation shall be based. Depreciation of Theatrical Costumes If costumes purchased by actors and actresses are used exclusively in the production of a play, and are not adapted for occasional per- sonal use, and are not so used, a deduction may be claimed on account of such depreciation in their value as occurs during the year on account of wear and tear arising from their use in the production of the play, or to their becoming obsolete at the close of the production. Physicians' Claims for Depreciation In New York City a physician made the following claims for depreciation : Residence. Brick construction. On part occupied as offices only 5% Automobile 20% Books 20% Instruments 25% Office furniture 20% Country residence. Wood construction. . 10% Depletion The next item of allowable deduction provided for is an "amount allowed to cover depletion, in case of mines and oil wells, not to ex- ceed 5 per cent of the gross value at the mine or well of the output for the calendar year for which this return is rendered." The decisions and regulations relating to this deduction are sum- marized below. While many of the rulings refer to corporations, they also apply to individuals. The depreciation of coal, iron, oil, gas, and all other natural de- posits must be based upon the actual cost of the properties containing FEDERAL INCOME TAX 809 such deposits. In no case shall the annual deduction on this account exceed 5 per cent of the gross value at the mine (well, etc.) of the output for the year for which the computation is made. In addition to the deduction to measure the loss due to depletion, the corporation will be allowed the usual depreciation of its machinery, equipment, etc., such depreciation to be determined on the basis of the cost and estimated life of the property with respect to which the depreciation is claimed. Corporations leasing oil or gas territory shall base their deple- tion deduction upon the cost of the lease, and not upon the estimated value, in place, of the oil or gas. Corporations operating mines (including oil or gas wells) upon a royalty basis only cannot claim depreciation because of the exhaustion of the deposits. Gross Value at Mine "Gross value at the mine," is held to mean the gross price at which the product could be sold at the mine ; that is, its actual bona fide market value. The owners, however, may deduct depreciation from royalties received. The term "gross" as applied to "value" contemplates the aggre- gate value of the product at the mine determined upon the basis of the market conditions at the time and place, and is best defined as the price at which the product sells or would sell when delivered at the mouth of the mine in a marketable condition. Five per cent of the value thus determined will constitute the maximum amount which a mining corporation may deduct under the federal income tax law from gross income on account of depletion of natural deposits. This does not contemplate that the full 5 per cent of the gross value will be allowed if the aggregate amount calculated at a less rate will equal the cost in place of such deposits or secure to the corporation the return of its capital when the deposits have been exhausted. The term "gross value at the mine," as used in paragraphs B and G of section 2 of the act of October 3, 1913, prescribing a limit to the amount which may be deducted in the return of individuals and corporations as depreciation in the case of mines, is held to mean the market value of ore, coal, crude oil, and gas at the mine or well, where such value is established by actual sales at the mine or well; and in case the market value of the product of the mine or well is established at some place other than at the mine or well, or on the basis of the bullion or metallic value of the ore, then the gross value at the mine is held to be the value of the ore, coal, oil, or gas sold, or of the metal produced, less transportation, reduction, and smelting charges. If the rate of 5 per cent per annum shall return to the corporation its capital investment prior to the exhaustion of the deposits, the rate on which the annual deduction for depletion of deposits is based must be lowered in accordance with the estimated number of years it will take to exhaust the estimated reserves. In case the reserves shall be in excess of the estimates, no further deduction on account of depletion shall be made when the capital investment has been returned to the corporation. This limit will in some cases be found to restrict the exhaustion 8io AUDITING allowance to less than the actual cost of the minerals to the taxpayers. For instance, if a tract of coal land costing $600 per acre averages, say, 8,000 tons of coal per acre, the cost of the coal in place is lYz cents per ton. The land after being mined out might have some value which would reduce the net cost of the coal, but such value is usually comparatively little and for the purpose of the present illustration may be ignored. If the average selling price per ton at the mine during the year was, say, $1.20, the maximum exhaustion allowance would be 6 cents per ton or only 80 per cent of the actual cost. Consequently the amount on which the owner of the mine would be taxed in this case would be in excess of the true income from the mine. Exhaustion of Oil Wells. The 5 per cent allowance must be very carefully handled by lessors of the land on which the wells are located. It is customary in leasing oil lands for the lessor to receive as royalty a fixed part of the oil produced by the wells, one-eighth of the out- put being a widely used figure. Assuming that the entire production of the wells (over the sale of seven-eighths of which the lessor has no control) is sold at about the same average price at which he sells his royalty oil, 5 per cent of the value of the oil produced would be equal to 40 per cent of the royalties received. The cost of drilling dry holes (i.e., if oil is not struck) should be taken credit for as expenses of operation and not as a depreciation allowance. The report to the National Tax Association says on this point : Allowances for the Depreciation of Property and for the Deple- tion OF Natural Resources Should be on a Basis Which Will Permit the Return of the Capital Invested Therein, Free from Tax, as Nearly as Possible Coincident with the Obsolescence of the Property or the Exhaustion of the Resources. The same rule should apply to allowances for depletion of natural resources as to depreciation. That is, the amount of capital originally expended by the corporation or individual owner in development work should be returned free from tax. The annual allowances should not be limited to 5 per cent of the gross value at the mine, but should be such reasonable amount as will in the aggregate equal the amount of capital originally expended at or as near as possible to the time when the natural resources are exhausted. If the allowance aggre- gates an amount equal to the amount of capital originally invested before the resources are exhausted, no further allowance should be made, as the net income thereafter will represent gain entirely. Should the natural resources diminish more rapidly than estimated, a larger allowance should be made, permitting if necessary a claim equal to the entire net income in the year in which exhaustion occurs. Your Committee would suggest the adoption of the Wisconsin phraseology, which has been found to be both practicable and suffi- ciently elastic to permit of equitable application. The Wisconsin law authorizes "in the case of mines and quarries an allowance for deple- FEDERAL INCOME TAX 8ll tion of ores and other natural deposits on the basis of their actual original cost in cash or the equivalent of cash." OVERPAYMENT OF TAX (Forms 1008 revised and 46) It frequently happens that by reason of the tax having been with- held at the source on a large amount of income, the total deduction from "net income" will be in excess thereof. Where the total net income is in excess of $20,000, there will of course appear an amount of additional tax to be paid, and it would seem to be beyond cri.i- cism and an efficient method of settlement for the amount of the tax on the excess of deductions to be deducted from the total additional lax, thus making one net amount to be levied ty and paid to the gov- ernment. It has been held, however, that the total amount of addi- tional tax must be paid in full and the overpayment to the govern- ment by those deducting the tax at the source must be collected by claiming a refundment. If a simple claim upon using the required form and presenting the proven evidence were sufficient to procure a refund of the overpayment, the annoyance might not be burdensome, but unfortunately when the Treasury of the United States receives money to which it is not entitled it is a long and troublesome task to get it back. In one case a taxpayer whose net income was $44,000 and whose total deductions were $52,000, was subject to an additional tax of $240 which he was forced to pay. This made an overpayment for which he was entitled to a rebate of $80. He was required to execute and file Form 46, which was done. After waiting a long time he received a letter from the collector of his district advising him that he had better send in a duplicate of Form 1040 revised, as there might be difficulty in locating the original filed by him in due course seven months previously ! This was done, but up to this time the overpay- ment has not been refunded. Adjustment Before Overpayment of Tax If possible, an individual having an income on which the tax may be withheld at the source in an amount exceeding his total net income, should so arrange that an adjustment will be made before the tax is assessed and collected, thus obviating the painful delay and annoyance of trying to get the overpayment refunded. This is accomplished by filling out Form 1008 revised. The Commissioner's regulations relative thereto are as follows : 1, A person who has had income tax withheld from his income during the year 1914 in excess of his total liability for the normal gl2 AUDITING tax should file Form 1008 revised, with either the withholding agent, or the collector of internal revenue with whom the withholding agent's return is required to be filed, as he may elect. The with- holding agent is required by Treasury Decision 1965 to retain the amount of tax withheld by him until thirty days prior to March 1, 1915, in order to refund amounts withheld in excess of the taxpayer's liability for the normal tax, should a proper claim be filed for deductions and exemptions. He is required by law to file his return on or before March 1, 1915, and may, in his discretion, file his return on any date between January 1 and March 1. If he has filed his return with the collector, Form 1008 revised should also be filed with the collector, who will notify the withholding agent and authorize him to make a refundment, changing the entry on the re- turn and filing therewith Form 1008 revised as a voucher for the refundment. If, however, the withholding agent has not filed his return, and a claim on* Form 1008 revised is filed with him, he will make the proper refundment on his own responsibility, filing Form 1008 revised as a voucher therefor. If Form 1008 revised is filed with the collector under these circumstances, he will authorize the withholding agent to make refundment. The withholding agent is not required by law to forward to the collector the tax withheld by him until he has received notice of assessment and then, like the tax assessed in other cases, payment should be made by him on or before June 30 of each year. 2. Where there are two or more withholding agents whose collec- tion districts are the same. Form 1008 revised should be filed with the collector of that district, and a statement setting forth the names of the withholding agents and the amounts withheld by each should be attached to the form. The collector will then notify the withholding agents of the exact amount that may be refunded by each. 3. Where excess deductions have been made by two or more with- holding agents in different collection districts, Form 1008 revised may be filed with either collector, as the individual may elect; and there should be attached to the form a complete statement setting forth the names of all withholding agents, the amounts withheld by each, and the exact amount claimed as a refundment from each. The collector with whom the statement is filed will accept it as a part of Form 1008 revised and as subject to the penalties imposed by law, and will notify the withholding agents, whether in his district or other districts, to make the refundment claimed from each. 4. It is to be noted that this ruling provides for the execution by the taxpayer of only one Form 1008 revised, covering all the general deductions and exemptions claimed by him for the tax year. PAYMENT OF ERRONEOUS OR ILLEGAL TAXES In all cases it must be remembered that the tax levied by the col- lectors must be paid even if it is clearly in error. The United States Court has said on this point: Remedy at Law. Congress has aflforded a complete and adequate remedy at law open to all persons aggrieved by the collection of an erroneous or illegal revenue tax. The taxpayer must pay the tax, and he may then bring an action to recover it after appeal. FEDERAL INCOME TAX 813 On this point the report to the National Tax Association says: Application for Refund of Income Taxes with Consequent Right OF Appeal from the Decision of the Department Should be Allowed Not Only as at Present Within Two Years from Date of Payment of the Tax but Also, as a Matter of Course, at Any Time, Without Limit, as an Offset, Where an Addi- tional Tax for Any Year Is Claimed by the Government. Section 3220 of the Revised Statutes now provides that the Com- missioner of Internal Revenue, subject to regulations prescribed by the Secretary of the Treasury, is authorized, on appeal made to him, to remit, refund, and pay back all taxes erroneously or illegally as- sessed or collected, all penalties collected without authority, and all taxes that appear to be unjustly assessed or excessive in amount, or in any manner wrongfully collected. Application for refund must be made within two years after the tax is paid. (Real Estate Savings Bank v. The United States, 16 Ct. Qs. 335; 27 Int. Rev. Rec. 153; 104 U. S. 728; 28 Int. Rev. Rec. 27.) The Act permits assessment by summary proceedings upon the dis- covery of taxable income at any time within three years after the due date of the return in which such income should have been reported. It often happens that the inspectors of the Bureau of Internal Revenue postpone examination of the books of taxpayers until after two years have elapsed and at that time examine all returns which have been made since the previous examination. In such event, when the agent of the government is so examining the records of the taxpayers for unreported income, the taxpayer also often finds instances which would lawfully entitle him to refund, but is precluded from applying there- for because of the expiration of the two years' limit. The appearance of the agent for the government is a natural oppor- tunity for the taxpayer to re-examine his own records in the light of new court decisions and new departmental rulings. The Committee believes it only just that he should at that time be enabled to assert his right to refund of excessive taxes paid within a period correspond- ing to that for which additional taxes may be claimed by the govern- ment. INDIVIDUAL EXEMPTION On this point the report to the National Tax Association says : The Specific Exemption Should be Lowered and the Language of Paragraph "C" Should be Clarified. The tax is now imposed on about one-half of 1 per cent of the population of the country. It should rest on a larger proportion of the population. The exemption of $3,000 of income to the individual citizen is un- doubtedly too high ; and since the government needs additional revenue, the Committee recommends that the exemption be lowered to $2,000. We recognize that the circumstances attending the enactment and first operation of the law of 1913 may have justified as high an ex- emption as $3,000, but we believe that those circumstances are passed. 8i4 AUDITING and that it is on every account desirable to reduce the exemption to $2,000. When this is done, the provision relating to husbands and wives living together and making a joint return of their incomes should be changed so as to do away with the absurdity of the present ar- rangement by which a husband and wife receive a larger total exemption if they live apart. If the individual exemption is lowered to $2,000, it will be entirely practicable to grant to a husband and wife living together and making a joint report of their income a total exemption of $4,000, which would be the same exemption that they would re- ceive if they lived apart and made individual returns, each receiving an exemption of $2,000. The language of paragraph C leaves to judicial construction the questions whether or not the specific exemption should be deducted from net income in assessing the additional tax ; whether or not it may be deducted by non-resident aliens either in tolo or in part ac- cording to the proportion of a non-resident alien's total income arising in this country; whether the aggregate incomes of husband and wife are to be considered as the income of the family as a unit or those having separate incomes are each entitled to a deduction of $3,000, and an additional deduction of $1,000 when living together. Before these questions are finally settled it will be necessary for the highest court to announce its opinion. This will take several years, and Congress in the meantime can and should summarily announce its intent in unmistakable language. The Secretary of the Treasury, in his report of December 6, 1915, recommended that the present exemption be lowered to $2,000 and $3,000 respectively. INCOME OF NON-RESIDENT ALIENS The law provides that the tax shall be levied upon the entire net income from all property owned and of every business, etc., carried on in the United States by persons residing elsewhere. The specific exemption of $3,000 or $4,000 is not extended to non-resident aliens. The Attorney-General has rendered opinions that interest upon bonds and dividends upon corporate stock are not taxable to non- resident aliens whether or not the securities themselves are in the United States. The reason for these opinions is that the tax is levied upon the income from property, businesses, etc., and the decisions of the courts hold that the bonds and stocks owned by non-resident aliens are not property within the United States, that is, such property as has a legal situs therein. The practical application is that the income from bonds and stocks held by non-resident aliens is taxed or taxable in their hands abroad, and it is the feeling in the United States that to tax such income here would make investment in our securities un- desirable. The responsible heads, agents, or representatives of non-resident FEDERAL INCOME TAX 815 aliens who are in charge of the property owned or business carried on within the United States by non-resident aliens shall make full and complete returns of the income therefrom on Form 1040 revised, and shall pay any and all tax, normal and additional, assessed upon the said income of such non-resident aliens. (T. D. 2090.) Under this decision it is mandatory that all income other than from bonds and stocks accruing to a non-resident alien, must be reported. Income from real estate, for instance, is taxable. FIDUCIARIES (Form 1041 Revised) No return need be made on this form unless some one beneficiary's interest subject to the normal tax exceeds $3,000. In other words, while the net income of a beneficiary may be in excess of $3,000, yet if the income on which the tax was paid at the source reduces the amount below $3,000, then no return is required on Form 1041. The regulations bearing on this are (in part) as follows: Annual Returns by Fiduciaries Fiduciaries shall, on or before March 1 of each year, make and render a return of the income coming into their custody or control and management from each trust or estate when the annual interest of any beneficiary in said trust or estate is in excess of $3,000. This return (Form 1041) must contain an itemized statement of the gross income and deductions claimed. This duty cannot be delegated to another person. When the interest of any one beneficiary exceeds $3,000 and a return is required, the name and full address of each beneficiary and the share of income to which entitled, even though it be less than $3,000, must be shown ; and in all cases where the beneficiary's interest is in excess ot $3,000, the fiduciary is required to withhold the normal tax unless exemption is claimed under paragraph C, and then only on the amount in excess of the exemption so claimed. A fiduciary acting for a beneficiary in more than one estate or trust is required to account for each estate separately, and if the amount of income from no one estate exceeds $3,000, no return or withholding will be required. (T. D. 2090.) A fiduciary acting in the capacity of guardian when there is but one ward shall render his return on Form 1040 revised, as agent of the beneficiary, and not on Form 1041 revised; but where there are two or more wards he shall render a return on Form 1041, and a personal return on Form 1040 for each ward. A fiduciary acting in the capacity of trustee, executor, or administrator, when there is only one beneficiary and that beneficiary a non-resident alien, shall render a return on Form 1040, but when there are two or more beneficiaries and those bene- ficiaries are non-resident aliens, he shall render a return on Form 1041, 8i6 AUDITING and a personal return on Form 1040 for each such non-resident alien beneficiary. Items Not Deductible Expenses of administration of an estate, such as court costs, attor- neys' fees, executors' commissions, etc., are chargeable against the corpus of the estate and are not allowable deductions in a return of a fiduciary on Form 1041. (T. D. 2090.) This, of course, applies to such items as are incurred once only, and not to the annual or continuing expenses, which are charges against income. In all cases it should be definitely ascertained by a fiduciary whether, under state laws, the terms of a will or by the decree of a court, the commissions in question are deductible from the corpus of the estate or from the income accruing to the beneficiaries of the estate, and his action in the matter should be guided entirely by the facts thus ascer- tained. If the commissions are properly deductible from the corpus of the estate, they should not be included in the fiduciary return on office Form 1041 revised, as allowable deductions against the interests of the beneficiaries. If, on the other hand, the commissions are to be deducted from the Income of the estate distributable among the bene- ficiaries, the amount should be entered on Form 1041 revised, as a legitimate and necessary expense, properly deductible from the income of the estate. Return by Beneficiary In answer to the following inquiry: Should a beneficiary report in his annual return the amounts actually received from the fiduciary, or should he account for the amounts reported by the fiduciary as having accrued to him in accordance with revised Form 1041 ? the Bureau of Internal Revenue made the following answer : . . . The taxpayer is required to account only for the actual amount received from the fiduciary. Taxation of Undistributed Income The income of trust estates, as any other income, is subject to the income tax. When such income is received annually by a beneficiary of an estate, the fiduciary will withhold the normal tax due and subject to withholding by him. Any part of the annual income of trust estates not distributed becomes an entity and. as such, is liable for the normal and additional tax, which must be paid by the fiduciary. When the beneficiary is not in esse and the income of the estate is retained by the fiduciary, such income will be taxable to the estate as for an FEDERAL INCOME TAX 817 individual, and the fiduciary will pay the tax both normal and addi- tional. When the beneficiary receives a part only of the income to which he is entitled from the estate, and the balance is retained by the fiduciary, the normal tax will be withheld on the income paid to the beneficiary, and the amount of such income retained by the fiduciary will be treated as income taxable to the estate for both the normal and additional tax, which tax will be paid by the fiduciary. When the gross net income not distributed and remaining in the hands of a fiduciary is less than $20,000, the estate will be listed as a beneficiary, and only the normal income tax will be assessable and such tax will be paid by the fiduciary. When the gross net income not distributed and remaining in the hands of a fiduciary exceeds $20,000, such income is subject to both the normal and additional tax, and the estate will be listed as a beneficiary and both the normal and additional tax will be paid by the fiduciary. In all cases where fiduciaries act for minors or other incompetents, they are held, for the purpose of the income tax, to be acting as the agents of such minors or other incompetents, and must pay all tax (normal and additional) chargeable on such income in their hands, as though the persons for whom they act were acting for themselves. (T. D. 2231.) The above decision superseded previous decisions and rulings. Prior thereto the practice was as follows : . . . where, under the express provisions of a will or of state laws, 'certain income passes into the corpus of an estate, to go. eventually with the estate to the persons entitled in remainder, the income tax does not attach to, and is not collectable from, the specified income at the time of its receipt by the executor, whether or not the remainder- men are determinable. The income tax can be levied only on such income as is payable to some natural or artificial person subject to the provisions of the law. Income which is accumulating in the hands of a trustee for account and benefit of a number of distributees may, it is true, exceed $20,000 in one year in the aggregate, but where the number of beneficiaries is such that the share of each one is less than $20,000, then it appears to be unjust to assess on them the burden of a supertax without the usual compensatory feature of the supertax, i.e., the receipt of a large income out of which the tax can be paid. OBLIGATIONS IMPOSED UPON CORPORATIONS BY THE INCOME TAX LAW There are certain features of the law and the regulations which aflfect corporations only. General principles, such as apply to all busi- ness enterprises whether in corporate or individual form, have been fully covered in the preceding pages. The points now to be considered relate exclusively to corporations. 8i8 AUDITING What Are Corporations Duty to Make Return Depends on Corporate Existence Rather Than on Income. The duty to make a return depends upon corporate or associational existence and not upon the receipt of income. (T. D. 2090.) Limited Partnerships Held to be Corporations. Limited Partner- ships are held to be corporations within the meaning of this act and these regulations, and in their organized capacity are subject to the income tax as corporations. (Art. 86, Reg. 33.) Books Must Confirm Figures Given in Annual Return No particular system of bookkeeping or accounting will be re- quired by the department. However, the business transacted by cor- porations must be so recorded that each and every item set forth in the return of annual net income may be readily verified by an examina- tion of the books of account. (Art. 182, Reg. 33.) The books of a corporation are assumed to reflect the facts as to its earnings, income, etc. Hence they will be taken as the best guide in determining the net income upon which the tax imposed by this act is calculated. Except as the same may be modified by the pro- visions of the law, wherein certain deductions are limited, the net income disclosed by the books and verified by the annual balance sheet, or the annual report to stockholders, should be the same as that returned for taxation. (Art. 183, Reg. 33.) Returns by Corporations Must Be Made on Specified Forms 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 forwarded to collectors and should be furnished to every corpora:ion, not expressly exempted, on or before January 1 of each year, in the case of corporations mak- ing their returns for the calendar year, or on or before the first day of the next fiscal year in the case of corporations making returns for their fiscal year. Failure on the part of any corporation, joint-stock company, association, or insurance company liable to this tax to re- ceive a prescribed 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 collector of internal revenue in whose district is located its principal place of business in ample time to have its return prepared, verified, and filed with the collector on or before the last due date as hereinafter defined. Failure in this respect subjects it not only to 50 per cent additional tax, but to the specific penalty imposed for delinquency. Each corporation should carefully prepare its re- turn so as to fully and clearly set forth the data therein called for. Imperfect or incorrect returns will not be accepted as meeting the requirements of the law. Returns of Subsidiary Corporations The law requires that a return shall be made by every corporation, FEDERAL INCOME TAX 819 notwithstanding that it may be entirely owned and operated by another corporation. On this point the report to the National Tax Association says: The Parent and its Subsidiary Corporations Should be Recognized AS a Single Entity for Purposes of the Return in Cases where They Constitute a Single Operating System or where, in Determining Net Income for Their Own Purposes, No Recog- nition IN Accounting is Made of the Subsidiary Companies as Distinct Operating Units; and in All Cases where All the Stock of the Subsidiary Company is Owned by the Parent Com- pany, A Consolidation of Figures Should be Allowed in Appro- priate Cases, Subject to the Approval of the Department. At the time of the passage of the income law there existed, and still exists, a well-recognized method of doing business. Railroad cor- porations were perhaps the first to make use of it where it was neces- sary for legal reasons to form separate corporations in the several states in which they desired to hold franchises. Business corporations use the method for convenience of operation, to protect trade names, to utilize good-will and established reputation, or for other legal and proper reasons. The method referred to is that of doing business by means of several corporations usually controlled by one known as the parent or holding comp>any and all constituting parts or branches of a single business enterprise. The fact that this method has been used at times in attempts to restrain trade or create monopoly does not con- demn it. There can be no doubt that the majority of business enter- prises so conducted are law-abiding and honest. To work injustice upon all in order to punish a few is contrary to the elementary prin- ciples of law, and it may be questioned whether it is within the province of a taxing act to attempt to regulate or to suppress a particular class of taxpayers. Justice and fair dealing demand that the burden of the tax should be equitably distributed. Transactions often take place between parent and subsidiary cor- porations, such as transfers of credit, sometimes incorrectly called "gifts," from the parent company to a subsidiary, to offset losses in- curred by the latter. Such transfers of credit should not be treated as either income of the subsidiary or expense of the parent company. As the law now stands, a "gift" is not deductible from the net income of the parent company but must be accounted for as income by the subsidiary. The result is a double tax on the amount involved in a transaction which is nothing more or less than a bookkeeping entry. The law should be so framed as to tax the parent and subsidiary companies on their aggregate gross income minus their aggregate allowable deductions and to permit a combined return covering all cor- porations constituting a single business enterprise or system where no distinction is made by the company itself for accounting or financial purposes. This disposition of the matter would follow the practice now used by public service corporations in reporting to the Interstate Com- merce Commission. This change would not only be in the interest of fairness and equity but would go far toward simplifying the opera- tion of the law, substituting one return where several are now filed, and permitting easier inspection of the return by the government. 820 AUDITING Corporations and Associations Not Subject to Tax The law relating to exemption is as follows: Nothing in this section G (a) shall apply to labor, agricultural, or horticultural organizations, or to mutual savings banks not having a capital stock represented by shares, or to fraternal beneficiary societies, orders, or associations, operating under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system, and providing for the payment of life, sick, accident, and other benefits to the members of such societies, orders, or associa- tions and dependents of such members, nor to domestic building and loan associations, nor to cemetery companies, organized and oper- ated exclusively for the mutual benefit of their members, nor to any corporation or association organized and operated exclusively for re- ligious, charitable, scientific, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual, nor to business leagues, nor to chambers of commerce or boards of trade, not organized for profit or no part of the net income of which inures to the benefit of the private stockholder or individual ; nor to any civic league or organization not organized for profit, but operated exclusively for the promotion of social welfare ; Provided^ further, That there shall not be taxed under this section any income derived from any public utility or from the exercise of any essential governmental function accruing to any state, territory, or the District of Columbia, or any political subdivision of a state, territory, or the District of Coliimbia, nor any income accruing to the government of the Philippine Islands or Porto Rico, or of any political subdivision of the Philippine Islands or Porto Rico; Provided, That whenever any state, territory, or the District of Columbia, or any political subdivision of a state or territory, has, prior to the passage of this act, entered in good faith into a contract with any person or corporation, the object and purpose of which is to acquire, construct, operate or maintain a public utility, no tax shall be levied under the provisions of this Act upon the income derived from the operation of such public utility, so far as the payment thereof will impose a loss or burden upon such state, territory, or the District of Columbia, or a political subdivision of a state or territory ; but this provision is not intended to confer upon such person or corporation any financial gain or exemption or to relieve such person or corporation from the payment of a tax as pro- vided for in this section upon the part or portion of the said income to which such person or corporation shall be entitled under such con- tract. Exemption Must Be Specific Treasury Decision 2152 says as to this: Corporations liable to make returns : The tax imposed by the federal income tax law is not imposed only upon such corporations as are organized and operated for profit. Any corporation, joint-stock com- pany, or association, and any insurance company, no matter how created or organized or what the purposes of its organization may be, unless it comes within the class of organization specifically enumerated in the act as exempt, will be required to make returns of annual net FEDERAL INCOME TAX 82 1 income and pay income tax upon the net income which arises and accrues to it during the year. A corporation is not exempt simply and only because it is primarily not organized and operated for profit. If income within the meaning of the law arises and accrues to a corporation which is not organized and operated for profit, such income will be subject to the tax imposed by this act. It is therefore held that commercial men's associations, farmers* mutual fire insurance companies, and like organizations, come within the requirements of the law. Corporations not completely organized : Corporations which have applied for and never received charters, or corporations which have received charters and never perfected their organizations, transacted no business and had no income whatever from any source, may, upon presentation of these facts to the collector of internal revenue, be re- lieved from the necessity of making returns of annual net income so long as they remain in this unorganized condition. Mutual Insurance Companies Subject to Tax The federal income tax law provides : That mutual fire insurance companies requiring their members to make premium deposits to provide for losses and expenses shall not return as income any portion of the premium deposits returned to their policyholders but shall return as taxable income all income received by them from all other sources plus such portion of the premium deposits as are retained by the company for purposes other than the payment of losses and expenses and reinsurance reserves. It would appear from this provision of the law that all assessments received by a mutual fire insurance company and not returned to the policyholders, but retained for purposes other than paying losses and expenses incurred during the year for which the return is made and for such reinsurance reserves as the laws of the state require, are taxable income. Therefore, if mutual fire insurance companies retain out of moneys received on account of assessments an amount in excess of the losses, expenses, and reinsurance reserves of any particular year, that excess, plus amounts received from interest, dividends, or any other source, will be considered net income, upon which the tax will be assessed. The above quoted provision of the law as construed by this oflfice applies to all mutual fire insurance companies, regardless of the fact that some of them may not be primarily organized for profit. Any organization which has been held by the Commissioner of Internal Revenue to come within the class of organizations enumerated in paragraph G of the income tax law is not required to deduct and withold the normal tax from the amount of any salary or interest paid by it, and it is subject to no requirements of said law. Interest on Bonds of Exempt Organizations Such organizations are not only relieved from the payment of an income tax, but are- not required to file a monthly or annual list re- turn; however, income from bonds of such an organization should be 822 AUDITING accounted for by the owner if the said owner is a taxable person or corporation. Clubs May Register as Exempt Organizations All clubs are not exempt from the provisions of the income tax law, even though not operated for profit. A club desiring to be registered as an exempt organization should file wuth the Commis- sioner of Internal Revenue a copy of its charter, or an affidavit of its principal officer, setting forth the nature of its organization, the purpose for which organized, the source, if any, from which it de- rives income, and the disposition made of such income as is received by it for consideration and determination as to whether or not it comes within the class of organizations held to be exempt under the pro- visions of paragraph G of the income tax law. Social Clubs Clubs which are organized and operated exclusively for pleasure, recreation, and other non-profitable purposes, and which have no net income inuring to the benefit of any private stockholder, individual, or member, are exempt from the requirements of the federal income tax law. FISCAL YEAR In response to a very general demand, the following provision was inserted in the law relative to the period as of which corporations might report: Any corporation, joint-stock company or association, or insurance company, subject to this tax may designate the last day of any month in the year as the day of the closing of its fiscal year and shall be en- titled to have the tax payable by it computed upon the basis of the net income ascertained as herein provided for the year ending on the day so designated in the year preceding the date of assessment instead of upon the basis of the net income for the calendar year preceding the date of assessment ; and it shall give notice of the day it has thus designated as the closing of its fiscal year to the collector of the district in which its principal business office is located at any time not less than thirty days prior to the date upon which its annual return shall be filed. The Commissioner has held that a fiscal period must alway? end with the last day of some month, unless a corporation ceases business on some other day. Fiscal Year of New Corporations T. D. 2137 provides as to the fiscal year returns of new corporations : ■ FEDERAL INCOME TAX 823 In the case of new corporations, if they shall file or shall have filed within the prescribed time, a notice designating the last day of some month as the close of the fiscal year, such corporations will be per- mitted to make their returns as of the period ended with the date designated, provided the period intervening between the date of organi- zation of the corporation and the date designated as the close of its fiscal year does not exceed twelve months. If such period does exceed twelve months, the corporation will make a return for the portion of the calendar year preceding the beginning of the fiscal year, which return must be filed on or before the first day of March next follow- ing the calendar year of which it is a part. Corporations partially organized during the year 1914 should file a return for the period ended December 31, 1914. unless they shall have established a fiscal year for this purpose, and if they shall have actually done no business during the period for which the return is made, that fact will be set out in a notation on or a rider attached to the return. T. D. 2090 provides : The statute provides that returns must be made on the basis of a calendar year unless the corporation, etc., involved shall designate a fiscal year, other than the calendar year, in the manner provided by the statute. When the calendar year shall have passed, a return of income for the entire period of such calendar year is then due and must be made out and filed with the proper collector of internal revenue on or before March 1 then next following. This is true even of corporations and institutions making return as corporations, except that such corporations, etc., are given the privilege of filing with the collector of internal revenue (with whom their return must be filed) not less than thirty days (more, but not less) prior to March 1 (the date when the return on the basis of a calendar year is to be filed), a notice, in writing, setting forth that such corporation, etc., has designated the last day of some month in the year (other than the last day of December) as the day of the closing of its fiscal year, and that from the date so designated as the close of its fiscal year its books have been or will be kept on the basis of such designated fiscal year. When this said notice is filed with the collector of internal revenue, a return must then be made on or before March 1 for such part of the calendar year elapsed as is not included in the said designated fiscal year, and return for the full designated fiscal year must be made and filed within sixty days next succeeding the last day of said designated fiscal year. This rule will apply whether the designation affects the future or past, provided always that the return of income cannot cover more than twelve consecutive months. Example : 1914 1915 A X B C Y Z Jan. 1 June 30 Dec. 31 Mar. 1 June 30 Aug. 29 AB is calendar year and C is March 1, the time when return on the basis of the calendar year must be filed. At any time not less than thirty days prior to C a corporation may file with the collector with whom its return of income must be filed, a notice in writing setting 824 AUDITING forth that said corporation, etc., has designated the last day of some month in the year (other than December 31) as the day of the close of its fiscal year, as June 30, represented by X; thereafter, on March 1, a return will be filed for the period AX. XY represents the first designated fiscal year, and for this said fiscal year a return of income must be made (covering the period XY) subsequent to June 30 and on or before August 29; in other words, the sixty-day period next following the close of the fiscal year. Thereafter returns of income will be made and filed annually subsequent to June 30, and on or before August 29. The return for a completed period must be made independently of any other period. A corporation changing from the basis of a calendar year to a fiscal year, and because of said change having a part of the calendar year, for which return is to be made, will be required to make a separate return for the fraction of the calendar year, and another separate return for the entire fiscal year; as June 30 being designated as the end of the fiscal year, the part of the calendar year from January 1 to June 30 must be covered in a return to be made on or before March 1, then following, and on or before sixty days next following June 30 (next after the filing of return for the fractional part of a calendar year) a return must be made and filed for the entire fiscal year of the corporation. GROSS INCOME The first item of importance in the corporation form (1031 revised) is that of gross income from operations. As a matter of classifica- tion, the item is of little importance in itself. Under the heading of allowable "deductions" in the return will be found : Expenses, general Rentals Losses Depreciation Depletion Interest Taxes Some corporations would deduct one or more of these items be- fore arriving at an amount which would be called gross income from operations, and others consider gross income as an amount from which other deductions than those mentioned must be made in order to arrive at net income. However, little difficulty has been experienced in the use of the form. So long as the item of net income is accurate it is not believed that the Internal Revenue Commissioner will, for instance, require a re-analysis of a corporation's books of account in order to state the amount of "general expenses" where no such account appears in the books. FEDERAL INCOME TAX 825 Extracts from the rulings on this point are as follows: Inventory of Materials and Merchandise In order that certain classes of corporations may arrive at their correct income, it is necessary that an inventory, or its equivalent, of materials, supplies and merchandise on hand for use or sale at the close of each calendar (or fiscal) year shall be made in order to determine the gross income or to determine the expense of operation. A physical inventory is at all times preferred, but where a physical inventory is impossible and an equivalent inventory is equally accurate, the latter will be acceptable. An equivalent inventory is an inventory of materials, supplies, and merchandise on hand taken from the books of the corporation. Gross Income Embraces Income from All Sources Gross income embraces not only the operating revenues, but also income, gains, or profits from all other sources, such as rentals, royalties, interest, and dividends from stock owned in other corpora- tions, and appreciation in values of assets, if taken up on the books of account as gain. Proceeds of Sale of Capital Stock Are Not Income The amount received by a corporation for the original issue and sale of its capital stock is held to be the capital of the corporation. In cases where the stock, as originally issued, is sold at a price greater or less than the par value, neither the premium nor the discount will be taken into account in determining the net income of the corporation for the year in which the stock is sold. This is purely a capital trans- action and the income is neither increased nor decreased by reason of the sale, per se, of the stock at a price greater or less than its par value. Dividends of Other Corporations Dividends from the net earnings or established surplus created from the net earnings of any corporation, joint-stock company or association, and insurance company, are vested in the stockholder on the date on which such dividends are declared, whether distributed or not, and regardless of the time when the surplus or undivided profits from which such dividends are declared were earned and entered on the books of the corporation as such. Dividends so declared . . . should be included in the gross income of corporations, etc., regardless of the amount of income. For comments on the latter part of the foregoing ruling, see page 787, et scq. Earnings or Dividends Received from Subsidiaries Every corporation, no matter how closely related it may be to any other corporation, is required to make return of annual net income and to pay any income tax thereby shown to be due. 826 AUDITING Income from Tax-Free Bonds Returnable The federal income tax law specifically provides that corporations subject to the law must return, for the purpose of the tax, all income which they receive from every source, the only exception being income received on account of interest on the obligations of a state or its political subdivisions or the obligations of the United States or its possessions. The act also specifically enumerates the items which they may allow- ably deduct from the gross income so returned. Under the provisions of this act corporations must return as income the full amount of the interest received on bonds, although such bond may contain a tax-free covenant — that is, a covenant in which the debtor corporation agrees to pay any tax assessed upon the bonds or income therefrom — and since there is no specific provision in the law for excluding or deducting from gross income interest upon bonds of this character, the receiving corporation cannot allowably omit or deduct such interest from its gross income, and the same will necessarily be reflected in the net income upon which the tax is computed. Sinking Fund Increment Taxable Income In cases wherein corporations set aside and place in a sinking fund under the control of trustees their own bonds or the bonds of other corporations which they may own, it is held that the fund thus set aside by the corporation is an asset of the corporation, and any increment to that fund as a result of investments made by the trustees having the same in charge is income to the corporation and should be so included and accounted for in its returns of annual net income. If the trustees have invested the amount of the sinking fund reserve or any portion of it in the bonds of the corporation and such cor- poration pays to the trustees the interest on these bonds, such cor- poration will be permitted to deduct such interest from its gross income, provided the amount of the interest thus paid, plus the interest, on any other outstanding indebtedness which it may have, does not exceed the limit fixed by the law, and provided further that the interest paid to the trustees, together with all other earnings on investments of the sinking fund made by the trustees, is included in the income of the corporation. Accrual Basis While the law states that certain expenses may be deducted only when paid in cash during the taxable year, yet the policy of the de- partment directs that all income, whether collected or not, must be reported. The regulations provide that: Accounts or bills receivable of a corporation are to be treated as income for the year in which they are created, that is to say, in the year in which the accounts are set up on the books or the bills receiv- able are accepted. FEDERAL INCOME TAX 827 Appreciation of Capital Assets In almost all corporations instances occur where items of assets are sold or otherwise disposed of at a profit or loss as measured by the book value. In the case of corporations where appreciation has accrued exclusively after January 1, 1909, no objection can be made to reporting the item and paying the tax thereon. Where any part of the appreciation can be traced prior to January 1, 1909, then no tax need be paid on such portion. If no accurate apportionment can be made between the part accrued prior to and the part accrued sub- sequent to January 1, 1909, then it is equitable to prorate the gain over the entire period.* Rulings on this point are as follows: Losses due to fluctuations during a taxable year in the value of capital assets, even though evidenced by book entries, do not con- stitute such losses "actually sustained" as within the meaning of the law may be allowably deducted from gross income. Losses are not actually sustained until, as a result of a completed, a closed transaction, such losses have been definitely ascertained and the amount they rep- resent has irredeemably disappeared from the assets of the individual or corporation. Likewise and conversely any appreciation in the value of assets due to appraisal or adjustment and taken up on the books of the individual corporation is held not to be income within the meaning of the law until such appreciation, as a result of a completed, a closed transaction, has been converted into cash or its equivalent, that is, has been realized as an addition to and a part of the tangible assets of the individual or corporation. A book entry reflecting only an enhanced value of assets during the year evidences an increase in the net worth of the cor- poration or individual for that year, an increase which, under adverse conditions, may disappear the next year. An increase in value thus evidenced is intangible, unstable and is not such income as the federal income tax law contemplates shall be returned for purposes of the tax. Returnable and taxable income is that actually realized during the year, that is, that which is evidenced by the receipt of cash or its equivalent. Until any appreciation taken up on the books has been so realized, it will not be required to be returned as income. Hence, in the preparation of returns and in the examination of books for the purpose of verifying the same, mere book entries of appreciation in the value of capital assets will be disregarded. It should be understood, however, that in the event of the sale of the assets, the increase in whose value has been taken up on the books, the profit or income to be returned as a result of the sale will be determined upon the basis of the difference between the cost and the selling price of the assets ; that is to say, in the case of a sale, book values will be ignored save and except as such book values represent the actual cost of the properties. Any rulings previously made by this office and in conflict with the holdings hereinbefore made are superseded by this letter, but any re- ♦For an excellent article pointing out the fallacy of the prorating method. Journal of Accountancy for November, 1915, page 381 et seq. 828 AUDITING turns, adjustments, or assessments made in accordance with previous rulings will in no wise be affected by the foregoing instructions. (Let- ter to collectors, August 14, 1914.) The difference between the original cost price of property and its increased fair market value at the time of the incidence of the tax may properly be added to the original cost in determining the amount to be deducted on account of depreciation of property or for restoration of capital in computing net income from the sale of such property. Lumber Companies A lumber company in 1903 paid $2,25 per thousand feet for standing merchantable hard wood timber, $8.00 per thousand feet for pine timber, and $2.00 per acre for cut-over or stump land, at which prices the properties were carried on the books of the company. The prop- erties increased materially in value. In its excise tax returns for the years 1909-1912 the company deducted from the gross receipts from timber and stump lands sold, an amount, for return of capital assets, which admittedly was no more than the fair market value of such timber and stump land at the time of the incidence of the excise tax. The government allowed the original cost as a deduction but assessed an additional tax on the amount of the increase of value which the company had deducted. The company paid under protest and sued to recover. Judgment was entered in favor of the plaintiff for the amount of the taxes paid by it under protest. (Michell Brothers Company, plaintiff, v. E. J. Doyle, collector, defendant, U. S. District Court, Western District of Michigan, Southern District.) Income of Contracting Companies As this office requires no special system of bookkeeping, neither does it require any specific method by which the net income to be returned by corporations shall be determined. In the case of a large contracting company, which has numerous uncompleted contracts which probably, in some cases, run for periods of several years, there does not appear to be any objection to such corporation preparing its return in such manner that its gross income will be arrived at on the basis of completed work — that is to say, on jobs which have been finally completed and payments made during the year in which the return is made. If the gross income is arrived at in this method, the deductions from gross income should be limited to the expenditures made on account of such completed contracts. Contracting companies usually keep their books by double entry and report the estimated net profit on unfinished contracts. It would require many adjustments to comply with the above regulation, but most contractors would save a considerable amount of tax by com- plying therewith, so that consideration should be given to the method mentioned. Income from Real Estate Transactions Gains and profits resulting from a real estate transaction are subject to income tax in so far as they represent actual net income for the FEDERAL INCOME TAX 829 year in which the transaction occurred. The amount of income to be returned for the purpose of the income tax in the case of the sale of capital assets is the amount received upon the sale of the property in excess of its original cost, provided both the purchase and sale of the property took place since January 1, 1909. If the property was acquired prior to January 1, 1909, the difference between the cost price and the selling price will be considered income to the corporation, which income may be prorated according to the number of years the property was held prior to its sale, and the amount thus apportioned to the years subsequent to January 1, 1909, will be returned as income for the year in which the property was sold. In determining the arpount of income to be accounted for on this basis, the corporation will consider mortgages, mortgage notes, or any other credits received in payment of the property as though they were cash, and if it should occur that the purchaser of any of the property should later default in payment the corporation will be entitled to take credit as a loss for the amount of loss actually sustained by reason of the default. In determining the cost of the property for the purpose of arriving at the profit realized upon the sale, it will be permissible for the cor- poration to add to the initial cost such carrying charges as interest, taxes, insurance, etc., provided such carrying charges have not been deducted from net income which the corporation may have had and returned for years subsequent to January 1, 1909, and prior to the date of the sale of the property. In the Baldwin Locomotive case the department endeavored to tax a mere writing up of capital assets, but the United States Circuit Court of Appeals of the Third Circuit decided otherwise. In the opinion the court said: When the corporation was organized it took over certain real estate, manufacturing plant, and securities at a valuation, and took over also a large amount of patterns, drawings, tools, and fixtures without valuing them at all. In 1910 the assets were appraised at their actual value as of December 31, 1909, and by this appraisement the valuation of certain shares of stock of the Standard Steel Works Co. was in- creased $485,000; the value of the patterns, drawings, etc., was fixed for the first time at $2,954,086.72; and the valuation of its real estate was adjusted — raised in part and lowered in part — the net result being an increase of $593,499.66. Against this total an item not in dispute was charged off, leaving as the balance to be added to the capital valua- tions 00 its books the sum of $3,795,461.25. On this sum the govern- ment collected a tax of $37,954.61, and this is the second item in dispute. We agree with the District Court that this increase of valuation was not income within the meaning of the statute. Nothing whatever was added to the corporate property, which remained exactly the same after the appraisement as before. The only thing done was to put upon the company's books an expression of expert opinion that certain property was worth a certain sum, and this can hardly be said to be income, or even gain, in any proper sense. The company could not become either richer or poorer by making a few book entries that merely recorded a new estimate of how much it was worth. 830 AUDITING Gifts to Corporations Taxable The Treasury decision on this point is as follows: Gifts to Corporations Are Income. The value or amount of a gift to a corporation is held to be income to such corporation and should be returned as such for the year in which the gift is received. The provision of the act of October 3, 1913, which exempts gifts, bequests, etc., from the tax imposed by the act applies to individuals and not to corporations. As a rule gifts are not made to profitable corporations. They are frequently made to unprofitable ones. In the latter case it would seem that the losses sustained would be large enough to offset the inclusion of gifts as income. If this is not the case, the following decision represents the position of the department: A company which has been unable to pay any interest on its bonded indebtedness for some years proposes to settle that indebtedness, part in new securities and part in cash, the creditors to reduce the face of the bonds by $100,000 as an inducement for the raising of $100,000 cash. By this process the apparent financial condition of the debtor com- pany is improved by $100,000 not through any earnings, but by effect- ing a settlement with its creditors by which $200,000 of its bonds are canceled at a cost to it of $100,000 in cash, namely at 50 cents on the dollar. In reply to your inquiry as to whether such a compromise of in- debtedness is taxable as income, you are informed that while in fact the earnings of the corporation are in no wise increased by this com- promise, the liabilities are reduced and to that extent the corporation gains in its net worth. In somewhat similar cases to this, in which the creditor has for- given the debt of the debtor, this office has held that the amount of the debt forgiven, constitutes income. In this particular case, in the opinion of this office, the difference between the amount realized by the corporation when the bonds were sold and the amount which it now is required to pay upon the redemption of the same, constitutes income, which income may be prorated over the period elapsing be- tween the date of the bond issue and the date of their payment, and that portion of such income apportioned to the years subsequent to January 1, 1909, will be returned as taxable income for the year in which the bonds are redeemed. Gross Income from Dividends That part of the law which relates to individuals provides among the allowable deductions (as it affects the normal tax) : "The amount received as dividends upon the stock or from the net earnings of any corporation, joint-stock company, association, or insurance company, which is taxable upon its net income as hereinafter provided"; but no such provision is included as relating to corporations. This is made specific in T. D. 2137; FEDERAL INCOME TAX 83 1 The federal income tax law specifically sets out that there shall be returned as gross income all income received from all sources during the year for which the return is made, and it specifically enumerates the items which may be allowably deducted from such gross income. There is no provision of the law whereby dividends received from other corporations may be excluded from gross income or deducted therefrom. Each corporation is a separate and distinct entity and must return, for the purposes of the tax. the income which it receives (ex- cept interest on obligations of a state or its political subdivisions or on the obligations of the United States or its possessions), regardless of the source from which such income is received or regardless of the fact that a portion of such income may constitute dividends from other corporations subject to tax. The intent of this provision is obvious in that a penalty is laid upon so-called holding corporations. For some inscrutable reason the law- makers decided that moral turpitude was involved in one corporation holding stock in another, irrespective of the object intended or result reached, so in order to prevent, or lacking prevention, to punish such offenders it is provided that a double tax shall be paid on the income represented by dividends paid by one corporation to another. The double taxation lies in the fact that the corporation paying the dividend is taxed 1 per cent upon its entire net profits out of which dividends are paid and the receiving corporation is taxed again upon its entire net income, including such dividends. On this point the report to the National Tax Association says: Every Corporation Should be Permitted to Deduct All Amounts Received by It Within the Year as Dividends upon the Stock of Other Corporations, Joint-Stock Companies, or Associations, Subject to the Income Tax. That provision of the law which taxes corporations upon dividends received from other corporations, while exempting such dividend in the hands of individuals, is an unjust discrimination between classes of taxpayers and is double taxation of income. It seems to have been the deliberate intent of Congress to tax holding companies at a greater rate than other taxpayers. This is accomplished by requiring corporations to pay the tax on dividends received from other corporations. To penalize a corporation for hold- ing stock in other corporations under lawful authority of the state in which it is incorporated is not within the proper scope of a taxing act. The ulterior motive is to be condemned. If Congress intends to dis- courage the holding of stock by certain corporations, suitable legis- lation to accomplish that purpose should be enacted after a full dis- cussion of the questions of constitutionality and public policy involved therein. ALLOWABLE DEDUCTIONS TO CORPORATIONS Expenses The allowable deductions which can be claimed by corporations cor- respond closely to those applicable to individuals. Where they are the 8:»2 AUDITING same, the regulations relative thereto and comments thereon will be found on pages 789-811, supra. Only those points wherein the procedure differs from individuals will be dealt with in the following pages. Corporate deductions for expenses of all kinds may be calculated on the "accrued" basis, that is, whether paid or not within the tax year. The regulations cover this as follows : It is immaterial whether the deductions, except for taxes and losses, are evidenced by actual disbursements in cash, or whether evi- denced in such other way as to be properly acknowledged by the corporate officers and so entered on the books of the corporation as to constitute a liability against the asset of the corporation making the return. . . . Except as the same may be modified by the provisions of the act, limiting certain deductions and authorizing others, the net income as returned for the purpose of the tax should be the same as that shown by the books or the annual balance sheet. Accounts payable, representing ordinary and necessary expenses of maintaining and operating the business and property of a corporation, if actually charged into the Expense account and so entered on the books as to constitute a liability against the assets of the company, and so treated in the preparation of the return of annual net income that they will not be included in the deduction in the year in which they are actually paid in cash or its equivalent, such' accounts payable may be deducted from the gross income of the year in which the expenses were incurred. This ruling applies only to accounts payable representing ordinary and necessary expenses of maintaining and operating the business, that is, to such expenses as are incurred by the corporation in producing the gross income which it is required to return. Organization and Similar Expenses On page 345 hereof will be found the author's views as to when and how incorporation and similar expenses should be charged off. If the expenses are actual and are incurred in good faith, they constitute allowable deductions for the period during which they appear on the books as charged to profit and loss. The action of certain inspectors in disallowing deductions of this nature is not supported by the letter nor the spirit of the law, and is not in harmony with official decisions. Proceeds of Life Insurance in Favor of Corporations In cases wherein corporations pay premiums on insurance policies insuring, in favor of the corporations, the lives of officers or others, such premiums may be allowably deducted from the gross income of the corporations paying the same. In all such cases, the proceeds of the policies when paid at maturity or upon death of the insured shall be returned by the corporation as income for the year in which such proceeds were received. (T, D. 2090.) FEDERAL INCOME TAX 833 Incidental Repairs Incidental repairs which neither add to the value of the property nor appreciably prolong its life, but keep it in an operating condition, may be deducted as expenses. Improvements The following extract from a decision of the United States Court is of interest: Amounts expended by a business corporation in enlarging or making improvements in its office or premises, not in the nature of permanent improvements to the property, but to facilitate the transaction of a growing business, should properly be deducted as necessary expenses of the business, (Connecticut Mutual Life Insurance Co. v. Eaton, 218 F. 206.) Pensions to Ex-Employees Amounts paid for pensions to retired employees, or to their families, or others dependent upon them, or on account of injuries received by employees, are proper deductions as ordinary and necessary expenses. Lobbying Expenses Sums of money expended for lobbying purposes and contributions for campaign expenses are held not to be an ordinary and necessary expense in the operation and maintenance of the business of a cor- poration, and are therefore not deductible from gross income in arriv- ing at the net income upon which the income tax is computed. Cost of Manufactured Products A manufacturing corporation may include as an element of the cost of manufactured products, the cost of the raw material, the cost of labor of the men who actually work on such products, as well as the cost of supervisory, or what may be denominated as "unproductive" labor, such as that of the foremen, inspectors, overseers, etc., provided such expenditures are not separately deducted from gross income in the return of annual net income. The overhead charges referred to in Form 1031 (revised) should include the salaries of officers, clerk hire, and such other office ex- penses as do not have to do directly with the manufacture of the product. Items Entering Into Cost of Manufacture The only interest which constitutes an allowable deduction from gross income under the federal income tax law is the amount actually paid within the year on the maximum principal ascertained by adding to the full amount of the paid-up capital stock outstanding at the close of the year one-half of the interest-bearing indebtedness also then outstanding and such interest as is actually paid on indebtedness wholly secured by collateral the subject of sale in the ordinary busi- ness of the corporation. B34 AUDITING Interest payments of this character, being allowable deductions from gross income, will not be taken into account as a part of the cost of manufacture for the reason that to consider them an element of the cost of manufacture and to deduct them from gross income as specific items would in effect result in a double deduction of amounts involved. A corporation would not be permitted to include in its deductions the rental value of the property which it owns and occupies nor would it be permitted to deduct from gross income the interest which the capital invested or employed would earn were it otherwise invested. It therefore follows that a corporation cannot take into account as a part of the cost of manufacture any possible earnings ; that is, earnings which might accrue on its capital or investment had such capital been so placed as to earn a given rate of interest. Gifts, Gratuities, or Bonuses to Employees Gifts or gratuities to employees in the service of a corporation are not properl]^ deductible in ascertaining net income. Gratuities are not allowable deductions in a return of income by corporations. (T. D. 2090.) In answer to an inquiry on this point the Commissioner wrote : This office is in receipt of your letter of the 19th instant, in which you ask a ruling of this office as to how payments made under the bonus system or profit-sharing plan may be treated by corporations in making their returns of annual net income. . . . This office has consistently held and still holds that in cases where these increased compensations, denominated as bonuses or profit shar- ings, are paid to the employees pursuant to a contract between the employees and the corporation, the amounts so paid will be considered an ordinary and necessary expense of operation of business, and as such will constitute an allowable deduction from gross income of the corporation making such payments. If, however, there is no contractual relation between the employee and the employer by reason of which the employee could enforce his claim for the additional compensation, it is held that these payments are gratuities on the part of the corporation and as such are not allowable deductions from gross income. Salaries Rulings relating to salaries and special compensation of officers and employees are as follows : In regard to salaries, it has been the consistent ruling of this office that such amounts as corporations actually pay as fair and reasonable compensation for the services rendered by the officers or employees, constitute allowable deductions from gross income. The salaries such as are here defined should not depend upon the profits earned by the corporation, the presumption being that the officers and employees of corporations render services equally valuable regardless of the fact that the net earnings of the corporation may differ from year to year. FEDERAL INCOME TAX 835 Special Compensation When Deductible Special payments made by a corporation as extra compensation to certain of its employees may be deducted from gross income, if it is clearly shown that such payments are made as compensation for services rendered and are paid in pursuance of a contract expressed or implied. If such so-called "compensation" is a gratuity or voluntary pay- ment, for which no service is rendered, the amounts so paid are not deductible. In cases wherein the payments are made as compensation for services rendered, the employee receiving the same, if he be a "taxable person," will be required to include the amount of such compensation in his personal income tax return. Commissions to Salesmen Paid in Stock Commissions allowed salesmen, paid in stock, may be deducted as expense if so charged on books at the actual value of such stock. Donations by Agricultural Corporations to Fairs, etc. A corporation engaged in agricultural business cannot be allowed to make a deduction from gross income on account of donations to fairs, churches, and associations, such donations being made for the purpose of obtaining and preserving the good-will of the farmers who raise crops for it, since the amounts so expended are clearly in the nature of gratuities and are not necessary expenses of operation and maintenance as there is no such consideration in this case as is con- templated in T. D. 2090. If followed literally, this decision would deprive some corporations of the right to claim advertising as an allowable deduction. Many pub- lic service corporations advertise to retain the good will of their cus- tomers, rather than to seek new business. Fortunately for corporations, questions as to what are and are not necessary expenses to obtain and retain the good-will of customers will not be decided by the Commissioner of Internal Revenue but by the courts. Until such decision, corporations will continue to deduct all those expenses necessary to properly maintain their businesses. This is in accordance with the law and with common sense. Compensation Based on Stockholdings Amounts paid as compensation or additional compensation to offi- cers or employees, which amounts are based upon the stockholdings of such officers or employees, are held to be dividends, and although paid in lieu of salaries or wages, are not allowable deductions from gross income, for the reason that dividends are not deductible. Here, of course, the burden of proof is on the government to show that salaries and vv ages are not reasonable. If reasonable in the opinion of the board of directors, the full amounts paid should be deducted among expenses. 836 AUDITING Donations for Welfare of Employees Donations by corporations which legitimately represent a considera- tion for a benefit flowing directly or indirectly to the corporations as an incident of its business are allowable deductions from gross income in ascertaining net income subject to the income tax, as donations to a hospital upon consideration that employees of the corporation are to have a ward for their use in case of accident or illness. The absence of consideration moving in some form to the corporation will make a contribution a mere gratuity. (T. D. 2090.) Donations made for purposes connected with the operation of the property when limited to charitable institutions, hospitals, or educa- tional institutions, conducted for the benefit of the employees of a cor- poration, or their dependents, shall be proper as a deduction under the head of expense in the return of the corporation. (T. D. 2090.) Gifts of Merchandise Probably every retailer is requested to make gifts to charitable and religious organizations. Usually the solicitor is a good customer and the donation is made. The author has never heard it seriously con- tended that gifts of this nature were other than expenses of doing business, and of course, they are, and should be, so treated in income tax returns. The Department, however, would probably rule that they are some other kind of expenditure and not allowable deductions. Corporations as a rule do not make payments representing "mere gratuities" but expect and receive some consideration for expenditures of a quasi-charitable nature. Inspectors have mentioned to the author that they are expected to discover many thousands of dollars of addi- tional taxes, and this may account for such items as gifts to hospitals being thrown out as allowable deductions. As soon as the courts pass on the word "expenses" as used in the law, all items of this nature will be found to be deductible. Interest on Indebtedness Wholly Secured by Collateral the Subject of Sale in Ordinary Business As to this the law says: In case of indebtedness wholly secured by collateral the subject of sale in ordinary business of such corporation, joint-stock com- pany, or association, the total interest secured and paid by such company, corporation, or association within the year on any such in- debtedness may be deducted as a part of its expense of doing business. The following extracts are from Treasury Department decisions : Many inquiries come from corporations engaged in buying and sell- ing real estate, which real estate is pledged for the payment of in- FEDERAL INCOME TAX 837 debtedness, and the question submitted is whether or not such real estate is "collateral" within the meaning of the proviso quoted and whether or not corporations paying interest on indebtedness wholly secured by such collateral may deduct from gross income as ''an ex- pense of doing business" the amount of interest paid on such indebted- ness. Relative to this you are informed that "collateral," as used in this proviso, comprehends and includes real estate or any form of physi- cal or tangible property bound for the performance of certain cove- nants, the payment of certain obligations, and if such real estate or other physical or tangible property is the ''subject of sale in the ordi- nary business of the corporation" owning the same, that is, if such corporation is, as a matter of its ordinary business, engaged in buy- ing and selling, or dealing in such property, the interest actually paid within the year on indebtedness wholly secured by such collateral (a mortgage on such property) may be allowably deducted from gross income under item 4 (a) of the return form as an expense of doing business, without regard to the limit of deductible interest as set out in subdivision "Third," paragraph (b), subsection G of the law here- inbefore cited. This construction of the proviso quoted is not intended to and does not authorize the deduction as "an expense of doing business" of any interest paid or indebtedness secured by property, real or per- sonal, which is not the "subject of sale in the ordinary business of the corporation," but which is held by it for the purpose of, or as an instrument in carrying on, its ordinary business — such as the rights of way and other property of public utility companies, permanent office buildings and property of like character held or occupied for their own particular use or purpose in the furtherance of the objects of the corporation, but which property is not the subject of sale in their ordinary business, and which is simply occupied or used as an in- strument or means of, or essential to, the carrying on of the ordinary business for the transaction of which they are organized. The fact that such property may be subject to sale under extraordinary or peculiar conditions does not qualify but rather disqualifies, it as "collateral" such as is contemplated by this provision of the act cited. The only corporations, joint-stock companies, or associations, which will be allowed under this proviso, as herein interpreted, to deduct as "an expense of doing business" interest paid on indebtedness wholly secured by mortgage on real estate, or other physical and tangible property, are those corporations, joint-stock companies, or associations, which are organized and operated for the exclusive purpose of buy- ing, selling, and dealing in the particular kind of property upon which the mortgage is given, and the particular property pledged for the debt upon which the interest is paid must be the "subject of sale in the ordinary business of the corporation." Any corporation whose indebtedness is secured by a trust mort- gage or by any form of indenture which covers and includes in the lien any property which is not the subject of sale in the ordinary business of such corporation, will be and is excluded from the benefit of this proviso, as hereinbefore construed, and its interest deduction will be limited to the amount authorized in subdivision "Third" above referred to— that is, the interest actually paid within the year, at the contract rate, on an amount of bonded or other indebtedness at no 838 AUDITING time within the year in excess of a sum ascertained by adding to the paid-up capital stock outstanding at the close of the year one-half of the total amount of the interest-bearing indebtedness also then out- standing. Corporations which under this ruling are entitled to deduct as "an expense of doing business" the total amount of interest paid within the year on "indebtedness wholly secured by collateral the subject of sale in the ordinary business of such corporations," are required to state separately in their returns the amount of indebtedness upon which such interest is paid, segregating it from the indebtedness not so secured and upon which the interest paid is taken credit for or deducted under item 6 (a) of the return form. The interest-bearing indebtedness stated under item 2 of the return form as one of the bases for determining the amount of interest which may be allowably deducted under item 6 (a) must not include any "indebtedness wholly secured by collateral the subject of sale in the ordinary business of the corporation." Failure to segregate the two forms of indebtedness will render the interest deduction under item 6 (a) subject to sus- pension and disallowance. (T. D. 1993.) As used in the act, the expression "collateral the subject of sale," etc., refers to physical or tangible property bound for the performance of certain covenants or payment of certain obligations, and which physical or tangible property is the "subject of sale in the ordinary business of a corporation" owning the same. Where such corporation is, as a matter of its ordinary business, engaged in buying and sell- ing, or dealing in such property, the interest actually paid within the year on indebtedness wholly secured by such collateral may be al- lowably deducted from gross income as an expense of doing business, without regard to the limit of deductible interest as otherwise pro- vided by the statute. The corporation, etc., must be organized and operated for the purpose of buying, selling, and dealing in the par- ticular kind of property which becomes the collateral in question, and the particular property pledged for the debt upon which the interest is paid must be the "subject of sale in the ordinary business of the corporation." Real estate mortgages, and the property of corporations organized for and engaged in the business of buying, selling, and deal- ing in real estate ; warehouse receipts representing property the sub- ject of sale in the ordinary business of the corporation owning the same, and which warehouse receipts are pledged as collateral for such corporation's own debt, are examples where the interest paid will be deductible as a "business expense" and not be subject to the statutory limitation as to interest deduction. (T. D. 2090.) Rentals Interest paid pursuant to contract on an indebtedness secured by mortgage on real estate occupied and used by a corporation, in which real estate the corporation has no, equity or to which it is not taking title is an allowable deduction from gross income as a rental charge, payment of which is required to be made as a condition to the con- tinued use and possession of the property. This is a very important distinction, as there is no limit to the amount of rental payments, for which credit may be claimed, so long FEDERAL INCOME TAX 839 as the propriety of the payments themselves is unquestioned, whereas there is a definite limit to the amount of interest payments for which credit will be allowed. Especially will public service corporations which hold part or all of the property under leases providing that as rental the lessee shall pay the interest on bonds or a guaranteed divi- dend on stock of the lessor company outstanding at the time of making the lease, find this construction of these payments as rentals to be a most important subject for consideration when making their income tax returns. Losses Bond Discount Where a corporation sells bonds at less than par it is because the nominal rate of interest as expressed in the bonds is less than the effective rate actually realized. In other words, if a corporation has a high credit and there is a favorable market for securities, it will secure the advantage of a low rate of interest. Its 5 per cent bonds may sell at 110, but if its credit is not so high and the market is not so favorable, its 5 per cent bonds may sell at 90. In both cases it is the effective interest rate in force at the time which governs the price of the bonds. Therefore, proper accounting calls for a reflection of the effective or actual rate spread over the life of the bonds, and this is readily accomplished by adjusting the interest account to correspond. The Commissioner has ruled that discount on bonds is a loss and may be deducted under item 5 (a). His position is shown in the following correspondence : Replying to your letter asking for a decision on the following question: "A corporation sells a bond issue at 90, the bonds running say, twenty years, when is it proper for the corporation to charge off the loss or discount of ten points?" you are advised that such bond discount should be prorated over the life of the bonds and the pro- portionate part applicable to each year deducted in preparing the re- turn of annual net income for that year. In the case you cite, 1/20 of such discount may be deducted in each year. The deduction from gross income on this account should be made under item 5 (a) — "Losses Sustained." In this connection you are informed that a discount on an issue of bonds issued prior to the year 1909 and such discount charged against the income of the year when issued, is considered a closed transaction and no prorated part of such discount can now be con- sidered an allowable deduction from gross income in arriving at the net income for a taxable period. A similar position is taken with respect to bonds purchased at a premium. 840 AUDITING Losses Incurred by the Retirement of Bonds Ruling by the Internal Revenue Bureau : ^ This office is in receipt of your letter stating the following propo- sition and requesting the ruling of the Department thereon : "Under the terms of its indenture securing an issue of bonds, a corporation is required annually to purchase and retire a certain num- ber of said bonds. If the said corporation^ when purchasing in the market the required bonds so to be retired, is compelled to pay more than par for said bonds, is it entitled to deduct as a loss in that year the difference between the amount paid and the par value of the bonds, such difference being charged off as a loss on its books?" In reply, you are advised that the question presented may be viewed from different angles according to the circumstances connected with the issuing of the bonds. If the bonds were issued at par, then the corporation may deduct the difference between par and the price at which purchased for retire- ment. If the bonds were issued at a premium and such premium accounted for as income for the year in which issued, then the difference between par and the purchase price may be deducted as a loss, but if the pre- mium at which the bonds were issued had not been carried into in- come account, then the loss to be claimed should be the difference between the price at which the bonds were issued and the purchasing price. In the event that the bonds were issued at a discount and the dis-. count was charged against the earnings of the year in which issued, the difference between par and the purchase price may be deducted as a loss, but if the discount on the bonds was prorated over the life of the bonds and the annual proportion charged against the yearly income, the amount to be charged off as a loss for the year in which the bonds are purchased for retirement should be the difference between the price at which the bonds were issued and the purchase price minus an allow- ance for the sums that had been charged off annually on account of the prorated discount on such bonds. Interest The law provides as a deduction : The amount of interest accrued and paid within the year on its indebtedness to an amount of such indebtedness not exceeding one-half of the sum of its interest-bearing indebtedness and its paid-up capital stock outstanding at the close of the year, or if no capital stock, the amount of interest paid within the year on an amount of its indebted- ness not exceeding the amount of capital employed in the business at the close of the year. Preferred Stock Preferred stock is not a liability, hence cannot be treated as interest- bearing indebtedness. Dividends upon preferred stock are not payments of interest and no deduction in respect thereof is proper. FEDERAL INCOME TAX 84 1 The Commissioner of Internal Revenue, in his report of December 6, 1915, stated that a great many corporations have treated preferred stock as interest-bearing indebtedness, and the payments of dividends as the equivalent of interest payments. No good accountant would sanc- tion such practice, but in view of the Commissioner's statement the law should be amended to accord with proper practice. The regulations and decisions state infer alia: "Paid-up capital stock outstanding at the close of the year," when used in connection with "interest-bearing indebtedness," to determine the maximum principal upon which interest for the purpose of an authorized deduction is to be computed, means the par value of shares issued as reported in item 1 of the return form, and will not include the surplus carried by the corporation. Full amount of stock, as represented by the par value of the shares issued, is to be regarded as the paid-up capital stock, except when such stock is assessable on account of deferred payments, or payable in instalments, in which case the amount actually paid on such shares will constitute the actual paid-up capital stock of the corporation. The interest to be deductible must have been computed on the proper principal at the contract rate and must have been actually paid within the year. Interest paid pursuant to contract on an indebtedness secured by mortgage on real estate occupied and used by a corporation, in which real estate the corporation has no equity or to which it is not taking title, is an allowable deduction from gross income as a rental charge, payment of which is required to be made as a condition to the con- tinued use and possession of the property. If, however, the corpora- tion has an equity in or is purchasing for its own use the real estate upon which such mortgage is a prior lien, the indebtedness will be held to be indebtedness of the corporation within the meaning of the law and the interest paid on such mortgage will be deductible only to the extent that it, with interest on other obligations of the corpora- tion, is within the limit fixed by the act. It is held that in the case of a corporation having capital stock, this deductible interest is interest actually accrued and paid within the year, on an amount of indebtedness not exceeding the paid-up capital stock outstanding at the close of the year, increased by the addition thereto of one-half the interest-bearing indebtedness outstanding at the close of the year. The qualifying phrase "outstanding at the close of the year" ap- pearing in the foregoing quotation, is held to apply to both paid-up capital stock and indebtedness, and "one-half the sum of" qualifies only the indebtedness, which indebtedness, like the paid-up capital stock, is required by the law to be reported, in making return of annual net income, as outstanding at the close of the year. If no indebtedness is outstanding at the close of the year, the maxi- mum deduction allowable on account of interest paid, will be the amount of interest actually accrued and paid on an amount of indebted- ness not exceeding at any time within the year, the entire paid-up capital stock outstanding at the close of the taxable year, that is, in such case, the paid-up capital stock outstanding at the close of the 842 AUDITING year, measures the highest amount of indebtedness upon which de- ductible interest can be computed. For the purpose of an allowable deduction, interest on the maxi- mum amount of indebtedness, determined in the manner above indi- cated, can be computed upon such amount only for the time during which such amount of indebtedness is not in excess of the paid-up capital stock increased by one-half the sum of the interest-bearing in- debtedness outstanding at the close of the year. In any event, the amount of interest, in order to constitute an allowable deduction, must not only be within the limit of the law as herein defined, but must have actually accrued and been paid within the year for which the return is made. In cases where no capital stock exists, the limitation as to deduction is confined to interest actually paid on an amount of indebtedness not exceeding at any time during the year, the capital employed in the business at the close of the year. Interest on bonded or other indebtedness bearing different rates of interest may be deducted from gross income during the year, pro- vided the aggregate amount of such indebtedness on which the in- terest is paid does not exceed the limit prescribed by law, and in case the indebtedness is in excess of the amount on which interest may be legally deducted, the indebtedness bearing the highest rate may be first considered in computing the interest deduction and the balance, if any, will be computed upon the indebtedness bearing the next lower rate actually paid, and so on until interest on the maximum principal allowed has been computed. The limitation in the law is indefensible. Corporations should be permitted to deduct all interest paid on indebtedness. Individuals are permitted to deduct "all interest paid within the year by a taxable person on indebtedness." The discrimination against corporations in this respect is hard to understand. Either no interest should be deductible or all interest should be an allowable deduction. An arbitrary selection of "one-half," etc., is simply ridiculous. It is also an inducement to excessive capitalization. Whatever reasons may have existed under the corporation tax law for considering interest paid on indebtedness as a distribution of net income, have disappeared under the income tax law. By the terms of the former act the individual recipient of the interest was not taxable ; under the present act he is. To tax a corporation on an amount of income accrued to it, and then to tax the same amount again upon its payment to the recipient, is not equitable. If there is any logical reason for exempting dividends from the normal tax because the corporation has paid a tax on the income represented thereby, that reason applies with equal force to in- terest disbursements from income on which the corporation has been taxed. Conversely, if the owner of the evidence of indebtedness is to be taxed on the interest he receives, the corporation should be permitted to FEDERAL INCOME TAX 843 pass to him that part of its income represented by such interest, without the imposition of an intermediate tax an the corporation. If no change is made in this respect, corporations may find it ad- vantageous to change their fiscal years to dates when their indebtedness is largest, as by so doing they can secure a larger allowable deduction. Taxes The regulations refer to tax deductions as follows: Reserves for Taxes Are Not Deductible. Reserves for taxes can- not be allowed as the law specifically provides that only such sums as are paid within the year for taxes shall be deducted. Deductions for taxes, however, should be the aggregate of the amounts actually paid, as shown on the cash book of the corporation. Certain Taxes Are Not Deductible. Taxes paid for local benefit* are not deductible. Taxes paid by a corporation pursuant to a contract guaranteeing that the interest payable on its bonds or other indebtedness shall be free from taxation are not deductible. Import duties or taxes are not deductible under the item of taxes paid during the year, but should be included in arriving at the cost of "goods under item 4 (expenses). Corporations with "tax-free" provisions in their bonds can save money by close attention to the exemption certificates filed with them. Many bondholders do not trouble to claim exemption where interest is "tax free," because their gross income is less than $3,000 and they know they do not have to pay a tax in any event. Therefore, where feasible, and the recipient is entitled to exemption, certificates claiming exemption should be secured and substituted for those not claiming exemption. Supplementary Statement for Corporations Deductions The classification of expenses called for by Form 1031 revised, has been more burdensome to taxpayers than is justifiable. Corporations with good accounting systems are most affected, while those with poor systems find it easier to comply with the requirements. It would seem, however, that the Internal Revenue Commissioner is concerned chiefly with securing a somewhat more detailed classifica- tion of expenses than was originally contemplated, and he shows a willingness to accept a different classification from that shown on the form, provided the items are as informative as the Commissioner re- quires. The following extract from correspondence bears directly on this point. The Commissioner said in answer to an inquiry: 844 AUDITING In reply to your request that the railway companies which you represent be permitted to file a schedule of the deductions allowed under the law in conformity \Vith the uniform system of accounts ordered by the Public Service Commission, instead of the division indicated by the return, you are informed that the division indicated in the supplementary statement forming a part of the return is merely suggestive. This office desires information, as far as possible in detail, as to what items go to make up the general expenses. If this information is sufficiently given in detail in the schedule of deductions allowed under the law in conformity with the uniform system of accounts ordered by the Public Service Commission, this office has no objection to such a statement being attached to the return. It should be understood, however, that this permission does not carry with it a ruling that all of the items included in such schedule will be held to be allowable deductions from gross income for the purposes of the income tax. And in answer to another inquiry: This office does not desire to cause corporations any unnecessary trouble or expense in preparing the supplementary statement referred to and therefore if the books of the corporation which you represent are kept in such a manner as to make it very difficult to give the in- formation in the exact form called for on the supplementary state- ment, a reasonable explanation in detail of the manner of arriving at gross income and expenses will be accepted. However, it is desired that this information shall be furnished in such a manner that the returns can be intelligently audited upon receipt thereof in this office. If the Treasury Department will adopt and enforce reasonable rules only, and will conform to modern accounting practice in the adminis- tration of the law (the success of which depends upon honest and accurate accounts), then corporations can be depended upon for full and complete co-operation in the compilation of returns and the pay- ment of taxes. DEDUCTION OF TAX AT SOURCE OF INCOME Present Method of Deduction The framers of the law have followed to a certain extent the British precedent of deducting the tax at the source of the income wherever feasible. This is accomplished by requiring all persons or firms, corporations and associations, whether acting for themselves or on behalf of some one else, to deduct the normal tax of 1 per cent from payments of "interest, rents, salaries, wages, premiums, an- nuities, compensation, remuneration, emoluments, or other fixed or de- terminable annual gains, profits, and income of another person exceed- ing $3,000 for any taxable year" ; and pay such tax over to the govern- ment. FEDERAL INCOME TAX 845 The tax is to be deducted and paid over to the government from .all payments of interest on bonds and mortgages, or deeds of trust, or other similar obligations of corporations, whether payable annually or at shorter or longer periods, irrespective of whether or not such interest payments amount to $3,000. The tax must also be deducted from all collections of interest and dividends (irrespective of amount) on foreign bonds and stocks not payable in the United States. Another form of collection at the source arises out of the taxation of 1 per cent upon the net income of corporations, the dividends out of which are afterwards exempt so far as the normal tax of individuals is concerned. There are certain exceptions to the foregoing requirements, e.g., tax is not to be deducted from payments to corporations, nor where exemp- tion is properly claimed, nor where bonds are "tax free." The corpora- tion which issues "tax-free" bonds does not withhold the tax on the interest payments but pays it to the government as if it had deducted it. The regulations and procedure in connection with deduction at the source are complicated and of no general interest. Rather than attempt to master all of the numerous regulations and decisions, it will be easier, where any doubt obtains as to the procedure in a given case, to consult one's local bank or internal revenue collector. Excessive Cost of Collection at Source The report to the National Tax Association suggests a much better method of procedure, as follows: That Part of the Act Which Requires the Collection of the Tax AT THE Source Should be Modified. It is morally wrong that the government should force corporations and individuals who by accident of circumstance have control over the payment to others of interest, rent, salaries, wages, premiums, annuities, compensation, remuneration, emoluments, or other fixed or deter- minable annual gains, profits, and income, to perform the work of collection which properly belongs to the government and to bear with- out compensation a great part of the expense of collecting the tax. It might be claimed that this objection can be removed by the government agreeing to reimburse the original taxpayers for their outlay. It would, however, be exceedingly cumbersome for the govern- ment to make such an arrangement and there would be grave danger of abuse. Moreover, even if such an arrangement was made, the objec- tion would be only in part removed. For the real difficulty with the scheme is the excessive cost of collection, whether this cost be defrayed by the government or by the taxpayer. It is true that since the law first went into operation, there has been, as might be expected, some reduction in the cost of collecting 846 AUDITING the tax ; but it is still excessive. Your Committee has instituted a careful inquiry into this matter and finds the facts to be as follows : A group of financial institutions who act as pa5'ing agents or fiscal agents for corporations, report that the cost of collecting the tax ranges from 10 per cent to 20 per cent of the amount turned over to the government. The variation is doubtless due partly to the fact that where bonds are tax-exempt the work of handling certificates is much less than where the corporation does not assume the tax, and certificates have to be handled with the greatest care. If ^most of the bond issues on which a trust company pays interest are 'tax-exempt, the cost is naturally lower than in the other case. That the maximum figure of 20 per cent is not excessive for many companies is very certain. With one large company the Committee has been able to go over the details of the calculation, and finds that the additional clerical assistance occasioned by the law has been from $5,000 to $7,000, and that the total tax collected has been $35,000 per annum. This figure of the cost does not take into account incidental items other than clerk hire, or include overhead charges. A number of small banks and trust companies which do not act as paying agents report an insignificant amount of tax collected and an insignificant cost of collection. The law has occasioned them some trouble, and much of it unnecessary ; but they are unable to estimate the expense, and say that neither the expense nor the tax is of any importance. From a number of corporations, railroads, other public service com- panies, and manufacturing corporations, the Committee has received data showing the cost of collection ranging from 1 per cent to 70 per cent. The figure of 1 per cent was given by a large corporation, the bonds of which are tax-free; but it is exclusive of any additional cost imposed upon fiscal agents. At the other end of the scale is another corporation, none of whose issues are tax-free, which reports the cost of collection in excess of 70 per cent. It pays its coupons over the counter; and this figure probably shows the whole cost of collection, since there is no paying agent. Most of the data secured by the Committee show costs of collection running from 10 per cent to 20 per cent, whether they are obtained from banks or from debtor corporations. These figures are confirmed by other evidence. We are informed that since the income tax went into operation, paying agents have very generally increased their charge for paying coupons from one-eighth of 1 per cent to one- fourth of 1 per cent, and corporations have accepted such increase as reasonable. If we assume that this increased compensation of one-eighth of 1 per cent represents the additional cost which the law occasions to the paying agent plus a reasonable profit, we see that the average cost to paying agents is one-eighth of the normal tax of 1 per cent less what- ever allowance may be made for profit. If, however, a large number of the bonds are held by persons with incomes of less than $3,000, the tax will not equal 1 per cent of the interest paid, and therefore the figure of one-eighth of 1 per cent may mean very much more than one-eighth of the amount of tax received by the government. In general, we can safely say that the cost of collecting the tax on bond interest ranges from 10 per cent to 20 per cent, and in a large number of cases is nearer the larger than the smaller figure. FEDERAL INCOME TAX Other Objections to Collection at Source 847 The excessive cost of collection is not the only objection to the system of collection at the source. Among the other shortcomings are the following: Collection of the tax at the source enriches the government wrong- fully at the expense of corporations indebted upon coupon or registered bonds. Where the corporation has assumed and agreed to pay the tax directed by the act to be withheld, compliance with the statute requires it to pay the tax in cases where the bondholder, although entitled to an exemption, fails or refuses to file a claim to exemption. The debtor corporation has no means of either compelling the bondholder to claim such exemption or of ascertaining whether or not in fact he is entitled thereto. Its only course is to pay to the government an amount equivalent to 1 per cent of the amount of interest paid to the bondholder. The amount so paid may or may not be a tax justly due the government. Frequently it is not. Naturally, it is impossible to gather figures to indicate the amount which is so paid, not as a tax but as a penalty. The corporation is penalized for the carelessness or perverseness of its bondholders. It is not an answer to say that the corporations should never have entered into these contracts. The contracts have served a useful purpose in relation to state laws where the bondholder is taxed and the corporation through its treasurer is required to deduct and to collect the tax. The assumption of the tax by the corporation has served to make the investment more attractive and has no doubt reacted upon the interest rate. Such contracts are now in no small measure a necessity in bond issues intended for wide distribution. The investor insists upon the covenant in some jurisdictions. Collection at the source in its relation to so-called "tax-free" covenants results in an unjust discrimination between bondholders under the same mortgage. Collection at the source is required only on payment of interest to individuals. Corporations and partnerships must by the terms of the act be paid in full without deduction for the tax. The debtor, therefore, under an agreement with all of its bond- holders intended to operate to the benefit of all alike, and accepted with that understanding by the investors, is compelled by the terms of the act co pay the tax for those of its bondholders who are individuals but not for corporations or partnerships. Either the debtor corporation should be required to assume the burden of the tax for all of its bondholders — or, as this committee contends, the burden should be placed where it properly belongs, that is, on the recipient of the income. Where an individual is an investor in the "tax-free" bonds of two or more corporations, and his aggregate income therefrom exceeds $3,000, if single, or $4,000 if married and living with his wife, he may for no particular reason, throw the burden of the tax upon any one of the corporations by deliberately refusing to claim a fair proportion of his exemption against the interest he receives from it. He is enabled by the terms of the act to work injury to his debtor, and the debtor has no remedy for the wrong. If he receives income from such bonds and also from other sources, the act permits and tacitly en- courages him to throw the burden of the tax on the corporation which pays him "tax-free" interest, and to claim all of his exemption against other income from sources which do not protect him by "tax-free" 848 AUDITING covenants. As a result he enjoys a greater exemption from the tax than that to which he is entitled. There is no attempt on the part of your Committee to advocate on behalf of debtor corporations a release to any extent from the respon- sibilities which they should lawfully assume under the provisions of the covenants here discussed ; but it does contend that the act should not enforce a partial and discriminatory execution of such contracts, nor should it so pervert the operation of the contracts as to cause the corporation to be unjustly burdened with the payment of moneys which do not represent the tax, or which represent the payment of more than a just proportion of the bondholder's tax. The covenants in terms specify that the corporations will pay for the bondholder any tax which it is required to withhold and deduct from interest payments. Where the bondholder is subject to no tax, the corporation should pay no amount to the government. Where the bondholder has other income, the corporation should in all justice be entitled to the benefit of a just proportion of the bondholder's exemp- tion, for the tax is not on his entire income, but only on that amount over and above the exemption. Neither is the tax imposed on all income from certain sources, leaving other income against which to claim exemptions. No such distinction between different kinds of income is intended by the act, yet the necessary result of the provisions for collection at the source is to make that distinction. The so-called tax-exempt covenant was in reality never intended to operate under a personal income tax. The Civil War income tax acts contained a provision that certain specified classes of corporations should be subject to pay a tax of 5 per cent of the amount of all their interest or coupon payments to whomsoever payable, with a proviso that said companies were authorized to deduct and withhold from all such payments the amount of the tax. The payment of the tax so deducted discharged the company from liability for a corresponding amount of interest upon the obligations referred to, except where the company might have contracted otherwise. This tax was held by the Supreme Court of the United States in Railroad Company v. Collector, 100 U. S. 595, and in United States v. Erie Railway Company, 106 U. S. 327, to be, not an income tax upon the holders of the corporate obliga- tions affected, but an excise tax upon the business of the corporation in respect to its interest payments, the company being merely granted the privilege of passing this tax on to the holders of its securities. The so-called "tax-free" clause in modern corporate obligations arose from these provisions of the Civil War income tax acts. It was designed to protect the creditor against the passing on to him of this type of tax. In other words, he took advantage of the suggestion in the law itself to demand contracts protecting him against the deduction of this kind of tax. The language of the typical "tax-free" clause, however, framed at the instance of creditors who demanded protection against every possible contingency in the premises, is, in its usual form, so broad as apparently to comprehend not only an excise tax upon the business of the corporation deductible as against its security-holders, but a tax like the present income tax which is levied, not upon the corporation, but upon the recipient of the interest, and which solely, SLS a means of collection, the corporation is required to withhold and pay to the government. The corporations and their creditors have accepted this construction of these clauses under the present act. The result has been that a tax which Congress intended to levy upon the FEDERAL INCOME TAX 849 income-receiver has, in this case, been shifted to the income-producer. It thus falls not upon the "swollen fortune" which it is the professed purpose of this act particularly to reach, but primarily upon the cor- poration and, in some cases, finally upon the unfortunate "ultimate con- sumer" who was supposed already to be more than sufficiently taxed. The recipient of income subject to deduction of the tax at the source is deprived of the use and benefit of the money withheld during the period of time between the date of withholding and the date on which by the terms of the act the tax becomes due. He receives no evidence of the payment of the tax on which he can rely for defense in the event of proceedings instituted against him by the Bureau of Internal Revenue. The danger is not fanciful. Tenants are withhold- ing agents and it is not inconceivable that a tenant may be insolvent or have disappeared when the time for payment arrives. Advantages of Collection at Source As opposed to these shortcomings of the system of collection at source, the chief argument advanced in its favor is that it insures the accuracy of the return and provides a control on the statements of individuals. Your Committee does not desire to express any opinion on the question as to whether such a control is necessary, nor does it desire to compare the system of collection at source, as practiced in England and the United States, with the system of individual return as found in the German income taxes. On the assumption, however, that such a control is desirable, your Committee would like to point out that the same purpose may be achieved by a system which is to a large extent free from the objections that attach to collection at source. This system, which has been called that of information at source, will be fully explained in the next recommendation, and would in the opinion of your Committee constitute a considerable improvement over the existing method. Information at the Source While the Committee believes that a proper system of information at the source will furnish all the safeguards needed to prevent eva- sion, it recognizes that there is one class of incomes with reference to which Congress may desire to retain the principle of collection at the source, namely, incomes received by American citizens residing in other countries and by non-resident aliens to the extent to which they are taxable under the act. If it should be desired to continue to collect the normal tax from these incomes at the source, it would be possible to make a provision by which this should be done. It might, for instance, be enacted that the normal tax of 1 per cent be withheld and deducted from fixed and determinable incomes of whatever amount received by, or accruing to, citizens of the United States residing abroad and taxable non-resident aliens, proper administrative provision being made in connection with the general scheme of informa- tion at source hereinafter developed to establish the taxable status of the recipient of such income. Operation of Deduction at the Source Under the present system of collection at the source, the Bureau of Internal Revenue has no means of accurately checking the returns 850 AUDITING of taxpayers except by assembling the multitude of ownership certifi- cates, arranging them under the names of the respective signers and adding up the total of income reported and exemptions claimed by each. Unless this be done, the Bureau must rely not only on the honesty of the taxpayer but on his intelligence and care as well. Many persons signing ownership certificates keep no record of the exemptions theretofore claimed on other certificates during the year, and many are uncertain as to the effect of claiming exemption on the certificates, and others are careless and unsystematic. Undoubtedly excessive claims for exemption are frequently made with no intent to defraud the government. The complicated arrangement of the annual return of individuals makes it not unlikely that amounts of income on which exemption was claimed are often placed in column A, resulting in a further possible loss to the government. The only means of guarding against the potential losses referred to in the preceding paragraph lie in the diligence with which the Bureau of Internal Revenue collects and assembles the ownership certificates. After the collection and indexing of the certificates has been com- pleted, it is of little practical importance whether the amounts thereon stated represent merely income from various sources or income from which the tax has been deducted. In either case the government has the same definite information concerning the income of the taxpayer and the same power to enforce payment of the tax. If the owner- ship certificates indicate the taxable liability of the signer, why should not the government proceed by direct means to collect the tax from the taxpayer instead of using the present indirect means which place additional expense upon certain classes of citizens and result in unfair discrimination? Operation of Information at the Source Your Committee recommends a system of information at the source which will require the recipient of income to give the payer once each year, or at the time of payment, a receipt in such form as may be prescribed by the Treasury Department. Such receipts should be for- warded by the payer to the local collector as ownership certificates now are. The payer should be required to make oath that he has obtained and filed receipts for all payments of income of the kinds enumerated in the act. Penalties should be prescribed for attempts to evade the law or the obligations placed by it upon payers and recipients of income. Your Committee further urges that a reasonable com- pensation be paid to the payer of income, based upon the number of receipts filed with the government, to compensate him for the expense incurred. A practical working out of this system would result in receipts used by individuals and corporations receiving many payments in the course of the year, having the name of the recipient printed thereon primarily for the convenience of the government in aiding it to de- cipher signatures. The signature on the receipt being merely for the purpose of authentication, the printed names only need be consulted in assembling the certificates. To put our suggestions more in detail, your Committee recom- mends that all persons, firms, corporations, etc., who pay to any other person subject to taxation under the act amounts of fixed and de- FEDERAL INCOME TAX 851 terminable income, other than interest upon bonds and other obliga- tions of corporations, joint-stock companies, and associations, in excess of the amount of $800 per annum, shall, on or before the first day of March in every calendar year, report to the collector of internal revenue of the district in which they reside the amount of all such income paid. In the case of interest paid upon bonds or other obligations of cor- porations, joint-stock companies, or associations, information can be secured of all payments by requiring the corporation or its fiscal agent to report, on or before the first day of March in each calendar year, the amount of such payments, whether they exceed $800 or not. To provide for the case of coupon bonds, it should then be provided that no corporation or its fiscal agent should pay any interest coupon unless it is accompanied by a certificate containing the name of the owner ; and then providing that no person, company, or corporation shall buy or accept for collection or deposit any such coupon without requiring the holder to file a certificate stating that he is the owner, and giving his address. The person, company, or corporation buying or accepting for deposit should be required to certify to the signature of the signer of the certificate, but not, of course, to the fact of owner- ship of the bond. Under this arrangement no person could cash or deposit a coupon without filing a certificate stating that he was the owner of the bond, and the person buying the coupon or taking it for collection would have to certify to the identity of the person who claimed to own the bond. The corporation or its fiscal agent would in this way be provided with evidence about the ownership of coupon bonds, and could by a card index keep track of bondholders. The government would obtain its information once a year in convenient form, and after the first year changes in ownership only would need to be noted. Under this plan of information at the source, no questions need ever arise as to whethep a person was liable to tax or entitled to ex- emptions or abatements, because the person paying the income could in all cases file his certificate and let the government deal with the question of liability. Since no money is to be withheld and deducted and accounted for, the problem will be enormously simplified. The objection is sometimes made that to collect the tax from the bondholder will impair the obligation of contracts made between cor- porations and their bondholders. The Committee attaches no weight to this objection. As is pointed out above, the so-called tax-exempt covenant was never intended to operate under a law taxing personal income as such. But entirely apart from this consideration, it must be remembered that no one claims that it is a violation of the contract to collect from the bondholder the additional tax, which may amount to 6 per cent, and that the law does this without any question. How, then, can it be claimed that it is a violation of contract to collect the normal tax from the bondholder? In his annual report, dated December 6, 1915, the Secretary of the Treasury said: I am of the opinion that it would be very advantageous to have this law amended so as to do away with the withholding of the income tax at the source, and in place thereof to require information at the source; that it will mean the collection of a larger amount of revenue 852 AUDITING and eliminate a great deal of criticism which has been directed against the law. If such an amendment is adopted, an exception should be made in the case of non-resident aliens, whose tax would necessarily be withheld at the source. It is gratifying to note that the Treasury Department thus goes on record as favoring an amendment to the law along the lines suggested by the National Tax Association. FEDERAL INCOME TAX INDEX Accident benefit associations, exempt from income tax, 820 Accident insurance (See "Insur- ance, Accident") Accounting, good practice de- mands reserves against losses, 800 Agricultural associations, exempt from tax, 820 Agricultural corporations, donations by, to fairs, 835 Aliens, non-resident, dividends on corporate stock, 814 fiduciaries reporting for, 815 income of, 814 interest on bonds, 814 report on form 1040 revised, 815 Annuities, gifts, 782 life insurance, 782 Appreciation, capital assets, 827 Assessment districts (improve- ments) (See "Political Sub- divisions") Assets, capital, appreciation of, 827 Associations (See also "Clubs") commercial men's, not exempt, 821 dividends, 786 exempt from tax, 820 interest on bonds to be ac- counted for by holder, 821 fraternal benefit exempt from tax, 820 853 B Bad debts (See "Debts") Baldwin Locomotive Works, valuation increased by appraisal, 829 Banks, bank stock taxes paid, 795 mutual savings, capital stock not represented by shares, 820 Beneficiary, returns by, 816 Board furnished employees free, treated as income, 774 Boards of trade, exempt from in- come tax, 820 Bonds, American corporations, foreign holders not taxable for interest, 161 coupon, and information at source, 851 discount on, as losses, 839 method of handling, 839 exempt organizations, interest to be accounted for by holder, 821 exemption certificates affect re- turns, 843 fidelity; premium on, 791 foreign, interest on, 845 losses in purchase and sale, 801 premium on, 839 retirement, losses by, 840 tax free, 794, 845 abuse of, by individual, 847 income returnable, 826 rrovisions in, 843 854 INCOME TAX INDEX Bonds — continued worthless, charged off as debts, 801 Bonuses to employees, 834 Buildirg and loan associations, domestic, exempt from in- come tax, 820 "Business," definition, 798 Business leagues, exempt from in- come tax, 820 Campaign contributions not ex- pense, 833 Capital stock, paid up, defined, 841 preferred, dividends not deductible, 841 not a liability, 840 proceeds of sale, 825 subscriptions, proceeds of sale of rights, 786 Cemetery companies, exempt from income tax, 820 Chamber of Commerce, exempt from income tax, 820 State of New York ; income tax for State favored by, 760 Charitable associations, exempt from income tax, 820 gifts of merchandise to, 836 Cities (See "Municipalities") Civil War income tax, 348 Clergymen, English, rent of study under British income tax act, 792 fees received, 776 gifts, Christmas, 776 parsonage rent free, 774 Clubs (See also "Associations") exempt organizations, require- ments to register as, 822 social, exempt organizations, 822 Collateral, as contemplated by act, 837 indebtedness secured by ; inter- est on, 836 real estate as, 837 the subject of sale, defined, 838 Collection at source, advantages of, 849 and financial institutions, 846 and information at source, 851 cost of, 846 excessive, 845 objections to, 846 operation of, 849 suggested modification, 845 unjust discrimination, 847 Columbia, District of, public utilities owned and op- erated by government exempt from income tax, 820 Commercial men's associations, exemption from tax does not apply, 821 Commissions, executors'; chargeable to cor- pus of estate, 816 paid in stock, 835 real estate agents', 791 salesmen's, 792, 835 Companies, joint-stock, dividends, 786 Compensation based on stock hold- ings, 835 Compensation, special; when de- ductible, 835 Connecticut Mutual Life Insur- ance Co. V. Eaton, 833 Consumer, effect of tax on, 849 Contract, employment ; affects tax- able items, 776 Contracting companies, income based on completed work, 828 INCOME TAX INDEX 855 Corporations (See also "Indivi- duals") accounts payable, treatment of, 832 agricultural, donations to fairs, etc, 835 appreciation of capital assets, 827 associations and, exempt from tax, 820 bonds held by foreigners, in- terest on, 767 bonds, tax free, 794, 826, 843 books must confirm figures of annual returns, 818 capital stock, proceeds of sale, 825 collection at source unfair ex- pense upon, 847 deductions allowed, 831 (See also "Deductions") defined, 818 discrimination against, 842, 847 dividends received upon stock, 830 domestic, dividends, 786 donations, 835, 836 exempt from income tax, 820 expenses, 832 paid within year, 769 scheduling, 844 fiscal year, 822 forms specified for returns, 818 income accruing, 821 income returns and books should agree, 769 income, taxation of, 768 interest on indebtedness, 768 interest, two classes figured separately, 838 inventory to determine gross in- come or expenses, 825 losses actually sustained within year, 769 obligations imposed upon, 817 officers' salaries, 834 operating mines on royalty basis, 809 penalty for failure to file re- turns, 818 profit, net for year, 769 public utility, income tax returns should conform to Interstate Com- merce Commission rules of accounting, 770 rental value of property owned, 834 subsidiary, dividends, 825 returns of, 818 supplementary statement for, 843 surplus distributed in liquida- tion, 788 taxes paid within year, 769 wrongfully burdened with col- lection expenses, 847 Costumes, theatrical, depreciation on, 808 County employees exempt from tax, 773 Customs duties, 794 Debts, bad, past-due items ascertained worthless and charged off, 800 rents, unpaid, 800 salaries os wages, when permis- sible to treat as, HZ salaries, unpaid, 800 wages, unpaid, 800 Debts forgiven constitute income, 830 Decisions (See "Treasury Deci- sions") 856 INCOME TAX INDEX Deduction at source of income (See also "Collection at Source") method of, 844 operation of, 849 Deductions, 789, 831 method of scheduling, 843 Depletion (See also "Deprecia- tion"), allowance for, mines, oil wells, 808 franchises, 785 mines, 785, 808 National Tax Association re- port, 810 oil wells, 785, 808, 810 patents, 785 timber lands, 807 Depreciation, 801 (See also "De- pletion") books, must appear on, 803 costumes, theatrical, 808 good-will, 807 National Tax Association re- port, 810 • obsolescence, 802 patents, 807 physician's, 808 rates of, 806 inspectors, harmful criticism by, 769 reserves, 805 timber lands, 807 Wisconsin law on, 802 Differentiation of income tax, funded and unfunded, 767 state and local taxes compli- cate, 767 Discount, bond, as losses, 839 method of handling, 839 Discrimination, individual required to report for calendar year, 111 real estate dealers affected, 711 securities, brokers and dealers affected, 171 Dividends, cash, 787 compensation on stock holdings, 835 exempt from normal tax, 786, 845 Exempt from tax up to $20,000 per annum, 772 from other corporations, 825 life insurance, 782, 787 not interest, 840 scrip, cash value questionable, 787 stock, 787 subsidiary corporation, 825 Doctors, deductions allowed in making returns, 791 Doctrine, income, 765 Donations (See also "Gifts") by agricultural corporations, 835 for welfare of employees, 836 to charitable or educational in- stitutions, or hospitals, deductible as corporation ex- pense, 836 Duties, 794 import, not deductible, 843 Educational associations, exempt from income tax, 820 Educational institutions, donations to for employees, 836 Employees, bonuses to, 834 compensation to, 834, 835 contract, employment affects taxable item, lid, 834 gifts to, 834 gratuities to, 834 I INCOME TAX INDEX 857 Employees — continued pensions to ex-employees, 833 premium on fidelity bond paid by them, 791 profit-sharing items deductible if contract exists with, 834 salaries paid, 834 state, county, municipal; com- pensation exempt, 773 welfare donations, 836 Endowment, income from, defined, 782 life insurance, 782 England, income tax, diflferentiation of, 767 Erroneous taxes, 812 remedy at law, 812 Estate, administration expenses, 816 trust, undistributed income, 816 Excessive capitalization, induce- ment for, 842 Exempt, dividends, 786 dividends on life insurance en- dowment policies, 782 dividends up to $20,000 per an- num, 772 interest, bonds of American corpora- tions exempt from taxation, 767 on obligations of public dis- tricts, 783 public utilities, municipally owned, 782 state, county, municipal em- ployees, 773 Exemptions, lower, recommended by Presi- dent Wilson, 763 Expenses, campaign contributions, 833 classification of, 843 improvements, 833 lobbying, 833 repairs, incidental, 833 Farm, definition, 779 Farmers, "gentlemen," operating for pleasure, 780 income of, defined, 779 items purchased and resold, 779 live stock, 780 mutual fire insurance companies, 821 tools, ordinary, 780 Federal income tax (See "Income Tax, Federal") Fees, compensation in, method of returns, 776 Fiduciaries, 815 annual returns by, 815 deductions not allowed, 816 guardians of one ward report on form 1040 revised, 815 incompetents, acting for, 817 minors, acting for, 817 report on form 1041 revised, 815 Financial institutions, and collec- tion at source, 846 Fiscal year, individual must report on cal- endar year, 777 individual partner can report on partnership fiscal year, 777 of corporations, income tax returns covering fiscal instead of calendar year, requirements to file, 822 new organizations, 822 Foreigners (See aliens, non-resi- dent, 814) 858 INCOME TAX INDEX Forms, fiduciaries report on form 1041 revised, 815 fiduciary reporting as guardian uses form 1040 revised, 815 individual (form 1040 revised), m overpayment of tax (form 46), 811 adjustment (form 1008 re- vised), 811 Fuel furnished free to employees, 774 G Gifts (See also "Donations") Christmas, to clergymen, 776 of merchandise, 836 property acquired by, gains, profits, or income, 785 value, 785 to corporations, 830 to employees, 834 to individuals, 830 Good-will, depreciation of, 807 Government, support of, individual subjects should con- tribute, 760 Gratuities to employees, 834 Great Britain, income tax, 759 Gross income (See "Income, Gross") Guardian, fiduciary reporting as, 815 H Heat, fuel, etc., furnished free, 774 Horticultural associations, exempt from tax, 820 Hospitals, donations to, 836 Hull, Cordell (Congressman), federal income tax, 763 opinion on securities, deduc- tions allowable, 796 I Illegal taxes, 812 remedy at law, 812 Import taxes (See "Duties") Improvements providing for growth of business, 833 Income, corporate, taxation of, 768 debts forgiven treated as, 830 deduction at source of, 844 dividends exempt up to $20,000 per annum, 772 doctrine of, 765 double taxation of, 766 equivalents, rent, 774 farmers', 779 crop shares, rents, 780 deductions not allowed, 780 gifts to corporations considered as, 830 gross, accident insurance policy re- ceipts, 786 deductions allowed, 824 deductions from salaries or wages, 773 dividends received upon stock not deductible by corpora- tions, 330 interest included, 825 rent equivalent to employees not deductible, 774 rentals included, 825 royalties included, 825 salaries and wages, 773 source of, deduction at, 844 information at, 849 tax (See below) undistributed, trust estates, 816 valuation increased by appraisal is not, 829 Income tax, federal, authority on, 764 INCOME TAX INDEX 859 Income tax, federal — continued complexity of present law, 764 defects in, 763 differentiation of, 767 England; earned and un- earned, 767 Italy; property, business, and labor incomes, 767 United States; funded and unfunded, 767 erroneous taxes, 812 illegal taxes, 812 law, administration, competent, 762 efficient administration essen- tial, 769 legislation in United States, 762, 763 objections to, inquisitorial features, 760 revealing information un- founded, 761 on all earnings and receipts in U. S., 766 overpayment of, 811 states, application to, 761 Incompetents, fiduciaries acting for, 817 Increment, unearned, depreciation not based on, 808 Indebtedness, maximum interest deductible, 842 secured by collateral, interest on, 836 Individuals, assessments against local bene- fits, 794, 795 bonds, losses in purchase and sale of, 801 bonds, worthless, charged off as debts, 801 calendar year report required from, 777 commissions paid, 791, 792 custom duties as cost of goods, 794 custom duties as tax, 794 debts, bad, 800 deductions (See "Deductions") depreciation, 801 dues and expenses, business clubs and associations, 790 exempt; dividends up to $20,000 per annum, 772 exemption, 813 expenses actually paid, 769 expenses in earning income not subject to tax, 790 expenses, personal, living, and family, 789 gifts to, 830 income, net, defined, 771 income statement should be an- alyzed by, 772 income tax withheld at source or paid to collector, 795 interest, 793 paid within year, 769 losses actually sustained within year, 769 merchandise cost, 789 obligations imposed upon, return on income exceeding $3,000, 771 withhold at source, 771 partnership business expenses, 789 premium on fidelity bonds, 791 professional men, 791 property, improvements or bet- terments, 789 railroad fares, 790 replacements, cost, 802 salaries or wages uncollected, treatment of, 773 securities purchased or sold, 795 stocks, 801 86o INCOME TAX INDEX Individuals — continued taxes, 794 assessed on bank stock, 795 paid for landlord, 792 paid foreign countries, 794 paid on "tax free" bonds, 794 paid within year, 769 Information at source, 849 and collection at source, 850 operation of, 851 Inspectors* decisions, possible in- accuracy of, 771 Instalment payments, real estate, default less salvage on prop- erty repossessed portion chargeable to bad debts, 781 Insurance, accident, death beneficiaries (See "In- surance, Life") receipts from policy, 786 companies, dividends exempt, 786 fire, premiums, treatment of, 792 fraternal benefit, exempt from income tax, 820 life, annuities, 782 dividends, accrued or re- ceived, 782 dividends paid but not ma- tured, 787 dividends, paid-up policies, 787 partner, death of; insurance in favor of partnership, 792 premiums, 792 premiums on partner's life insurance in favor of part- nership, 792 premiums paid by corpora- tion, 832 proceeds received by corpora- tion, 832 mutual companies, exemption not applicable to, 821 Interest, as rental charge, 841 bonds of American corporations in foreign hands, 767 bonds of exempt organizations, 821 corporations limited as to de- ductions, 768 deduction at source, 845 deductions allowed, 793 deductions limited, 840 earnings report, regardless of source, 781 exempt, 782 government obligations, 785 manufacturing cost, 833 method of stating, 838 not dividends, 840 on indebtedness, maximum deductible, 842 secured by collateral, 836 secured by trust mortage, 837 real estate, deduct yearly, 781 investors in, 780 not allowed if added to book value, 781 Internal Revenue, Commissioner of, recommended, foreign taxes be made allow- able deductions, 794 income from dividends to be in- cluded in returns, 772 partnerships report on same basis as corporations, 785 returns on all incomes $3,000 or over, 773 Internal Revenue, Deputy Com- missioner, proceeds of sale of rights, 786 INCOME TAX INDEX 86 1 Interstate Commerce Commission, corporation income tax report should conform to balance sheet required by, 770 Inventory, equivalent, defined, 825 physical or equivalent, to de- termine gross income or ex- penses, 825 recommended to determine gains or losses, 778 Investor, real estate, 780 Italy, income tax, differentiation of, 767 J Joint-stock companies, 786 Labor, included in cost of manu- facture, 833 Labor, unproductive, supervision cost, 833 Labor associations, exempt from tax, 820 Lawton, William H., on deprecia- tion reserves, handling of, 805 Lawyers, deductions allowed in making returns, 791 Legislation, 762, 763 Lessee, royalty basis, operating mines, oil wells, etc., 785 Life insurance (See "Insurance, Life") Light furnished employees free, 774 Liquidation, mandatory, of cor- poration, 788 Loan associations (See "Build- ing and Loan Associations") Lobbying expenses, 833 Lodges, fraternities exempt from tax, 820 Lodging furnished employees free, 774 Losses, 795, 839 bond discount, 839 bond retirement, 840 fire, 795 on securities, 799 real estate, treatment of, 778 reserve for, 800 shipwreck, 795 stockbrokers', treatment of, 778 trade, 795, 798 Lumber companies, deduction for return of capital assets al- lowed by court, 828 M McAdoo, W. G. (Secretary of Treasury), losses, opinion on law, 798 Management expenses, 792 Manufactured products, cost of, 833 Manufacturing costs, interest deductible, 833 interest not deductible, 834 rental value not deductible, 834 May V. Sloan, "trade" defined, 797 Mayor's Committee on Taxation, income tax for state favored by, 760 Merchandise, gifts of, 836 Merchants' Association of N. Y. City, income tax for state favored by, 760 Michell Bros. Co. v. U. S. Inter- nal Revenue Collector, 828 Mines, gross value at, 809 income defined, 785 leased, base depletion on cost of lease, 809 royalty basis of operation pre- cludes depreciation claim, 809 862 INCOME TAX INDEX Minors, fiduciaries acting for, 817 Municipal employees exempt from tax, 773 Municipalities, income tax, adoption by, 760 income tax, application to, 761 N National Tax Association, authority on income tax, 764 discrepancies between law and modern accounting practice, 769 on allowances to corporations and individuals, 796 on collection at source, 845 . on deductions of dividends by corporations, 831 on depletion of natural re- sources, 810 . on depreciation of property, 810 on gains or losses determined by annual inventory, 778 on individual exemption, 813 on management expenses, 792 on refund of income tax, 813 on subsidiary corporations re- ports, 819 on taxes paid foreign countries, 794 Natural resources (See Mines, Oil Wells, Timber Lands) Nebraska Special Commission on Revenue and Taxation, objection to revealing informa- tion unfounded, 761 New York, State of, income tax law proposed, 760 O Obsolescence ( See depreciation, 802) Officers, United States Army, heat, light, etc., allowances equivalent to income, 774 Overhead, included in cost of manufacture, 833 Overpayment of tax, 811 Paid-up capital stock, defined, 841 Parsonages, rent equivalent re- turnable as income, 774 Partnerships, gains and profits, distributed or not, individual returns to in- clude, 783 income returns and books of account should agree, 769 interest on government obliga- tions, 785 limited, are corporations under federal income tax law, 818 profit, net for year, 769 profits and list of partners en- titled to same to be furnished Commissioner of Internal Revenue on demand, 783 returns can be for fiscal or cal- endar year by individual part- ner, 783 Patents, depreciation of, 807 Pensions, employees', 833 Physician, depreciation claimed by, 808 Political subdivisions defined, 782 Preferred stock, not liability, 840 Premium, bond, 839 insurance, 792, 832 Professions, 776 cash book, form suggested, Tl(i clergymen, rent allowed, 774 compensation in fees returnable year of receipt, 776 Profit, instalment payments in- cluded as earnings in real es- tate, 781 INCOME TAX INDEX 863 Profit-sharing expense, deductible if contract with employees exist, 834 Proprietor, sole (See "Individu- als") Prorating profits on real estate, 781 Protest, payment under, disputed items, 797 tax on dividends if assessed, 785 tax on interest on government obligations if assessed, 785 Public utilities, exempt from income tax when owned and operated by gov- ernment, 820 interest and rental, 839 Public Utility Commissions, uni- form accounts of, as basis for returns, 770 R Railroad Co. v. Collector, 848 Railway companies, schedule of deductions for, 844 Rates, depreciation (See "Deprecia- tion") exemption, changes proposed by Secretary of Treasury, 814 Raw material included in cost of manufacture, 833 Real estate, agents' commissions, 791 carrying charges can be added to initial cost, 829 dealer, interest on secured indebted- ness, 837 losses, 778 losses deductible if incurred, 780 interest, deduct yearly, 781 earnings reported regardless of source, 781 investor, losses cannot be de- ducted by, 780 pledge for payment, 836 profit, instalment payments do not affect inclusion of profit, 781 prorating of profits, 781 rent accounts receivable, meth- od of reporting, 781 rental, 838 Savings Bank v. United States, 813 taxable profits, 781 transactions, income from, 828 Receivable accounts, report as income, even if not collected, 826 Religious associations exempt from income tax, 820 ReHgious organizations, gifts to, of merchandise, 836 Rent, clergyman's study, deducted under British income tax act, 792 income, equivalent of, 774 interest on real estate as rental charge, 838 real estate, accounts receivable, method of reporting, 781 value in manufacturing cost, 834 Repairs, incidental, 833 Replacements, cost of, 802 Reserves, depreciation, 805 for taxes, 843 inspectors, harmful criticism by, 769 Retirement of bonds, losses by, 840 864 INCOME TAX INDEX Returns, checking of, 849 forms of (See "Forms") Royalties, mines, oil wells, pat- ents, franchises, 785 Salaries, 834 uncollected, treatment of, 773 Salesman, commissions to, paid in stock, 835 Scientific associations, exempt from income tax, 820 Scrip dividends (See "Divi- dends") Securities, accounting method suggested for partnerships dealing in, 799 deductions allowed, 795 losses on, 799 dealers', 778 shrinkage in values, 800 Seligman, Edwin R. A. (Prof.), income tax development, 759 Sick benefit associations, exempt from income tax, 820 Smith, Adam, "Wealth of Nations," 760 Societies (See "Associations") Source of income, deductions at, 844 information at, 849 Speer, L. F. (Deputy Commis- sioner), decisions by, 786, 795 State employees exempt from tax, m Statement, supplementary, for cor- porations, 843 States, income tax, adoption of, 760, 761 New York State law prob- able, 760 Wisconsin income tax law, 760 Stock, capital paid up, defined, 841 deduction not allowed as it is not debt, 80i dividends, taxable income, 787 live, breeding; treated as capi- tal invested, 780 paid as commission, 835 preferred, not liability, 840 Stockholders, bank, taxes assessed deductible by in- dividual stockholder, 795 Stockholdings, compensation based on, 835 Subsidiary corporations (See "Corporations") Supertax higher, recommended by President Wilson, 763 Surplus liquidating corporation surplus taxable as dividends, 788 Tax, federal income (See "In- come Tax, Federal") Taxation, corporate incomes, 768 double, 766 dividends of corporations, 831 Taxes, 843 assessed against local benefits, 794, 795 bonds, tax paid on tax-free, de- ductible by individual, 794 for local benefits, 843 foreign country, paid to, 794 import (See "Duties") national, state, county, school and municipal, 794 paid by tenant for landlord, 792 reserves for, 843 INCOME TAX INDEX 865 Tax-free bonds (See "Bonds") Teachers, public school, exempt from tax, unless com- pensation is paid by United States, 773 Tenants, as withholding agents, 849 Textile, depreciation' on mill working double shifts, 803 Theatrical costumes, depreciation on, 808 Timber lands, depreciation of, 807 "Trade," definition of, 797 Treasury decisions, aliens, non-resident (2090), 815 compensation in fees, making returns (2090), 776 corporations liable to make re- turns (2152), 820 deductions, method of schedul- ing (1031), 843 dividends received by corpora- tions (2137), 830 donations by agricultural cor- porations (2090), 835 donations for welfare of em- ployees (2090), 836 estate, administration of (2090), 816 fallibility of, 793 fiduciaries (2090), 815 fiduciaries acting for minors and incompetents (2231), 817 fiscal year, corporations (2090, 2137), 822, 823 gifts, gratuities, bonuses to em- ployees (2090), 834 insurance, life (2090), 832 policies (2090), 832 "in trade," definition (2005), 798 interest, non-taxable (2090), 782 interest on indebtedness secured by collateral (2090), 838 interest, two classes (1993), 838 losses (1989), 798 losses must be absolute to be deductible (2005), 778 method of stating interest (1993), 838 overhead charges, 833 partners' distributive interest, 1914 (2137), 783 political subdivisions (1946), 783 premium on fidelity bonds (2090), 791 real estate (2090), 781 real estate agents' commissions (2090), 791 real estate, taxable profits, 781 rent equivalent (2090), 774 stock dividends (2274), 787 status as dealer, manufacturer or trader must be established to claim losses (2090), 798 surplus distributed in liquida- tion taxable (2163), 788 taxes (2090), 792 taxes paid foreign countries (2090), 794 U. S. army officers (2079), 774 wages or salaries (2224), ITh Treasury, Secretary of (See "United States Treasury") Trustee, compensation for serv- ices, treatment of, 774 U United States army officers (See "Officers, U. S. Army") United States Treasury, Secretary of, citations from annual report, 770, 851 U. S. V. Erie Railway Co., 848 g56 INCOME TAX INDEX V W Valuation, Wages (See "Salaries'") real estate, annual valuation of, Wisconsin, 779 depreciation, law on, 802 Vocations (See professions, 776) income tax law, 760 GENERAL INDEX (For federal income tax, sec special index in income tax section, page 853 et seq.) Acceptances, 175 Accident and health insurance, 584 Accommodation indorsements, 170 Accountants, fees, 35 Accounting, as a qualification for an audi- tor, 3 distinguished from auditing, 1 Accounts, bad or doubtful, 371 branch, 376 classes of, in auditing, 530, 531 classification, public utilities, 632 controlling, 301, 303 capital stock of banks, 539 certificates of deposit, 546 hospitals, 720 ledgers, subsidiary, 398 municipal accounting, 688 notes and securities in banks, 545 stockbrokers, 559 trust funds, 551 preparation of system of, 467 public utilities, uniform system, 631 Accounts payable, verifying, 147 Accounts receivable, borrowing on, 177 confirmation of, 319 fictitious, 75 from subsidiary companies, 512 general, 71 schedule of, 370 test of, 77 valuation of, 73 verification of, 78, 308 written off, 328 Accounts stated, when binding, 190 Accrued expenses, 225 Accumulated dividends, as a lia- bility, 197 Actions at law, expenses of, 473 Adams, Prof. H. C, on deprecia- tion, 414 Advances, not accounts receiv- ables, 76 Advantages of an audit, 9 Advertisements, misleading; mis- use of reports in, 290 Advertising, charges, 456 cost percentage in retail busi- ness, 622 Advertising agencies, 742 internal audit, 742 Agency accounts of branches, 376 Agents' reserve, verifying ac- counts in bank audits, 537 Agreement, partnership, 185 Allowances, rebates, 208 returns, 351 Amateur auditors, 5 867 868 INDEX American Association of Public Accountants, insurance accounting methods, 581 public utilities classification of accounts. 640 American Bankers' Association, form of statement for borrow- ers, 256 American Gas Light Association, classification of accounts basis, Public Service and Interstate Commerce Commission re- quirements, 676 American Malting Co., directors' liabilities, court de- cision on, 232, 332, 751 Amortization, bond premiums and discount, 374 general, 130 N. Y. Public Service Commis- sion on, 408 reserve, telephone companies, 680 Anticipation, of earnings and profits, ^)9 on sales not delivered, 214, 331 Appraisals (See "Valuation") Appreciation of assets, 216, 470 Appreciation of securities, book value not advanced, SS'i Architects, 728 certificates of, 380 commissions earned, 729 Arrears of dividends, 197 Assessments, on capital stock, 137 Assets, appraisals of, 434 appreciation in value of, 216, 470 changeable, verification in banks, 535 contingent, 136 current, proportion to liabilities, 65 current, verification of, 61 fixed, 104 omission of, on balance sheet, 144 profit on sale of, 216 sale of, 470 verification of, 60, 372 wasting, 134, 195, 232 writing down, 141 Asylums (See charitable organi- zations, 719) Audit, advantage of an, 21 balance sheet, 50 limitations of, 60 principles of, 59 banks, national and state, 531 beginning an, 29 cash audit, timing of, 69 cash book, discussed, 47 certificate of, 243 completed, 293 continuous, 293 detailed, 48, 293 determination of type of, 46 fees, 33, 162 interim, 294 internal, advertising agencies, 742 railroads, 651 agents' accounts, 652 minor objects of, 12 of prior periods, 297, 433 place of, 37 procedure in banks, 535 procedure in case of previous, 45 program, banks and trust companies, 545 building and loan associations, 566 INDEX 869 Audit — continued program — continued land and development compa- nies, 740 retail merchants, 610 stockbrokers' accounts, 561 wholesale merchants, 608 purposes and advantages of, 9 scheduling books, records, and clerks' names, 45 single-entry books, 44 special points in different classes of, 530 unfamiliar business, 43 working papers, 38 Auditing, accounting clistinguished from, 1 business man's attitude, 2 by tests and scrutiny, 295 profession of, 4 Auditor, advisory capacity of, 186 as lawyer, 108 as teacher, 21 bank audit report, 542 bank audits and responsibility of, 542 certificates and reports of, 235 experience necessary, 3, 43 fees, 33 fees, contingent, 36 legal duties summarized, 7 liabilities summarized, 7 liability for failure to discover defalcation, 13 liability for negligence, 8 must not prophesy, 460 non-professional, 5 not an appraiser, 86-87 not an insurer, 7 recovery against for negligence, 28 tact essential, 33 testimony as expert in court, 438 working papers of, 38 Authorization, ledger transfers in banks, 541 Automobile, depreciation of, 118, 426 Automobile dealers, 626 branch accounts, 628 inventories, 627 reserve for repairs, 627 B Bad accounts, 208, 371 Balance, depositors' accounts, ledger and pass-book to be re- conciled, 539 Balance sheet, bank audit, verification of items, 535 building and loan association, form of, 571 charitable organization, New York City, 722 consolidated, 508 branch and home office ac- counts, 628 form of, 247 holding companies, 508 life insurance company, 582 manufacturing accounting; American form, 590 manufacturing accounting ; Eng- lish form, 591 municipal, capital account, 698, 708, 710, 711 consolidated, 704, 711 fund, 701, 709 general account, 697, 706 trust fund, 700, 710 object of, 191 omissions from, 150 taxicab company, 666, 668 870 INDEX Balance sheet audit, 50, 59 Baltimore & Ohio R. R. Co., receivership 1896, causes of, 653 Bank audit, 531 auditor's report, 542 building, valuation of, 142 capital stock certificates, 539 cash and securities, 535 cashier's cheques, 538 certificates of deposit, 538 certified checques, 538 charges for acceptances, 177 correspondents' accounts, 537 defalcation by means of collec- tion items, 543 defalcation, detection of, 543 demand notes, 537 depositors' accounts, 539 monthly statements to depos- itors, 540 pass-book and ledger to be re- conciled, 539 statements on inactive ac- counts to depositors, 539 expense accounts, 541 income, verification of, 540 discounts unearned, 540 loans exceeding 10% capital and surplus, 546 national bank, 531 procedure, bonds and securities, 545 cash, 545 cashier's cheques, 546 certificates of deposit, 546 correspondents' accounts, 546 employees' bonds, 547 employees' duties, 547 notes, 545 overdrafts, 546 savings bank, 547 deposit, limit on amount, 550 discounting notes not allowed, 547 insurance on property mort- gaged, 547 investments, 547 Massachusetts form of audit report, 548, 549 state bank, 531 stock ledger, 539 Bank balances, verification of, 304 Bank examiners' fees, fixed by Federal Reserve Board, 531 Bank loans, value of audit for, 22 Banks, certified statements for, 51 credit information, 146 interest rule of, 524 statements of, 304 statements required by, 252 Bonding employees, 355 advantage of audit in, 26 of bank, 547 Bonds, 157 auditing, 388 discount on, 349 premium and discount on, 374 valuation of, 130 verification in bank audit, 545 Bonds and mortgages, 132 Book publishers, 592 Books and records, precautions in handling, 435 styles of, 391 Borrower's statement, 253-265 Branch accounts, 376 foreign, automobile dealers, 630 internal check for, 57 Breweries, audit of, 602 Budget, municipal accounting, 685 Building and loan association, 565 balance sheet, form of, 571 capital stock, statement, of, 572 income verification of, 567 dues and fines, 567 interest on loans, 567 INDEX 871 Building and loan association — continued profit and loss account, form of report, 572 profits, distribution of, 569 securities owned, verification of, 568 Building lots, sale of, 333 Buildings, depreciation of, 419 payments on, 379 valuation of. 111 Buildings and land, encumbered, 107 By-laws, building and loan asso- ciation; examination of, 567 Calls and assessments, capital • stock, 137 Cancellation of vouchers, 368 Cannon, James G., on certified statements, 257 Capital, insufficient, 462, 498 proportion of, to current assets, 65 reserve for working, 196 revenue distinguished from, 230 Capital charges, public utilities, 637 Capital expenditures, 377 Capital payments, cash discounts on, 378 Capital stock, auditing, 192, 388 building and loan association, 566, 572 calls and assessments, 137 issue to be verified with general ledger, 539 premiums, 194, 375 surplus and, 190, 376 unissued, 134 Cash, in bank, audit of, 67 internal check for, 53 on hand, audit of, 68 petty, internal check for, 53 transfer from cages and vaults while auditing, 536 verification of, in bank audit, 535 Cash book, falsification of, 307 tabular, 254 Cash discounts, 226, 317, 378 C. O. D. shipments (See depart- ment stores, 616) Cash payments, 309 Cash receipts, 306 Cashier, duties of, 296 Casualty insurance, 587 Census Bureau, U. S., water supply systems, uniform accounts, 678 Certificates, and reports, 235 audit, 243 deposit (See "Deposit") of stock, 193 qualifications in, 244 Charitable organizations, Chicago Association of Com- merce, report on audit of ac- counts, 721 contributors, receipts from, 719 New York City, report required by, 722 state appropriations, 720 Charts and graphs. preparation of, 281 use of, 276 Checking, internal, banks, 541, 552 insurance companies, 575 retail merchants, 610 872 INDEX Cheques, cashier's, stubs deposited in locked box for auditing, 538 verification of balances in bank audits, 538, 546 certified, verification of account in bank audit, 538 deposits of, 303 receipts constituted in, 334 unpaid by clearing house to be reported to auditor, 536 verification of, 309 Chicago Association of Commerce, charitable organizations, sub- scription investigations com- mittee report, 721 Churches (See institutional, 725) Circulation, bonds of national banks to U. S. Treasurer, 538 redemption fund of national banks, 538 "Circulation audits" (See publish- ers, 599) Clearing house, items to be verified in auditing bank, 536 stock exchange, 557, 558 Clerks, scheduling, 45 Client, auditor's relation confidential, 8 fixing responsibility of, 29 instructions from, 431 staflf. of, 31 Clothing, costs in retail business, 622 Clubs, accounting in, 726 depreciation of property, 728 embezzlements, 726 members' accounts, 726 Coal mines (See "Mines") Collateral, verifying in bank au- dits, 536, 538 Collection charges, 361 Collections, internal check for, 56 unaccounted for, 318 Columnar ledgers, 398 Commission, 162, 357 errors, 19 Commissioner of Corporations, 125 Commissions, rulings of. Interstate Commerce (See "In- terstate Commerce Commis- son") New Jersey Board of Public Utility Commissioners ; pres- ervation of investment values, 643 Public Service Commission (N. Y.) ; depreciation, 638 Compensation, contingent fees as, 36 of auditor, 33 Competition, 466 Completed audit, 293 Comptroller (See "New York, City of") Comptroller of Currency (See "United States") Compulsory reports, 292 Concealment, of railroad's financial standing, by incorrect charges to capital accounts, 650 reserve, secret; created by, 138 Condition of affairs, value of audit for ascertaining, 22 Confirmation, customers' accounts, 319 savings bank depositors' ac- counts, 550 slips, cheques sent through clearing house verified, 536 INDEX 873 Confirmation slips — continued method of handling, 536 securities in hands of trans- fer agents, 561 Consigned goods, 71, 153, 328 Construction, expenditures in pub- lic utilities, 636 Containers, 117 deposit for, 117 empty, 354 Contingent assets, 136 Contingent fees, 36 Contingent liabilities, 168 Continuous audit defined, 293 Contractors, 733 architect's certificate for pay- ment to, 734 contract unit of accounting, 733 depreciation, 734 Contracts, 474 unfulfilled, 178 Controlling accounts (See "Ac- counts, Controlling") Coolcy, Prof. M. E., on causes of depreciation, 404 Co-operation with client's staff, 31 Copying devices, 393 Copyrights, 121 valuation on, 595 Corporations, directors' liability, 748 Correspondence, verification by, 78 Correspondents' accounts to be verified in bank audits, 537, 546 Cost, interest as element in, 95 Coupons, 164 bonds, 389 Coart decisions, public utilities, depreciation (Idaho Supreme Court), 638 replacements (U. S. Supreme Court), 639 Cravens, Geo. A., rates of depre- ciation, 424 Credit, bank ; purpose of, 146 Credit manager, statement for, 268 Credit purposes, investigation for, 492 Creditors, investigation for, 484 trade, 150 Cumulative dividends, 197 Current assets, proportion of, to labilities and • capital, 65 verification of, 61 Customers' accounts, 308 internal check for, 56 Customs as to interest, 524 D Damages as liabilities, 163 "Dating" invoices, 152 Debts, bad, 208 percentage in retail business, 622 Decedents' estates, principal and .income, 232 Defalcation defined, 507 (See "Embezzlement" ) Deferred assets and accounts re- ceivable, 77 Deferred charges, 456 to operation, 102, 332 Delivery, cost percentage in retail busi- ness, 622 department store cost of, 621 . equipment, 118 Departmental profits, 211 Department stores, 616 C. O. D. shipments, 616 cost of doing business, 622 delivery cost per package, 621 inventory calculation, retail method, 620 turnover, 624 874 INDEX Departments, check on, 397 Deposit, certificates of, defalcations by means of fraudu- lent, 544 stubs deposited in locked box for auditing, 538 verification in bank audit, 538, 546 Depositors' accounts, trial balances, 539 verification in bank audit, 539 Deposits, assets, current, 78 interest on, 469 liabilities, 164 on sales, 332 savings bank; limit on amount, 550 Depreciation, 401 calculation of, 406 causes for, 404 club property, 728 coal mines and mineral lands, 605 compulsory, railroad equipment, 633, 652 shipping companies, Interstate Commerce Commission, 654 contractors, 734 defined, 402 definition by Idaho Supreme Court, 638 distinguished from sinking fund, 412 doctors, 731 electric light and power compa- nies, 675 exhaustion due to, 411 fixed percentage basis of, 406 gas companies, 676 horses, 426 hotels, 741 investment companies, 553, 554 investment of reserve for, 415 leaseholds, 421 local issue, 415 machinery, 114 method of applying on books, 406 method of calculating, percentage of plant values. 588 production, rate per unit, 588 operating expense, 413 place of, in profit and loss ac- count, 222 property, different classes, 417 public utilities, 635 rates of, 417 reserve, 415 telephone companies, 682 shoes, retail stores, 615 shrinkage and, retail business, 622 sinking fund method, 407 telephone companies, 680, 682 textile industries, 588 theatrical companies, 747 tools, small, 116 Detailed audit, 48, 293 Detection of errors, 15 Dickinson, A. Lowes, depreciation, mineral lands, 605 profit and loss statement, 274 valuation of marketable invest- ments, 556 Directors, bank, attendance at meetings, 536 " examination in accordance with Comptroller of Cur- rency suggestions, 545 responsibilities, 534 books of corporation open to in- spection of, 750 compensation of, 749 liability of, 138, 748 court decision (N. Y.), American Malting Co., 751 INDEX 875 Discarded machinery, 115 Discount, 152 bank should maintain reserve for unearned items, 540 bonds, 349 amortization of, 374 capital payments, 378 cash, 226,' 317 department stores, 153 prepayment, 325 register as check on loans in banks, 543 trade, 227, 325 Discounted notes receivable, 169 Dishonored notes, 82 Dissolution of partnership, 187 District of Columbia, electric light and power com- panies under Interstate Com- merce Commission, 672 Dividends, capital used to pay, 230 cash, 386 declaration of, 229 investment companies, 553 liability, 197 principal or income, 233 stock, 386 stock and (extraordinary) cash, 233 stockholders and, 141 unclaimed, 166 Doctors, 730 depreciation* 731 Doubtful accounts, 371 ledger of, 371 schedule of, 371 Drafts, medium of defalcation in banks, 537 on correspondents or reserve agents, to be verified in bank audit. 537 unused to be accounted for in bank audit, 537 Drawings, 118 partners', 385 Drugs, costs in retail business, 622 Dry goods, costs in retail business, 622 Duties, vouching of, 361 Earnings, 207 gross, 207 public utilities, 634 net, public utilities, 634 Efficiency engineer, 390 Efficiency of organization, 399 Efficiency theory in office work, 400 Electric light and power compa- nies, 672 classification of accounts re- quired. Interstate Commerce Com- mission (District of Colum- bia), 672 Public Service Commission (New York), 672 depreciation, 675 Electrotypes, valuation of, 120 Embezzlement, 472 bank, certificates of deposit, fraudu- lent, 544 collection items manipulated, 543 drafts on correspondents a medium, 537 examiners' inability to audit completely contributes to, 533 individual holding position in two institutions, 544 loan record manipulated, 542 876 INDEX Embezzlement — continued defined, 506 discount register as preventive of, 543 insurance funds, 575 interest account in stockbroker's office as means of,^564, 565 money or goods, 13 "over and short" account as means of, 544 railroad, 652 real estate, 737 telephone companies, 680 theater accounts, 745 Embezzler, attitude toward, 505 Employees, bonds of, 355 sales to, 611 Empties, 353 English Companies Act balance sheet, 591 Entertaining expense, 357 Entries, false, 435 transfers, require authorization, 541 Equipment, depreciation of, 422 railroads, 633, 652 Erasures, 437 Errors, classified, 15 clerical, 16 detection of, 15 in the books, 477 of commission, 19 offsetting, 19 of omission, 17 of principle, 16, 498 Estates, decedents, 232 executors' and trustees' ac- counting, 713 lawyers' accounts of, 732 Evidence, books as, 436 Examination, federal reserve bank, 531 Examiners, bank ; clearing house, 533, 534 Executors and trustees, 713 commissions allowed, 714, 715 New York State, 715 estate, division or partition, 717 interest on funds applied to own use chargeable to trustees, 715 inventory of estate^ 713 investments, legality, 715 losses on unauthorized or ille- gal investments chargeable to trustees, 715 principal and income ; appor- tionment of receipts and pay- ment, 715 real estate, 714 securities, audit, 713 Expenditure, capital, 377 Expenditures, extraordinary, 348 Expenses, accrued, 225 audit of in banks, 541 extraordinary, 348 general, retail business, 622 income and, audit, 296 losses and, 219 operating, public utilities, 640 organization, 345 public utilities, 635 Export accounts maintained in United States and foreign cur- rency, 609 Express and freight expenses, 363 Extensions, 381 Extraordinary expenses, 348 Federal Reserve Act, 175 Federal Reserve Board, acceptances, 178 INDEX 877 Federal Reserve Board — continued borrower's statement, 262 requirements for borrowers, 263 Fees, auditor, 33 bank examiner, 531 Filing auditor's working papers, 42 Filing system, essential features of, 392 Financial (See Banks, Building and Loan Associations, In- vestment, Speculation, Trust Companies) Finished goods, value of, 94 Fire insurance, 574 Fire loss, 472 value of audit for proving, 25 Fixed assets, 104 defined, 104 valuation, 104 Fixtures, furniture and, 116 landlord's, 425 Flax crops, depreciation of land by, 419 Floy, Henry^ on obsolescence. 405 on public utility property valu- ation, 647 Fluctuation, depreciation and, 402 reserve, investment companies, 554 Footings, verification of, 297 Forced balances, 300 Forgan. James B., on employment of auditors by bank directors, 534 on responsibility of bank direc- tors, 534 Forgery, capital stock certificates of banks, 539 false entries and, 435 notes forged to cover shortage in bank, 543 Fraud (See also "Embezzlement") accounts receivable and, 302 audit not an insurance against, 7 capital stock certificates mis- used, 539 defined, 506 detection of, 12 in bankruptcy cases, 498 in banks, 542 (See also "Em- bezzlement") cashiers' checks as means of, 538 certificates of deposits as means of, 538 in investigations, 435 pay-roll padding, 617 sales accounts, 452 stockbroker's accounts, 564 "trusted employee" and, 502 Freight, 161 and express expenses, 363 Fund, circulation redemption, national bank ; to be verified by Treas- urer of U. S., 538 reserve, 130 sinking, 128 Fund investments, 130 Furnaces, blast; method of figur- ing depreciation, 588 Furniture, costs in retail business, 622 fixtures and, 116, 425 Future delivery, sales for, 214 Gambling, 343 Gas companies, 675 depreciation, 676 "Going concern" and "scrap' valuations, 107 Gold mines (See "Mines") 878 INDEX Goods, in process, 92 received for sale, 329 Good-will, depreciation of, 427 valuation of, 123 "Graft," 349 Graphs and charts, 276 Grocery, costs in retail business, 622 Gross earnings, 207 Guarantees, as contingent liabili- ties, 173 H Hardware, costs in retail business, 622 Harvard University, Bureau of Business Research, retail shoe store standard form profit and loss account, 613 Heat and light, cost percentage in retail business, 622 Holding companies, 508 Horses, depreciation of, 426 valuation of, 118 Hospitals (See charitable organiz- ations, 719) Hotels, 741 depreciation, 741 Hutchinson and McElheny, Jr., v. Curtiss and The American Malting Co., 752 Hypothecations and liens, 61, 272 Implements, costs in retail business, 622 Import accounts maintained in United States and foreign currency, 609 Imprest system, 344 Improvements, 381 Income, expenses and, audit, 296 extraordinary stock dividends and, 233 investments, 322 principal and, 230 verification of, 313 building and loan association, 567 Income tax, federal (See special index in income tax section) insurance companies, 587 Indorsements as liabilities, 170 Information not volunteered, 140 Instalment contracts, 83 Institutional accounting, 718 charitable organizations, 719 churches, 725 clubs, 726 educational, 718 securities and their income, 718 Instructions, client's, 431 Insufficient capital, 462 Insurance, companies (See below) firm, 188 merchandise on hand governs amount of, 612 mortgages protecting loans, property requires, 547 policies as guides to title, 62 premiums, 362 profit, 471 self, shipping companies, 655 sufficiency of, 497 taxes and, cost percentage in re- tail business, 622 Insurance companies, accounts, 573 casualty, 587 embezzlement, 575 fire, 574 embezzlement, 575 INDEX 879 Insurance companies — continued fire — continued liabilities, 577 liabilities, reinsurance reserve, 577 health, 587 income tax rulings, 587 investments, legal, 578 life, 577 accounting forms and meth- ods, 581 administration and general expenses, 586 agency accounts, 585 assurance account, 584 investments, verification, 578 reserves, calculation, 580 marine and inland navigation, 587 reserve, as a liability, 184 title guarantee, 587 valuation of securities, convention of commissioners, 578 State (N. Y.) Superintendent, 578 Interborough-Metropolitan Co., dividends of, 231 Intercompany profits, 213 Interest, calculating, method, 520 charges, 361 element of cost, 95 on deposits, 469 payable, 159 principal or income, 233 receivable, verification, 323 Interim audits, 294 Internal check, 50, 53 International Harvester Co., 125 rules as to profits on forward sales, 215 Interstate Commerce Commission, accounts, uniform system, 632 depreciation of railroad equip- ment, compulsory, 633, 652 depreciation of railroad track and structure, optional, 652 depreciation of vessels, compul- sory, 654 telephone companies ; fixed capi- tal, additions at cost, 681 Inventory, 57, 84, 374, 459 department store, 619 discount in retail shoe business, 615 - finished goods. 94 goods in process, 92 insurance carried dependent up- on, 612 perpetual, 394 reserves, secret, and, 140 retail method of calculating, 620 supplies, stores, etc., 98 turnover and, 98 valuation of, 99, 140 verification of, 88 wholesale establishment, calcu- lations and prices should be checked, 609 Investigations, 430, 431 purposes of summarized, 10 Investment, authority in minutes, 536 companies, 552 dividends, 553 fluctuation reserve account, 554 income, 553 reserve account, 553, 554 securities purchased and sold, 553 valuation of investments, 553, 554 income from, 322 insurance companies, 578 of funds, 130 of surplus, 199 88o INDEX Investment — continued requires investigation, 536 savings banks, 547 temporary, 101 Investment securities, inventory of, 99 Investor, balance sheet for, 191 Invoices, purchase, 337 Irish Woolen Mill Company, Ltd. V. Tyson and others, 341 J Jewelry, costs in retail business, 622 Jones V. Terre Haute and Rich- mond R. R. Co. (interest of stockholders in corporation), 386 Journal vouchers, 366 Judgments, 158 Kansas City Southern Railway v. Interstate Commerce Commis- sion, 639 Kings County Lighting Co., Court of Appeals (N. Y.), decision on rate-making for public utilities, 643 Kingston Cotton Mill Co., in re, 90 L Land, buildings and, 107 depreciation of, 421 valuation of, 109 Land and development companies, 738 Landlords' fixtures, 425 Lasts, 118 Lawyers' accounting, 731 client's funds, 732 personal funds, 732 Lawyers and accounting, 203 Leake, P. D., on depreciation, 402 Leaseholds, depreciation of, 421 sinking fund for, 112 valuation of. 111 Leases, investigation of, 457 Ledgers, columnar, 398 self-balancing, 398 subsidiary, 398 Legal expenses, 162, 349 Liabilities, 146 auditor's, 6, 7 contingent, 168 directors', 138, 748 importance of, in balance sheet audit, 146 proportion to current assets and capital, 65 Liability and assets items, 372 Liens and hypothecations, 61, 272 Life insurance, 577 Lighting (See "Electric Light and Power Companies" and "Gas Companies") Loans, rules for, 147 unsecured, savings binks not permitted to make, 547 Loose-leaf records, 436 Losses and expenses, 219 Lybrand, Wm. M.^ holding companies, 508 intercompany profits, 213 M Machinery, discarded, 116 equipment and, depreciation of, 422 valuation of, 113 purchase of, 383 Machine shops, method of calcu- lating depreciation, 588 Magazine publishers, 596 INDEX 88 1 Mail books, 343. 365 Mail, handling of incoming, 53 Mail order, costs of doing busi- ness, 622 Mailing department, 393 Maintenance, 405 asset accounts, secret reserves, and, 138 • expenditures, public utilities, 636 Manipulation of accounts, 14 Manufacturing, accounts, 587 and trading profits, anticipation, 210 balance sheet, American form, 590 English form, 591 cost records, 589 freight charges, checking, 588 purchase invoices, checking, 588 receiving records. 588 stock records, 589 wages, audit, 588 Marine insurance, 587 Massachusetts, State of ; savings bank audit report to, 548, 549, 550 May, Geo. O., expenses of sea- sonal business, 346 Memorandum books, 314 Memorandum, goods on, 328 Mercantile agencies, forms for statements of financial condi- tion. 266 Merchandising, retail, 610 wholesale, 608 Metz Fund, "Municipal Accounting and Re- porting, Short Talks," 690 Mileage account, 358 Mines, 603 coal. 603 depreciation, 195, 428, 605 gold, 607 valuation, 135 Minute book, building and loan association; examination of, 567 contingent liabilities shown, 179 Misappropriation, defined, 507 (See "Embezzlement") Mortgages, 156 bonds and, 132 coal or ore lands, 606 registry of, 156 Municipal, accounts (See below) bond issues, 686 departments, 687 ownership, water works, 678 revenue, 691 -assessments, 692 franchises, 692 rents, 692 taxes, 691 Municipal accounts, 685 accounts outstanding, audit, 693 balance sheet, 697, 706 capital account, 698, 708, 710, 711 consolidated, 704, 711 fund, 701, 709 general account, 697, 706 trust fund, 700, 710 budget, preparation, 685 controlling accounts, 688 equipment, audit, 693 examination, periodical, 690 expenditures, audit, 693 financial statements, 695 operations, surplus or deficit statement, 707 property and equipment, audit, 693 revenue, 686 audit of, 691 88: INDEX Municipal accounts — continued sinking funds, 694, 709 tax rate, method of fixing, 686 Murray v. Public Utilities Com- mission, Idaho, 638 N National Association of Credit Men, statement recommended by. 270 National City Bank (N. Y.), bank examination by directors, 545 National Civic Federation, mu- nicipal and private operation of public utilities report, 642 Negligence, auditor's liability for, 8 of auditor, right of recovery for, 28 Net profits, defined, 204 standardization of term, 220 Newspaper publishers, 596 New works in place of old, 138 New York, City of; charitable in- stitutions report to Comptrol- ler, 722 New York Clearing House, cus- tom as to interest, 526 New York Public Service Com- mission, on amortization, 408 New York Railways Co., accident reserve, 663 New York statute as to interest, 528 • New York Stock Corporation Law on dividends from capital, 230 New York Telephone Co., ap- praisal of property, 684 New York Third Ave. Ry. Co. amortization, 408 Nominal accounts, 307 Non-professional auditors, 5 Notes, demand, confirmation of amount by borrower, 537 held by bank's correspondents to be verified, 538 payable, concealing personal loans, 154 vouchers of, 384 receivable, 373 audit of, 80 discounted as liabilities, 169 discounted on balance sheet, 81 protested, 373 questionable in department stores, 619 savings banks not permitted to discount, 547 verifying discounted items in bank audit, 536 Obsolescence, 224 depreciation due to, 404 machinery, 115 provision for, 416 Office methods, 389 Offsetting errors, 19 Omission, errors of, 17 Operation, deferred; charges to, 102 Opinions and conclusions, 441 Order and receiving records, 150 Order books, 315 Organization, efficiency of, 399 expenses, 345 Orphanages (See charitable or- ganizations), 719 Outside enterprises, liabilities in, 172 loans, 324 Outstanding accounts, 370 INDEX 883 Outstandings, confirmation of, 319 verification of, 78 Overdrafts, bank audit; method of handling, 546 Overdue accounts, valuation of, 72 Paper, watermarked, 247 Participations and underwritings, 215 Partner, investigation for a retir- ing, 479 Partners, salaries, 473 withdrawals, 385 Partnerships, 185 agreements, 185 value of audit for, 24 Pass-books, 54 ledger balances to be verified with, 539 Patent litigation, investigation for, 500 Patents, depreciation of, 427 valuation of, 120 Patterns, valuation of, 118 Payments, internal check for, 53 Pay-roll, book, 354 internal check for, 56 padding, detection, 617 padding prevented by compara- tive statistics, 287 vouchers for, 342 Peculations (See "Embezzle- ment") Pennsylvania Railroad Co., re- serve for depreciation on roll- ing stock, 652 Percentage of profits, 278 Perpetual inventory, 394 Petty cash, imprest method of, 342 internal check for, 53 Physicians' accounting, 730 Plates, 120 Postage, 364 or mail books, 279, 343 stamps, 102 vouchers for, 364 Postings, verification of, 297 Power, electric (See ."Electric Light & Power Companies") Preferred stock, accumulated divi- dends as a liability, 197 Premiums, bond ; amortization of, 374 capital stock, 194, 375 - insurance, 362 Principal, income and ; distinction, 230 ' method of calculating, 520 Principle, errors of, 16, 498 Profession, auditing as a, 4 Professional accounts, architects, 728 doctors, 730 lawyers, 731 Profit and loss, account, ,201, 514 building and loan association, form of report, 572 statement, 273 consolidated, 508 form of, A. Lowes Dickinson, 274 form of, retail shoe store, 613 Profits, accountants' definition of, 205 anticipating, 331 contracts on maximum, 211 departmental, 211 disposition of, 228 distribution of, building and loan association, 569 884 INDEX Profits — continued economic definition of, 205 gross and net, charts, 278 retail store comparison, 623 insurance, 472 intercompany, 213 legal definition of, 203 on fluctuations, 455 on sale of assets, 216 surplus as distinguished from, 206 Promotion expense, 346 Proof-sheet of subsidiary ledgers, 398 Property, depreciation rates on, 418 Protested notes receivable, 373 Public, value of audit in protect- ing, 26 Public accountants, N. Y. State Society of certified, insurance accounting methods, 581 Public Service Commission of New York, 408, 476 depreciation, 638 electric light and power com- panies under, 672 gas companies under, 677 replacements, 638 telephone companies under, 679 Public utilities, 631 (See also Gas Companies, Light and Power, Railroads, Steam ; Railways, Electric; Shipping; Taxicab; Telephone; Water) appraisals of, 645^ 647 capital charges, 637, 650 construction expenditures, 636, 650 deposits required by, 164 depreciation, 635 earnings, gross and net, defined, 634 maintenance expenditures, 636 Public Service Commission (N. Y.),631 rates, 643 replacements not capital charges, 637 Publishers, book, 592 book stock, sheet and bound, 593 consignment accounts, 594, 595 copyrights, value, 595 plates, value, 594 royalty records, 592 magazine, advertising charges, 597 subscription income, 598, 600 newspaper, revenue, advertising, 597 revenue, circulation, 597 valuation of plant, 597 Pulitzer, Joseph, Estate of, 597 Purchase charts, 280 Purchase invoices, 337 Purchase or sale of a business, in- vestigation upon, 442 Purchase records, 300 Purchase returns, 367 Purchases, expenses and, 342 internal check for, 54 Q Qualification of auditor as expert witness, 438 Qualifications in certificate, 244 Quick assets, 61 Railroads, steam, 649 (See also "Railways, Electric") INDEX 885 Railroads — continued depreciation of equipment, com- pulsory, 633, 652 depreciation of track and struc- ture, optional, 652 earnings, traffic, 650 income, 651 agents' balances, verification, 652 Railroad Commission of Wis- consin ; telephone companies, depreciation, 682 Railways Act (England), 650 accounts certified prior to divi- idends, 650 reserve for depreciation, rolling stock, 652 Railways, electric, 656 (See also "Railroads, Steam") auditing department essential in interurban operation. 664 classification of accounts, Inter- state Commerce Commission, 656 depreciation, 660 reconstruction charges, 662 rehabilitation charges not to be capitalized, 661, 662 reserves, accident, 663 Rates, interest, 523 public utilities, 642 regulation of rates, 642 Raw materials, valuation of inven- tory, 84 Real estate (See also "Land and Development Companies") accounting, 736 payments on, 379 precautions against liens on, 108 valuation of, 107 Realizations from profit and loss, 327 Rebates, 208 Reckitt, Ernest, holding companies, 515 secret reserves, 145 Records, handling, 435 loose-leaf, 436 original necessary, 437 scheduling, 45 Redemption funds, circulation redemption fund of national banks, 538 Register, discount, defalcation prevented by check- • ing loans with, 543 Renewals and repairs, 350 Renf, 161 cost precentage in retail busi- ness, 622 receivable, 74, 326 Reorganization, investigation, 483 Repairs, maintenance and, 405 renewals and, 350 Replacements, electric railways, 660 maintenance charge in public utilities, 637 valuation, public utilities. 639 Reports, auditor's in bank audit, 542 certificates and, 235 clearness needed, 236 compulsory, 292 definite desirable, 434 restrictions on use of, 290 scope of, 241 Reserve funds, 129 Reserves, 181, 219 accident, electric railway, 663 amortization, telephone compa- nies, 680 balance sheet statement, 183 depreciation, electric railways, 660, 661 886 INDEX Reserves — continued depreciation — continued investment of, 415 telephone companies, 682 discounts unearned, 540 excessive, 139 insurance company, 184 life insurance ; calculation, 580 reinsurance, 577 investment companies, 553, 554 secret, 138 auditor's attitude as to, 145 auditor's report should cover, 541 fluctuation, 402 working capital, 196 Responsibility, auditor's, in bank audits, 542 Restaurants, 742 Retail merchants, 610 cost of doing business, 622 department stores, 616 inventory calculation method, 620 profit calculated on sales, 611 profit, gross, 623 profit, net, 623 shoe stores, 613 turnover, 624 Return purchases, 367 Returns, 207 allowances and, 351 Revenue, municipal, 686 audit of, 691 sources of, 688 taxes, 691 public utilities, 640 Royalties, 475 coal mined from leased lands, 604 S Salaries, 354 cost percentage in retail busi- ness, 622 sales, in retail businesses, 623 Sale, goods received for, 329 of business ; value of audit, 27 or purchase of a business ; in- vestigation upon the, 442 real estate, building lots, 333 Sales, charts, 276, 290 future delivery, 214 internal check for, 55 not delivered, 331 records, 301 verification of, 314, 452 Salesmen's commissions, 357 Savings accounts, employees', 165 Savings banks (See "Banks") Seasonal business, expenses of, 347 Secret reserve (See "Reserves") Securities, investment, 99 stock-in-trade, 99 valuation of, 131 insurance companies, 578 verification, audit of bank, 535 building and loan association, 568 Self-balancing ledgers, 398 Selling campaigns as a deferred asset, 347 Shipping companies, 653 depreciation, compulsory. Interstate Com- merce Commission, 654 rate of, 654 ships, 426 Interstate Commerce Commis- sion classification of accounts,, 653 revenue, sources of, 654 voyage unit of expense distribu- tion, 653 INDEX 887 Shoe stores, retail, 613 costs in retail business, 622, 623 depreciation, 615 Single entry, audit of books kept in, 44 Sinking funds, 128, 194 coal or ore land mortgages, 606 depreciation and, 412 ' municipal accounts, 694, 709 telephone companies, 680 Speculative securities companies, securities stock in trade, 555 Staff auditors, 50 Stamps, postage and other, 102 Standard Oil Co. of Indiana, stock dividend of, 387 State insurance commissioners, 573 Statements, comparative, 519 creditors', 150 depositors' accounts, auditing inactive bank ac- counts, 539 monthly instead of balancing pass-book, 540 financial condition (sample), 238 for credit purposes ; National Association of Credit Men, 268 form of, for bankers, 252 profit and loss, 273 Stationery of auditor, 39, 247 Statistics, comparative; value of, • 287 Stock accounts, retail merchants, 611 Stock, capital, 388 calls and assessments, 137 certificates, 193 dividends, 386 in default, 198 precautions when purchasing, 144 preferred ; cumulative dividends, 197 premium on, 194, 375 retirement of special issues, 198 subscriptions to ; audit, 82 treasury, 133 unissued, 134 verification of issue with general ledger, 539 watered, 145 'Stock Corporation Law, New York ; on dividends, 230 Stock on hand, 394 Stock records, internal check for, 57 Stockbrokers, 556 books of record, 556 Stockholders, value of audit as protection, 26 Stone, Melville E., Pulitzer Estate valuation, 597 Stores, inventory of, 98 Subscription record, 311 Subscriptions to stock as asset, 83 Subsidiaries, profits of, 213 Subsidiary ledger, controlling, 398 Supplies, 98 cost percentage in retail busi- ness, 622 Surgeons' accounting, 730 Surplus, investment of, 199 profits and, distinguished, 206 Suspense accounts (See contin- gent liabilities, 168, and out- standing accounts, 370) "System" Magazine, retail cost data, 621 Systems of accounts, criticisms of, 467 Systems, office, 389 INDEX Tabular ledger, 399 Tact necessary in auditor, 33 Taxes, 160 adjustments of, 475 auditing, 389 avoidance of, 140 municipal tax rate, 686 Taxicab companies, 26, 664 balance sheet, 666 earnings and expenses, state- ment, 666, 670 revenue, 665 Telephone companies, 679 appraisal of property, 684 capital, fixed ; additions at cost, 681 depreciation, 680 embezzlement through direc- tories, 68o public service commission con- trol of, 679 subscribers ledger, 681 Temporary investments, 101 Terminology of reports, simplicity advisable in, 236 Test defined, 295 Testifying, preparation for, 438 Textile industries, depreciation, method of figuring, 588 Theaters, 743 pay-rolls, 745 "settlement sheet," 744 Theatrical companies, 746 depreciation, 747 Theft, detection of, in wholesale establishment, 609 Third Avenue Railway Co. case, 408 Tickets, unused, 164 Timber lands, depreciation of, 429 valuation of, 136 Time of interest, 523 Title guarantee insurance, 587 Tools, small, 116 depreciation of, 425 Trade creditors, 150 Trade discounts, 227, 325 Trading, 608 retail merchants, 610 wholesale merchants, 608 Transportation (See Railroads, Railways, Shipping Compa- nies, Taxicab Companies) Traveling expenses, 162, 357 Treasurer of U. S. (See "United States") Treasury stock, 133 Trial balance, 369 depositors' accounts in banks, 539 forced, 300 Trust companies, 550 departments maintained, 551 income, 552 Trust funds, charitable organiza- tions, 721 Trustees (See "Executors and Trustees") Turnover, 98, 454 department stores, 624 retail stores, 624 U Unclaimed dividends, 166 Underwritings and participations, 215 Unfulfilled contracts as contingent liabilities, 178 Unissued capital stock, 134 Unit costs or earnings, 275 Unit period of interest, 527 United States, Census Bureau, water supply systems, uniform accounts, 678 INDEX 889 United States — continued Comptroller of Currency, national bank examination, 545 Corporations, Bureau of, 106 Treasurer of, balances due from national bank, 538 bonded amount of national banks, 538 circulation redemption fund, 538 U. S. Steel Corporation, intercom- pany profits of, 213 Usury (See interest, 520) V Vacations, should be compulsory, 57 Valuation, assets, 217, 434 Dickinson, A. Lowes, on market- able investments, 556 "going concerrt;" and "scrap" value, 107 inventories, 84, 99 public utilities, compulsory, 645 Interstate Commerce Commis- sion act, 645 New York Telephone Co., 684 securities in investment compan- ies, 553 Van Doren, A. E., statement for borrowers, 257 Vehicles, costs in retail business, 622 Verification, balance sheet items in bank, 535 bank balances, 304 cash and securities in bank, 535, 536 changeable assets, 535 footings and postings, 297 income, 313 inventories, 86 of finished goods, 95 rules for, 88 outstandings, 78, 320 Vouchers, 334 cancellation of, 368 cheques as, 334 journal, 366 missing, 342 petty cash, pay-rolls, etc., 342 useless checking of. 338 W Wages, 161, 358 (See also "Pay- roll") Wagons, depreciation of, 426 valuation of, 118 Wasting assets, 134, 195, 232, 428 Water companies, 677 accounting, uniform classifica- tion, 678 municipal ownership, 678 rates, 161 Weiss, Wm. F., on principal and income, 234 Wholesale merchants, 608 Wildman, John R., on trade dis- counts, 227 Wisconsin, Public Service Commission, 631 Railroad Commission, telephone companies, deprecia- tion, 682 valuation increase, gas and electric light company, 645 Witness, can testify to own work only, 439 expert, auditor as, 438 Woodcuts, 120 Work in progress, 209 Working capital, 196 Working papers, arrangement for audit, 38 method of filing, 42 preservation of, 432 14 DAY USE RETURN TO DESK FROM WHICH BORROWED LOAN DEPT. This book is due on the last date stamped below, or on the date to which renewed. Renewed books are subject to immediate recall. 'J^ll^lo-{ ^ r^?S^^^ ^'■■ -^ '' 'Cj4 REC'D Ll FEB 1 5 '64 -11 AM APR 1 6 1S73 X RETOnJ JUN 6 73 - 8PW 7 5' LD 21A-40ot-4,'63 (D6471sl0)476B General Library I*! Iversity of California Berkeley ^y^ THE UNIVERSITY OF CALIFORNIA LIBRARY