balance-sheet they should be shown by dividing the surplus, if it is in excess of the dividends in arrears, or by a footnote if the surplus is less than the unpaid dividends.

Pending law suits are contingent liabilities which might be found by examination of the minutes or by communication with the client's attorney. The liability would not appear on the books, and it is doubtful whether or not an auditor should insist on clearly showing it as such on the certified balance-sheet, as the client might object on the ground that the appearance of the item on the balance-sheet might be interpreted as an admission of liability. If the auditor believes there is a great probability of an adverse decision of the suit, he might insist on the creation of a reserve for contingencies which would have the effect of reducing the surplus without publishing what could be construed into an acknowledgment of the debt.

Question 4:

How may the amount of a merchant's stock on hand be estimated from time to time when it is not practicable to take a physical inventory more than once a year?

Answer, Question 4:

Stock on hand may be estimated at dates between the taking of physical inventories by applying the gross profit method. The rate of gross profit on sales since the last inventory may be estimated on the basis of the rate of gross profit earned on sales in prior periods. Any changes during the period in the cost or selling price of merchandise would have to be taken into consideration in estimating any probable variation between the rate earned in prior periods and the rate earned in the current period. The sales since the date of the last inventory would be multiplied by this estimated rate of gross profit to determine the estimated gross profit on the goods sold. Then the sales minus this estimated gross profit would be the estimated cost of goods sold since the last inventory. The opening inventory plus the purchases, freight and other additions to the cost of goods, minus the estimated cost of goods sold, would give the estimated inventory.

Question 5:

State concisely your understanding of the purpose of and the difference between the following kinds of audits, indicating briefly your conception in the absence of special instruction of the extent of your responsibility in each case, whose interests you would consider yourself obligated to protect, and the forms of certificates you would expect to furnish, assuming no qualifications were desired. Except where stated to the contrary, you may assume the audits relate to a corporation.

(a) Continuous or periodical cash audit.

(b) Annual audit.

(c) Financial audit or investigation.

(d) General audit of trustees' or executors' accounts for probate.

(e) Audit required under a patent infringement.

Answer, Question 5:

(a) A cash audit is one which has as its sole purpose the examination

of cash records and supporting papers to determine whether there has been

any error or fraud in handling the cash. The auditor is expected to safeguard only the interests of the corporation, and its interests only to the extent of the cash. The audit would be continuous if the auditor exercised supervision and made examinations at frequent intervals during the period. Otherwise it would be periodical.

Certificate

"I hereby certify that I have examined the cash records of the Blank Company for the year ended December 31, 1919, and find no evidence of uncorrected errors or of fraud."

(b) The term "annual audit" is vague, as a cash audit, a balance-sheet audit or a detailed audit would be an annual audit if conducted annually. Probably what is meant is an annual detailed audit. A detailed audit is such a comprehensive examination of the books and other records as will satisfy the auditor that the record of income and expenses during the period and of the assets and liabilities at the end of the period is correct as to facts and accounting principles. The auditor would be responsible not only to the corporation itself, but to all third parties who might rely on his report for information.

Certificate

"I have audited the accounts of the Blank Company for the year ended December 31, 1919, and I hereby certify that in my opinion the above balancesheet and profit and loss statement correctly present the financial condition of the company at December 31, 1919, and the operations of the company for the year ended on that date."

(c) A financial audit or investigation involves such an examination as will enable the auditor to report to his client upon the present financial condition of the corporation, the earnings of at least one and probably several periods and the prospects for the future so far as they affect the probable repayment of the loan under consideration. The auditor would be responsible to the corporation for a true statement of its condition and to the bankers or other ultimate purchasers of the securities who relied on his report.

Certificate

"I have audited the accounts of the Blank Company for the years ended December 31, 1919, and I hereby certify that the above statements in my opinion correctly present the operating earnings of the company for each of the years, the financial condition of the company at December 31, 1919, and the condition after giving effect to the proposed re-financing."

(d) In an audit of executors' accounts for probate, the auditor should see that all the assets in the inventory of the estate have been taken into the accounts and verify all the transactions of the executors affecting the principal and income of the estate, assuring himself that the law and the terms of the will have been observed. In auditing the accounts of trustees he should see that they have taken up the assets of the trust as turned over by the grantor or the executors, and that the records as to principal and income are

in conformity with the facts, the law and the provisions of the trust. The auditor should protect the interests of all beneficiaries, the trustees and executors and the court.

Certificate

executors (or trustees) of

during the period from

to

"I have audited the accounts of the estate of and I hereby certify that the above summary statements correctly present the operations of the executors both as to principal and income, and that the foregoing balance-sheet is a correct statement of the financial condition of the estate at

(e) An audit required under a patent infringement would be devoted to ascertaining the estimated profit which accrued to the corporation by reason of the infringement. The auditor would be responsible to the persons who engaged him to make the audit and it would be his duty to arrive at a fair and unbiased estimate.

Certificate

"I have audited the accounts of the Blank Company from

to

and I hereby certify that the foregoing statement in my opinion presents a reasonable estimate of the gross profit accruing to the Blank Company by reason of the alleged patent infringement, together with the proportion of expenses properly deductible therefrom."

Question 6:

What steps should be taken in the most complete possible verification of the capital stock account of a corporation in an audit for a year, if during that year the authorized capital was increased and new stock was issued and certain shares were acquired and held by the company (assuming that it is legal to do so), and if (a) there is a registrar of the stock and (b) there is not?

Answer, Question 6:

The capital stock account on the general ledger, minus the treasury stock account and the unissued stock account, would give the amount of stock purporting to be outstanding. This would be verified by listing the open stubs of the stock certificate book and the balances of the stockholders' accounts in the subsidiary stock ledger. The totals of these two lists should agree with the outstanding stock shown by the ledger. If there is a registrar of the stock, a certificate would be obtained from him as to the amount outstanding, but in as complete a verification as possible the foregoing comparisons would be made whether there is a registrar or not. As to the new issue, the auditor should see that it was authorized by the stockholders or directors, if the latter were empowered to do so, and by the proper state officer, and the subscription lists and cash records should be verified. The vouchers for the purchase of the treasury stock should be examined. If a transfer journal is kept the entries therein should be verified by reference to the cancelled certificates.

Question 7:

State definitely the procedure you would follow in verifying the liability of a corporation on account of notes payable as shown by its books.

Answer, Question 7:

The audit of notes payable should involve two things: determining whether or not the business received value for the notes-which would be accomplished by examining the vouchers underlying the transactions-and determining whether or not there are any unrecorded notes payable. The search for unrecorded notes payable would involve the following:

An analysis should be made of the interest account to find whether there was a recorded note corresponding to every interest payment or not. The client's bank should be asked for a statement of the notes held by it. If there is any evidence to indicate that money is borrowed from other sources, statements should be requested from them as to the amount of paper held. If creditors are asked for statements, it might be desirable to ask for the liability on notes as well as on accounts. If credits appear in the partners' capital accounts during the year, it is possible that these credits arose from investments of the proceeds of notes which are a liability of the business. If credits appear in officers' accounts it is possible that the corporation is liable on notes for loans which have been credited to these personal accounts instead of to notes payable; hence such payments should be investigated. If purchases of fixed assets appear on the books, it is possible that the purchases have been made on an instalment basis and the fixed asset accounts have been charged with payments made while notes are outstanding for the bulk of the purchase price. Therefore the auditor should ascertain whether the charges represent the entire purchase price or only that portion which has been paid.

Question 8:

You ae engaged by bankers to undertake an investigation of a business incidental to a proposed refinancing. The instructions from the bankers are received subsequent to the date of the balance-sheet which you are expected to certify. How would you proceed to verify the asset of cash, explaining the necessity for each step?

Answer, Question 8:

I would obtain the bank's statement in the client's office of the date of the balance-sheet, count the cash on hand at the date of the audit and ask the bank for a statement of its account with the client at the same date. I would then check the cashier's reconciliation of the bank account of the date of the balance-sheet and make a reconciliation of the date of the audit, thus determining the outstanding cheques and any other differences at the two dates. All entries for cash receipts and cash payments between the two dates should be verified by vouchers and returned cheques to see that all cash received has been recorded and that all cash credits represent actual disbursements. Otherwise a shortage at the balance-sheet date might be covered by unrecorded receipts or by fictitious entries for disbursements. Then,

to the sum of the cash on hand at the date of the audit and the bank balance at the same date there should be added the disbursements made since the date of the balance-sheet. From this total should be deducted the receipts for the same fractional period as shown by the cashbook. The resulting figure would represent the balance on hand at the date of the balance-sheet, which should be compared with the balance shown in the balance-sheet.

Question 9:

Draft forms of certificates for inventory and outstanding liabilities of a manufacturing business with which you are familiar, stating nature of the business.

Answer, Question 9:

It is most unusual for an auditor to certify merely to the inventory or merely to the outstanding liabilities of a business, and it is consequently difficult to understand what is required by the question. Usually the auditor would certify the balance-sheet and profit and loss statement as a whole and not any particular elements of them. If an occasion should arise in which an auditor was instructed to verify only these items, his certificates might be somewhat as follows: "I have verified the inventory of the Blank Company as of and hereby certify that in my opinion the quantities are correct, and that each item is correctly priced at cost or market whichever was lower at the date of the inventory." Or, "I have examined the accounts and records of the Blank Company and hereby certify that in my opinion the balance-sheet of discloses all the liabilities of the company outstanding at that date."

It is not unlikely that the question refers to the certificates which the auditor might require from officers and employees of the corporation. In the matter of inventory, the auditor might require a certificate from each person engaged in the preparation thereof, as follows:

"I hereby certify that I participated in preparing the inventories of December 31, 1919, by:

"Ascertaining quantities on hand, and I know of no understatement or overstatement thereof.

"Pricing; the raw material was priced at (cost), (market), (cost of market whichever was lower).

the goods in process were priced at

the finished goods were priced at

"Extending.

"Footing."

(Signed)

As to liabilities, an officer of the corporation might be required to certify somewhat as follows:

"I hereby certify that all liabilities known by me to be existing at December 31, 1919, appear on the books at that date."

(Signed)