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and physical inventories. When it becomes apparent that the costs are not correctly absorbed the cause should be ascertained.

The first step would be a comparison of the actual material cost with the corresponding specification cost to ascertain whether there are any important variations or not. A similar procedure should be followed for labor; and of course there would be a comparison of the actual factory overhead expenses with the estimated amount included in the specification costs.

In regard to the raw material, the examination will consist of a comparison of actual invoice prices with the specification cost used, particular attention being given to whether or not freight, discount, storeroom charges and similar items have been handled uniformly—that is, if included in the specification material cost, they should be included in the material accounts on the books and not in the other accounts.

As to labor, there will be two elements to consider : labor rates and the unit cost of production. A check will be made to ascertain if the labor rates actually paid are the same as the labor rates used in the specification costs, and if overtime paid, bonuses, etc., are handled similarly in the ledger accounts and in the specification costs.

The unit cost of production is apt to disclose serious errors. For instance, it was found in one case that the employees over-reported the quantity of work performed, with the result that the factory showed a lower cost of labor per unit than the actual cost; and this ver cost was used in the specification costs, resulting in a very material under-absorption of labor costs in cost of sales as well as in work in process and finished product.

The discrepancy in burden will undoubtedly exist, because if the volume of actual production is materially in excess of the estimated volume there is apt to be over-absorption of burden, and, on the contrary, if the volume of production is materially less than expected there is apt to be underabsorption.

After the various factors have been analyzed, an effort should be made to allocate the discrepancies as between inventories of finished products and work in process and cost of goods sold, the purpose of the adjustment being to state the inventories at cost.

Question 7 (optional):

What could a purchaser who wished to realize 3 per cent on his investment give for a bond for $10,000.00 which had four years to run at 5 per cent interest, payable yearly, and thereafter was payable with a bonus of 10 per cent? Solution, Question 7:

1 • 1.03 = .97087379 P. V.@ 3% of i due i period, hence 97087379 = 1.035.94259591 P. V.@ 3% of i due 2 periods, hence .94259591 = 1.03=.91514166 P. V.@ 3% of i due 3 periods, hence .91514166 = 1.03= .88848705 P. V.@ 3% of i due 4 periods, hence Present value of par and premium: $11,000.00 X .88848705 =

$ 9,773.36

1.00

Present value of coupons:

.88848705 = .11151295 compound discount, .11151295 •.03= 3.717098 P. V. of annuity of 1 $500.00 (annual coupons) X 3.717098

1,858.55

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EXAMINATION IN AUDITING
November 16, 1920, 9 A. M. to 12:30 P. M.

Answer all the following questions:
Question 1:

You are called upon to audit the accounts of a large railroad system. State shortly what its sources of income are, what records you would expect to find containing the details of them, how they are generally summarized in order to bring them on the books of the company, and how you would satisfy yourself of their accuracy. Answer, Question 1:

If enough students of accounting were interested in the subject of railroad accounts to justify the use of the necessary space, it might be desirable to devote a series of articles in this department to answering this question. The assistant comptroller of a large railroad with general offices in Chicago was asked to "state shortly what its sources of income are.” The following is condensed from his statement, which occupied three single-spaced typewritten pages:

This railway company derives its revenue from the following sources:

Freight revenue. The freight earnings are derived from the handling of local freight, and this carrier's proportion of freight handled on through way-bills on basis of tariff rates. Also the transportation of mail matter and empty pouches at freight tariff rates. Revenue received from reconsigning privileges, stop privileges and transit privileges are also credited to freight revenue.

Passenger revenue, the earnings derived from the transportation of passengers, based on regular tariff fares. The sources of these earnings are from the sale of local tickets, this company's proportion of foreign tickets sold by our agents and foreign tickets sold by agents of other lines to destinations on this company's lines. This also includes mileage scrip

honored and conductors' cash fare collections, as well as the surcharge recently added to sleeping-car fares.

Excess baggage, revenue derived from the transportation of baggage in excess of the authorized allowance, which is usually 150 pounds, and from the transportation of articles such as baby carriages and bicycles.

Sleeping car revenue, derived from the sale of berth and seat accommodations in sleeping cars.

Parlor and chair car revenue, derived from seat accommodations in parlor cars.

Mail revenue, amounts received from the United States post office department for the transportation of mail are credited to this account, and fines assessed by the government for failure properly and promptly to handle mail are charged to this account.

Express revenue, including amounts received from the express company for the transportation of express matter, and for the use of facilities on trains and at stations incident to such transportation.

Other passenger train revenue, from the transportation of packages, newspapers, dogs, etc., as well as lump sums received for transportation of passengers on regular or chartered trains in excess of the regular tariff fares.

Unclaimed penalty collections, the value of mileage books, coupons and scrip books unredeemed.

Milk revenue, from the transportation of cream, milk, etc., on the basis of tariffs at so much per package.

Switching revenue, received for switching cars loaded or emptied between connecting lines and between local industries or at industry plants.

Special service train revenue, earnings received for running trains either on the basis of a rate per mile or a lump sum rate for the train, including the handling of baggage cars in special trains for theatrical companies and the running of trains for federal and state governments for the transport of troops.

Other freight train revenue.
Dining and buffet revenue.
Hotels and restaurants,
Station, train and boat privileges.
Parcel room revenue.
Storage-freight.
Storage-baggage.
Demurrage.
Telegraph and telephone.

Stock yards, including revenue from feeding, watering and bedding live stock at company stock yards; also revenue from shearing and dipping sheep and cattle, stabling horses and inspecting live stock.

Rents of buildings and other property.
Miscellaneous revenue.
Joint facilities.

Revenue from miscellaneous operations, such as interest on track material borrowed by other companies.

Hire of freight cars.
Rent from locomotives.
Rent from passenger train equipment.
Rent from work equipment.
Income from lease of road.
Dividend income, covering dividends received on stocks owned.

Interest income, covering interest on bonds and other interest-bearing investments.

As to "what records you would expect to find containing the details of them, and how they are generally summarized in order to bring them on the books of the company," I am informed by a railroad accountant that "these records comprise something like fifty separate forms, which, of course, would be too lengthy to permit of their being described." And when so much space has been required merely to mention the sources of income, it would seem that a volume would be required for an adequate description of the procedure by which an auditor would satisfy himself of their accuracy. Certainly a reasonable proportion of the space devoted to answering the ten auditing questions is wholly inadequate.* Question 2:

In auditing the accounts of a large corporation you find an account with Liberty bonds charged with $200,000.00, representing the cost of bonds subscribed and paid for by the company. At the date of the balance sheet to which you are to certify, the bonds had a market value of $187,500.00. What attitude would you take as to their valuation in the balance-sheet? Answer, Question 2:

There are two rules for the valuation of securities. In the case of dealers in securities, the rule is that the securities be valued at cost or market, whichever is lower, because the securities are stock in trade. When stocks or bonds are held as permanent investments by companies not dealing in them, the rule is that stocks be valued at cost, and that bonds be valued at cost plus the amortized discount or minus the amortized premium. Presumably the corporation referred to in the question is not a dealer in securities, and hence the second rule would apply. As the bonds were apparently purchased at par, they should be shown on the balance-sheet at their cost, $200,000.00, there being no discount or premium to amortize. The market value might be shown in parentheses, but there is no necessity for doing so, because every one knows that Liberty bonds are quoted below par.

Question 3 :
What do you understand by the terms

(a) Contingent assets?

(b) Contingent liabilities? *[The editor of the Students Department overlooks the phraseology of the question. The demand is that the candidate state "shortly." The board of examiners doubtless desired a list of the principal items which would occur readily to the average practising accountant or in fact to the ordinary man of business.-Editor The JournAL OF ACCOUNTANCY.]

Give three illustrations of each.
Where would you look for items?
Should they be set up on the books the company?

Should they appear on a certified balance-sheet of the company? If so, where and how stated ?

Answer, Question 3:

A contingent asset is property the title to which may or may not vest in the claimant or an unacknowledged claim which may or may not develop into an unconditional receivable, depending on the outcome of a dispute or other uncertainty.

A contingent liability is a claim which is not at present a positive liability but may become one through the action or default of a third party or through the outcome of some other uncertainty.

When notes receivable have been discounted a contingent asset and a contingent liability have been created. If the debtor pays the note to the party to whom it has been negotiated the contingent asset does not develop into a real one and the contingent liability does not become real. But if the debtor does not pay, the endorser must. Thus the contingent liability becomes positive, and since the endorser has a claim against prior endorsers as well as the maker of the note, his contingent asset develops into a real asset. If the books have been properly kept, the facts would appear in the accounts, the contingent asset in the notes receivable account being offset by the contingent liability in the notes receivable discounted account. If discounted notes have been credited to the notes receivable account, a statement should be obtained from the client's bankers and note brokers as to the amount of unmatured discounted paper held by or disposed of through them. The facts would be shown on the certified balance sheet by deducting the discounted notes from the total of the notes on hand and discounted. The contingent liability might also be shown short on the liability side.

A contingent asset will arise when a company has paid under protest a larger federal tax than it considers due and has instituted or intends to institute proceedings to recover. Such a claim would be found by examinatioff the company's tax records; or information might be received from the company's officers or attorney. It would usually be omitted from the accounts; and if set up on the balance-sheet it should be offset by a reserve.

There might be deposits of various sorts coming under the classification of contingent assets. When deposits have been made on account of court costs of a case not yet come to trial, the deposit would be a contingent asset dependent upon the outcome of the trial. It should appear in the accounts, separated from the cash, and in the balance-sheet under a heading clearly stating its nature.

Cumulative preferred stock dividends in arrears are contingent liabilities. The auditor would discover them by comparing the amount of dividends paid on the stock with the amount which should have been paid to fulfill all requirements. The books would not show the amount of the dividends in arrears, as no entry is made for dividends until they are declared. On the

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