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APRIL, 1917





APRIL, 1917



The following tentative proposal for uniform methods for the preparation of balance
sheet statements to be adopted by manufacturing and merchandising concerns appeared
in the April (1917) number of the Federal Reserve Bulletin under the caption "Uniform
Accounting," and is reprinted for more general distribution.
It is recognized that banks and bankers have a very real interest in the subject, because
they are constantly passing upon credits based upon statements made by manufacturers
or merchants.
It is quite as much of vital interest to merchants and manufacturers, because they
realize that their credit sometimes suffers by reason of losses incurred by bankers through
credits given to merchants and manufacturers whose statements do not correctly reflect
true conditions.
Lastly, it is of immense importance to auditors and accountants, because they have
a professional as well as a practical interest in having the character of their professional
work thoroughly formulated and standardized. Losses incurred by bankers by reason of
credits given to merchants or manufacturers, if such credits were given because the statements were either actually false or misleading in their nature, tend to discredit accountancy
as a profession and to shake the confidence of bankers in the real value of any statements.
Hence it is that the Federal Reserve Board puts out this tentative proposal with the
hope of encouraging the fullest criticism and discussion.



Through the courtesy of the Federal Trade Commission the federal Reserve Board has
been enabled to take advantage of a large amount of information and data which the Trade
Commission acquired in connection with the study of the statements made by merchants,
manufacturers, etc., as showing the condition of their business. Because this matter was
clearly of importance to banks and bankers, and especially to the Federal Reserve Banks
which might be asked to rediscount commercial paper based on borrowers' statements,
the Federal Reserve Board has taken an active interest in the consideration of the suggestions which have developed as a result of the Trade Commission's investigation, and now
submits in the form of a tentative statement certain proposals in regard to suggested
standard forms of statements for merchants and manufacturers.
The problem naturally subdivides itself into two parts:
(1) The improvement in standardization of the forms of statements.
(2) The adoption of methods which will insure greater care in compiling the statements
and the proper verification thereof.
In recent years bankers, through their associations and otherwise, have made rapid
progress in the direction of more uniform and complete forms of statements. Much has
also been accomplished in the improvement of the quality of the statements rendered and
in securing statements which do not depend for their accuracy on the borrower's statement
alone but are verified to a greater or less extent by independent scrutiny and audit. The
advantage of a statement certified by trustworthy public accountants over an unverified
statement is evident. A t the present time, however, there is no uniformity as to the
extent of verification in the case of statements put forward as having been verified.
The Federal Trade Commission in the course of its investigation of business conditions
has been strongly impressed with the lack of uniformity and has enlisted the aid of the
American Institute of Accountants, with a view to remedying the condition. It has found
that verified statements may be divided broadly into—
(а) Those in which the certificate is based on an examination of the books without
personal supervision of inventories and independent appraisal of all assets with the aid of
technical appraisers; and
(б) Statements verified with the personal supervision of inventories and independent
appraisal of all assets.
The value of the two classes of audits and their relation to each other depends to a great
extent upon the character and magnitude of the business involved.
In some cases method (6) has advantages over method (a). In other cases, notably
those of large companies in which personal supervision of inventories is arduous and perhaps



impracticable and the value of an independent appraisal of assets is liable to be considerably
exaggerated, the reverse may be true. That is to say, a verification based upon the books
themselves without an appraisal may be and often is the safer method of procedure. It
is highly desirable gradually to educate the business world to the great importance of a
complete form of audit statement, although any plan for immediate adoption intended to
produce practical results must recognize that under present practice probably more than
90 per cent of the statements certified by public accountants are what are called balancesheet audits, such as are described in paragraph (a) above referred to.
As a first step toward the standardization of balance-sheet audits and to insure greater
care in compiling and verifying statements the Federal Trade Commission requested the
American Institute of Accountants to prepare a memorandum on balance-sheet audits.
This memorandum was duly prepared and approved by the council of the institute representing accountants in all sections of the country.
After approval by the Federal Trade Commission the memorandum was placed before
the Federal Reserve Board for consideration. The Federal Reserve Board, after conferences with representatives of the Federal Trade Commission and the American Institute of
Accountants, and a careful consideration of the memorandum in question, has accepted
the memorandum, given it a provisional or tentative indorsement, and submitted it to the
banks, bankers, and banking associations throughout the country for their consideration
and criticism.
The recommendations in the memorandum apply primarily to what are known as
balance-sheet audits. This is an initial step which may easily be succeeded by future
developments tending still further to establish uniformity and covering more fully the
field of financial statements.



The scope of a balance-sheet audit for a fiscal year or other operating period of an
industrial or mercantile corporation or firm comprises a verification of the assets and liabilities, a general examination of the profit and loss account, and, incidental thereto, an examination of the essential features of the accounting.
Trial balances of the general ledger, both at the beginning and end of the period under
review, should be prepared in comparative form and checked with the ledger. The items
in the trial balances should be traced into the balance sheets before the assets and liabilities
are verified, to prove, among other things, that no "contra" asset or liability has been
omitted from the accounts, that the assets and liabilities have been grouped in the same
manner at the beginning and at the end of the period, and also that the balance sheets are
in accordance with the books. The disposition of any general ledger assets and liabilities
that may have been scrapped, sold, written off, or liquidated during the period under
review should be traced and noted in the working papers. Furthermore, a general scrutiny
of the general ledger should be made to see that the accounts, if any, that have been opened
and closed during the year have no bearing on the company's financial position at the close
of the fiscal period.
The auditor should obtain a copy each of the balance sheets at the beginning and the
end of the period to be audited, and should make a comparison between them, so that a



comprehensive view may be had by him of the changes in the figures during the period under
review. A statement of the disposition of the profits should then be prepared from this
comparative balance sheet as a further aid in impressing the meaning of the figures upon
the mind of the auditor.
The verification of assets and liabilities for convenience will be considered in the order
in which the items appear in the form of balance sheet attached hereto. This form of
statement has been determined by the desire to meet as nearly as possible the requirements
and practice of Federal Reserve Banks.

The cash on hand preferably should be counted after banking hours on the last day
of the fiscal period to be covered by the audit, and the amount thereof, together with the
cash stated to be in the bank, reconciled with that shown by the cashbook. The cash, bills
receivable, and investments must be examined on the same day, so as to make it impossible
for a treasurer to make up a shortage in one asset by withdrawing negotiable funds temporarily from another.
In counting the cash on hand the auditor must see that all customers' checks produced
to him as part of the cash balance have been duly entered in the cashbook prior to the close
of the period and should note the dates and descriptions of such checks, and also the dates
and descriptions of all advances made from cash and not recorded on the books. Advances
to employees should be strictly investigated, and if any are secured by personal checks the
auditor should see that the checks are certified by the bank on which they are drawn before
the close of the audit.
Certificates must be obtained, as of the evening of the closing date, from the banks in
which cash is deposited, by or mailed directly to, the auditor himself. The balances as
shown by the certificates must be reconciled with those shown on either the cashbook, the
checkbook stubs, or bank registers, taking into consideration outstanding checks.
In verifying the outstanding checks there is only one safe and satisfactory method
of proving their accuracy, and that is to compare the credit side of the cashbook from the
last day of the fiscal period backward, item by item, with the checks returned from the
bank for such period as may be necessary to account for all current outstandings. Any old
checks not yet cashed by banks should be made the subject of special inquiry. When this
work is completed, a list of the outstanding checks so ascertained should be prepared,
showing the dates of the checks and compared with the actual checks returned from the
bank at a later date, and any not so returned should be specially investigated. Special
care is necessary to see that no checks for cash ptuposes are drawn at the close of the period
and entered in the next period.
Where the currency and bank transactions are kept together in the cashbook and the
auditor does not count the cash until a date subsequent to the close of the fiscal year, he
must, in addition to verifying the bank balances as of the close of the year, verify them
as of the date of the count of cash. This is absolutely essential when it is considered that,
although the cash on hand, which forms only part of the balance, at the date of the count
is correct, it does not follow that the total cash is correct.

When receipts are shown in the cash books as being deposited in the bank on the last
day of the fiscal period, but are included in the reconciliation statement on account of their
not being paid into the bank until the next day, the auditor must obtain letters from the
banks acknowledging such deposits.
The deposits shown in the pass books should be checked in detail for the last two or
three days of the fiscal period from the books to prove that they were composed of bona fide
checks, and that no check drawn by the company was deposited in a bank without being
credited to the bank on which it was drawn prior to the close of the fiscal period.
So that the auditor may satisfy himself that deposits are promptly made in bank each
day, and that the same checks are paid into bank as are received, it is advisable to call for a
number of deposit slips and compare them with the receipts as shown by the cashbook for
the days in which the deposits are made. To make such verification absolute the deposit
slips should be obtained from the banks.
When the practice of a company is to pay all of its cash receipts into bank, they should
be compared and reconciled with the total deposits, as shown by the bank books, and
similarly the disbursements should be reconciled with the total checks drawn.
Outstanding checks not examined at a previous audit on account of not having been
returned by the banks must be called for and traced into the cashbook at the beginning
of the current audit.

A list of notes receivable outstanding at the end of the fiscal period should be prepared,
showing the dates the notes are made, the customers' names, the date due, the amounts
of the notes and the interest, if any, contained in the notes. If discounted, the name of the
discounting bank should be noted and verification obtained from the bank.
The outstanding notes must be carefully examined with the notes-receivable book, and
with the list prepared by or produced to the auditor, the due dates and the dates of making
the notes being carefully checked, and when notes have been renewed the original dates
should be recorded. When notes have been paid since the close of the fiscal year, the
cash should be traced into the books of the company, and, when they are in the hands of
attorneys or bankers for collection, certificates should be obtained from the depositaries.
When notes receivable are discounted by banks the company has a liability therefor
which should appear on the balance sheet. Lists of discounted notes not matured at the
date of the audit should be obtained from the banks as verification and their totals entered
under 20a if the cash therefor is shown as an asset.
The value of collateral, if any, held for notes should be ascertained, as it frequently
happens that the notes are worth no more than the collateral.
Notes due by officials and employees must always be stated separately from customers'
notes, as must also notes received for other than trade transactions.
Notes due from affiliated concerns must not be included as customers' notes, even
though received as a result of trading transactions. Affiliated companies' notes should be
shown as a separate item of current assets or as other assets as the circumstances warrant.
They may be fairly included in current assets if the debtor company has ample margin
of quick assets over its liabilities, including such notes.
The term "quick assets" is used here in the sense in which it is used by Federal
Reserve practice. 4'Current assets'; is used to comprise these assets and other assets

which, though, current, are excluded in determining the eligibility of the paper for Federal
Reserve purposes.
Optional.—The best verification of notes receivable is an acknowledgment by the party
named in each note as the payor on the due date that the note is a bona fide obligation.
Therefore if time permits, and the client does not object, it is advisable to obtain such
written confirmation for each note. The auditor should personally mail the letters, inclosing stamped envelope for reply addressed direct to himself.

The bookkeepers of the accounts-receivable ledgers should be asked to draw off lists
of the open balances at the end of the fiscal period, and distributions of the total columns
should be shown on the lists according to the age of the accounts, e. g., not yet due, less
than 30 days past due, more than 30 days past due. The accounts paid since the close of
the fiscal period should be noted in the lists before taking up the matter of past-due accounts
with the credit department, as payment is the best proof that an account was good at the
date of the audit.
The totals of the lists of outstanding accounts should agree with the controlling
account in the general ledger if separate ledgers are kept. When credit balances appear
on customers* accounts they should be shown on the balance sheet as a separate item and
not deducted from the total of debit balances; and debit balances on the accounts-payable
ledgers should be treated in the same manner.
The lists must be footed and compared in detail with the customers' accounts in the
The composition of outstanding balances should always be examined, as it frequently
happens that while a customer may be making regular payments on his account, old items
are being carried forward which have been in dispute for a considerable period of time.
Such items and accounts which are past due should be taken up with the credit department or some responsible officer; and the correspondence with the customers examined, so
that the auditor may form an opinion of the worth of the accounts and satisfy himself
that the reserve for bad and doubtful accounts set up by the company is sufficient.
Trade discounts (and also so-called cash discounts, if exceeding 1 per cent) and
freights allowed by the company should be inquired into, and if they have been included
in the accounts receivable a reserve therefor should be set up in the balance sheet. Also
inquiries should be made regarding customers' claims for reductions in prices and for
rebates and allowances on account of defective materials, so that it may .be seen that a
sufficient reserve has been established therefor.
Inquiry must be made as to whether any of the accounts receivable have been
hypothecated or assigned, and the sum total of accounts so listed entered under 20b.
The auditor should satisfy himself that the bad debts written off have been duly
authorized by responsible officials.
Accounts due from directors, officers, and employees must be stated in the balance
sheet separately and not included as trade accounts. This applies also to deposits as
security, guaranties, and other extraordinary items not connected with sales.
Accounts due from affiliated concerns must not be included as customers' accounts,
even though arising as a result of trading transactions. Affiliated companies' accounts




should be shown as a separate item of "current assets" or as "other assets,'' as the circumstances warrant. They may be fairly included as "current assets" if the debtor company has ample margin of quick assets over its liabilities, including such accounts.
Optional.—The best verification of an open balance is a confirmation by the customer;
therefore, if time permits and the client does not object, it is advisable to circularize the
customers. The auditor should personally see the circulars mailed after comparing them
with the lists of outstanding accounts. The envelopes for replies sent with the circulars
should be addressed direct to the auditor.
In large concerns the system of accounting is generally so arranged that it would be
almost impossible for accounts to be paid and not correctly credited on the accountsreceivable ledgers, but in small concerns, with imperfect systems, such occurrences are
quite possible, so much so, in fact, that it is generally admitted that the risk of errors and
omissions decreases in direct proportion to an increase in bookkeeping.

Under this caption must be listed securities in which surplus funds of the company or
firm have been temporarily invested and which are considered available as "quick
assets," i. e., can be turned into money in time of need. Where stocks or bonds represent
control or a material interest in other enterprises, the ownership of which carries more or
less value to the holder outside of the return thereon, they should be considered as fixed
A list of investments should be prepared showing—
The dates of purchases.
Descriptions of the investments.
Par value of the investments.
The denomination of the shares.
The number of shares or bonds owned.
The total capital stock of the various companies.
The amounts paid for the investments.
The interest and dividends received.
The market values of the investments.
The surplus or deficit shown by the balance sheets of the companies where no
market quotations are available.
If hypothecated, with whom and for what purpose.
This list must be compared with the ledger accounts concerned and the total of amounts
paid according to the list must agree with the balance of the investment account or accounts.
The securities must be examined by the auditor in person or he must secure confirmation of their existence from those who hold them as collateral. Those in possession of the
company must be counted and examined as soon as possible after the audit starts, and all
of them must be submitted to him at one time. It is much more satisfactory to see the
actual securities than to verify cash receipts and other evidences therefor after the audit
has progressed some time.
Certificates out for transfer must be verified by correspondence.
Where the market values of securities are less than the book values, save where the
variation is so small as to be trifling, a reserve for loss in value on the balance-sheet date
tnust be set up*

Care must be taken to see that the certificates are made out in favor of the company,
or that they are indorsed or accompanied by powers of attorney when they are in the names
of individuals.
Coupons on bonds must be examined to see that they are intact subsequent to the
latest interest payment date.
The investment schedule must show that the total interest and dividends receivable
by the company have been duly accounted for; the income from the investments shown in
the profit and loss account must be in accord with this schedule.
When market quotations can not be obtained for investments, the balance sheets of
the companies in which investments are held must be examined so that the auditor may
form an idea of their value.
In verifying purchases of stock exchange securities the brokers' advices must in all
cases be examined in connection with the verification of the purchase price.
Investments in deeds and mortgages must be supported by both the mortgages and
insurance policies, and, furthermore, it must be shown that all assessed taxes on the property have been duly paid, that the mortgages have been properly recorded, and that the
insurance policies are correctly made out to the company.
If any of the securities have been hypothecated the fact and amount (book value)
must be stated under 2od of the balance sheet.

Under this caption must be included only stocks of goods owned and under control
of the owner. Stocks are often hypothecated and if this is the case the fact should be
stated on the balance sheet.
Inasmuch as the accuracy of the profit and loss account is absolutely dependent upon
the accuracy of the inventories of merchandise at the beginning and end of the period under
review, this part of the verification should receive special attention. When a balancesheet audit is being made for the first time, the inventory at the beginning of the period
should receive as much attention as that at the end, and the auditor should take every precaution to satisfy himself that both inventories were taken on the same basis.
An acceptable program of audit for inventories is as follows:
(1) Secure the original stock sheets if they are in existence and carefully test the typewritten copies with them and with tickets, cards, or other memoranda that show the original
(2) See that the sheets are certified to or initialed by the persons who took the stock,
made the calculations and footings, and fixed the prices, and satisfy yourself that they are
dependable and responsible persons. Obtain a clear and detailed statement in writing as
to the method followed in taking stock and pricing it; also a certificate from a responsible
head as to the accuracy of the inventory as a whole.
(3) A thorough test of the accuracy of the footings and extensions should be made,
especially of all large items.
(4) The inventories should be compared with the stores ledger, work in progress ledgers
and finished product records and stock records as to quantities, prices, and values, and any
material discrepancy should be thoroughly traced.

(5) Where stock records are kept and no physical inventory is taken at the time of
the audit, ascertain when the last physical inventory was taken and compare it with the
book records. If no recent comparison is possible, select a. few book items of importance
and personally compare with the actual stock on hand.
(6) Where no stock records are kept, a physical inventory should be taken preferably
under the general direction of the auditor. After the inventory is completed, he should
apply the same tests to verify its accuracy as if the inventory had been taken before his
arrival upon the scene.
(7) When the cost system of a company does not form a part of the financial accounting scheme there is always a chance that orders might be completed and billed, but not
taken out of the work in progress records. Especially is this the case when reliance is
placed on such records to the extent that a physical inventory is not taken at the end of
the period to verify the information shown therein. In these cases the sales for the mGnth
preceding the close of the fiscal period should be carefully compared with the orders in
progress as shown by the inventory, to see that nothing that has been shipped is included
in the inventory in error. Cost systems which are not coordinated with the financial
accounts are unreliable and frequently misleading. Special attention should be called to
every case in which the cost system is not adequately checked by the results of the financial
(8) Ascertain that purchase invoices for all stock included in the inventory have been
entered on the books. Look for postdated invoices and give special attention to goods in
(9) See that nothing is included in the inventory which is not owned but is on consignment from others. If goods consigned to others are included, see that cost prices are
placed thereon, less a proper allowance for loss, damage, or expenses of possible subsequent
return. This does not include goods at branches, as the valuing of such stocks will be
governed by the same principles as apply at the head office.
(10) Ascertain that nothing is included which has been sold and billed, and is simply
awaiting shipment.
(11) If duties, freight, insurance, and other direct charges have been added, test them
to ascertain that no error has been made. Duties and freight are legitimate additions to
the cost price of goods, but no other items should be added except under unusual circumstaflces.
(12) As a check against obsolete or damaged stock being carried in the inventory at
an excessive valuation, the detailed records for stores, supplies, work in progress, finished
products, and purchased stock in trade, should be examined and a list prepared of inactive
stock accounts, which should be discussed with the company's officials and satisfactory
explanations obtained.
(13) The auditor should satisfy himself that inventories are stated at cost or market
prices, whichever are the lower at the date of the balance sheet. No inventory must be
passed which has been marked up to market prices and a profit assumed that is not and
may never be realized. If the market is higher than cost, it is permissible to state that
fact in a footnote on the balance sheet.
(14) It may be found that inventories are valued at the average prices of raw- materials and supplies on hand at the end of the period. In such cases the averages should

be compared with the latest invoices in order to verify the fact that they are not in excess
of the latest prices, and also with the trade papers, when market prices are used, to see
that they are not in excess of market values.
(15) Make an independent inspection of the inventory sheets to determine whether or
not the quantities are reasonable, and whether they accord in particular instances with
the average consumption and average purchases over a fixed period. Abnormally large
quantities of stock on hand may be the legitimate result of shrewd foresight in buying in
a low market, but may, on the other hand, arise from serious errors in stock taking.
(16) Always attempt to check the totals by the "gross profit test" and compare the
percentage of gross profit shown with that of previous years. In a business where the
average gross profit remains fairly constant this test is a dependable one, because, if the
rate of gross profit is apparently not maintained and the discrepancy can not be satisfactorily accounted for by a rise or fall in the cost of production or of the selling price, the
difference will usually be due to errors in stock taking.
(17) In verifying the prices at which the work in progress is included in the inventory,
a general examination and test of the cost system in force is the best means of doing this
work satisfactorily. In a good cost system little difficulty will be found with the distribution of the raw materials, stores, and pay roll, but the distribution of factory overhead
cost is one that should receive careful consideration, the main points to be kept in view
(а) That no selling expenses, interest charges, or administrative expenses are included
in the factory overhead cost.
(б) That the factory overhead cost is distributed over the various departments, shops,
and commodities on a fair and equitable basis.
(18) No profit should be included in the price of finished products or stock in trade.
The price list should be examined to see that the cost prices of stock are below the selling
prices after allowing for trade discounts, and, if they are not, a reserve should be set up on
the balance sheet for this loss. If the company takes immediate steps to increase the
selling price, however, the amount of this reserve may be limited to the loss on goods which
may have been sold since the close of the period to the date of the discovery.
(19) In the case of companies manufacturing large contracts it is frequently found
necessary to make partial shipments thereof. The question then arises as to whether it is
permissible to include the profits on these partial shipments in the profit and loss account.
As a matter of fact, it is evident that the actual cost can not be known until the order is
completed. It may be estimated that a profit will ultimately be made, yet unforeseen
conditions, such as strikes, delays in receiving material, etc., may arise to increase the
estimated cost. It is better not to include the profits on partial shipments, but information
of this character which may have its influence in the decision of the banker upon a proposed
loan may properly be laid before him. Of course, an exception should be made in cases
where the profit on the partial shipments largely exceeds the selling price of the balance of
the order.
(20) The selling prices for contract work in progress should be ascertained from the
contracts, and where it is apparent that there will be a loss on the completed contract a
due proportion of the estimated loss should be charged to the period under audit by setting
up a reserve for losses on contracts in progress.
73539°—18 3

(21) If a company has discontinued the manufacture of any of its products during the
year, the inventory of such products should be carefully scrutinized and, if unsalable, the
amount should be written off.
(22) The inventory should be scrutinized to see that no machinery or other material
that has been charged to plant or property account is included therein.
(23) Partial deliveries received on account of pin-chase contracts for material, etc.,
should be verified by certificates from the contractors, both as to quantities and prices.
(24) Advance payments on account of purchase contracts for future deliveries should
never appear in an inventory, but be shown on the balance sheet under a separate heading.
(25) Trade discounts should be deducted from inventory prices, but it is not customary
to deduct cash discounts. However, this may be done when it is the trade practice so to do.
(26) While the inventory is being verified, the auditor should ascertain the aggregate
sales for the last year. If the turnover has not been rapid, it may be due to a poor stock
of goods. Some business men dislike to sell below cost and would rather accumulate a
big stock of old goods than dispose of the old and unseasonable stock at a sacrifice. The
usual outcome is that the stock becomes unwieldy and funds are lacking to purchase new
goods. The inventory and the gross sales may, therefore, have a direct connection.
(27) It may be well to reiterate that interest, selling expenses, and administrative
expenses form no part of the cost of production, and therefore should not be included in
the inventory in any shape.

In preparing the leading schedules for the accounts grouped under this heading, such
as real estate, buildings, plant, machinery, etc., the balances at the beginning of the period,
the additions to or deductions from the accounts during the year, and the balances at the
end of the period must be shown.
The total of the balances at the beginning of the period must agree with the cost of
property figures given in the balance sheet at that date, and the balances at the end of the
period with the amount shown in the balance sheet that is being audited. The charges
entering into the additions must be verified in detail, and in this connection the following
notes are of value:
(1) Authorizations for the expenditure made during the year should be examined, and
where the costs of the additions have overrun the sums authorized, inquiries should be made
in regard thereto. The authorizations should show the accounts to which the expenditures
are chargeable, the amounts thereof, the approvals of the comptroller and manager, and
descriptions of the jobs. When the authorizations are not specific as to the work done,
the actual additions should, if possible, be inspected.
(2) The auditor should satisfy himself before approving additions that they were
made with the object of increasing the earning capacity of the plant, and that they are not
of the nature of either renewals or improvements, and in this connection changes in the
production and. capacity of the plant should receive consideration.
(3) To verify the pay roll and store and supply charges to jobs, one or two pay roll
distribution reports should be examined in detail, and also one or two storehouse reports.
In cases where large purchases have been made from outside parties for capital construction

work, the vouchers therefor should be examined and the usual precautions taken to see
that they are properly approved for the receipt of materials, prices, etc.
(4) For purchases of real estate the title deeds should be examined, together with the
vouchers, and it should be seen that the deeds have been properly recorded.
(5) While it may be considered permissible to make a charge for factory overhead cost
to additions to property such as, e. g., time of superintendent and his clerical force employed
on construction work, etc., it can not be deemed conservative business practice, inasmuch
as the probabilities are that the overhead charges of a plant will not be decreased to any
extent even though additions are not under way, and, therefore, the absorption of part of
these charges when additions are in progress, has the effect of reducing the operating costs,
as compared with months in which no construction work is under way.
(6) Construction work in progress at the end of the fiscal period should be shown in
the balance sheet under the heading of fixed assets and not as part of the inventories. This
is important to bear in mind because construction work is not an asset that can be quickly
turned into money, while everything in the inventory is supposed to be realizable in cash
within a reasonably short time.
(7) The auditor should inquire as to whether any installments are due on account of
construction work in progress which is being carried on by outside parties; and if so, the
liabilities for these installments should be included in the balance sheet, as they may have
a direct bearing on the amount of available cash on hand.
(8) When a company uses leasehold properties the leases should be examined and
notes made of the periods covered, so that it may he seen that improvements, etc., on such
properties are written off over the periods covered by the leases.
(9) The auditor should satisfy himself that the reserves for depreciation of buildings,
machinery, equipment, etc., are adequate to reflect the deterioration in the value of the
fixed properties. If in his opinion the reserves shown on the balance sheet are insufficient,
he should call attention to the matter in his certificate.
(10) Care should be taken to insure that property destroyed by fire or otherwise prematurely put out of service is correctly treated in the books. Any portion of the original
charge for such property which is not recoverable through insurance, as salvage or otherwise, and has not been provided for by the depreciation scheme should be written off.
It is to be observed that the foregoing notes are to be applied only to cost of properties
incurred during the period under audit. In addition, information may usefully be obtained on broader lines in regard to the composition of the real estate, building, and machinery accounts, and showing what principal property is represented thereby and how the
accounts have been built up from year to year for a reasonable time past if not from the
inception of the business. The information derived therefrom is valuable only in indicating the progressive policy of the concern, the extent to which it reinvests undivided surplus
in its plant, etc. beyond these facts the banker who is asked for ordinary discounts or
short-term loans is not interested; he looks more to the quick assets for his security.
Optional.—When the loan is greater than the quick assets seem to justify the auditor
should suggest a reliable verification of the cost of property prior to the period under audit.
Such action may become necessary even to the extent of calling for an appraisement by
.disinterested outside experts.


Under this heading in the balance sheet are grouped such items as unexpired insurance,
bond discounts applicable to a future period, prepaid royalties, experimental charges, etc.
After the clerical accuracy of the deferred charges has been verified the auditor should
satisfy himself that they are properly carried forward to future operations.
Wherever possible, documentary proof must be produced in support of the items
carried forward, as, for example, with unexpired insurance the policies must be examined
to verify the dates of expiration, the amounts covered, and the proportion of the premiums
carried forward; with royalties the agreements must be examined; with experimental
charges the vouchers and particulars of the work done must be looked into, etc.
The examination of the deferred charges will usually furnish the auditor with valuable
information in regard to the accounts of the company, as, e. g.:
(1) The verification of experimental charges carried forward will generally furnish
information as to the production and future policy of the company.
(2) Royalty vouchers will generally furnish a check on the production of mines.
(3) An examination of the insurance policies will show if the properties are mortgaged
or covered by lien, and thus be an additional verification of the liability for mortgages on real
estate, buildings, etc., shown in the balance sheet.
(4) The assets covered by insurance will be ascertained and if any omissions are discovered they should be mentioned.

Under this caption appear notes payable and drafts accepted. Schedules should be
prepared under the subcaptions, and in columns headed:
Date of making the notes or drafts.
Due dates.
Names of creditors.
Collateral hypothecated.
Additional indorsers.
Interest accrued to date of audit.
Notations of renewals (as information of this nature furnishes a guide to the
state of the concern's credit).
The schedule must be compared with the notes-payable book and the total of the
aggregate must agree with the balance of the ledger account of notes payable.
Statements must be obtained from all banks and brokers with whom the concern
does business, showing all notes and drafts discounted or sold by them for the benefit of
the concern. These statements when received must be checked against the loans shown
on the concern's books and approved in the minutes of the company.
Inasmuch as a note is a negotiable instrument, care must be taken to see that all of
those recorded as paid during the year under audit have been properly discharged, and the
canceled notes are the best evidence of this fact.
Careful attention should be given to the collateral deposited for loans, and statements
as to the existence of such collateral should be obtained from the holders thereof. Such
hypothecation of any of the concern's assets should be accounted for on the balance sheet.

When practicable the auditor might suggest to the client the advisability of drawing
notes payable on blanks bound in a book, like a check book, with a stub for each blank, the
blank and the stub to bear identical numbers. The officer, or officers, signing the notes
could, in such case, initial the stub as a certificate to the amounts, payees, and terms of
the notes issued. If this were done, the auditing of bills payable would be greatly facilitated.

A list of balances due on open accounts must be prepared and carefully checked with the
ledger accounts, care being taken to see that no open account on the ledger has been omitted
from the list. It should be ascertained that the balances represent specific and recent
items only. When any account does not appear regular a statement from the creditor
should be obtained. If there are many such accounts in dispute, and they amount to so
large a sum as to affect appreciably the total of current liabilities, the general causes for the
disputes should be inquired into and note made of the matter for the consideration of the
In concerns with modern voucher systems accounts payable are easily verified, as all
liabilities are then included in the books when incurred. Care should be taken, however,
to see that all goods received on the last day of the fiscal period, as shown by the receiving
records, and also all goods that were in transit and belonged to the concern on that date,
are included as liabilities, and the corresponding assets included in the inventories. This
test is necessary, as an increase in the accounts payable may have a very important bearing
on the financial position of the concern if the cash on hand is small.
Monthly expenses outstanding can usually be ascertained by a comparison of the
^expenses of the last month of the fiscal period with previous months, and those of the year
with the previous year. The voucher record should, however, be examined for the months
subsequent to the close of the fiscal year, in case any expenses included therein are applicable to the fiscal period under audit.
When a first-class voucher system is not in operation the auditor must take additional
precautions to satisfy himself that all liabilities are included in the accounts, among which
may be mentioned:
(1) Payments made in the months subsequent to the date of the fiscal period as shown
by the cashbook, which should be carefully scrutinized to see that none of them is applicable
to the period under review.
(2) The file of bills not vouchered or entered on the books should be examined to see
that none of them belongs to the period under audit.
(3) A careful perusal of the minutes of a company may further assist the auditor in
determining liabilities.
When a company has large purchase contracts in force for future deliveries they should
be examined, for if the contract prices are greater than market prices, it might be necessary
to set up a reserve for this loss. Any debit balance due to advance payments on such
contracts or to any other cause should be shown on the balance sheet under a separate
If the business under audit is one where there is any possibility of goods having been
received on consignments, and part or all of such goods having been sold without a liability

therefor having been shown in the books, the auditor must use all due diligence to cover
the point fully. This may readily happen, as consignment accounts are usually treated
as memoranda only.
If inquiry develops the fact that goods have been received on consignment, all records
in connection therewith should be called for. If the goods have all been sold, the consignor's account should show the full amount due, and if the debt is a current one, the
amount will appear among accounts payable due to trade creditors. Where only part of
the goods have been sold, the net proceeds due to the consignors should be shown on the
balance sheet under the caption of " Accounts pay able consignors."
As an additional precaution against the omission of liabilities a certificate should be
obtained from the proper officer or member of the concern stating that all outstanding;
liabilities for purchases and expenses have been included in the accounts of the period
under review or of former periods. In many cases it is also advisable to obtain a certificate
from the president stating that all liabilities for legal claims, infringements of patents,
claims for damages, bank loans, etc., have been included, as he may be the only executive
officer of the company to know the extent of such obligations.

It is not enough that a balance sheet shows what must be paid; it should set forth
with as much particularity as possible what may have to be paid. It is the duty of an
auditor who makes a balance-sheet audit to discover and report upon liabilities of every
description, not only liquidated debts but possible debts. The following are the usual
forms under which contingent liabilities will be found:
Indorsements.—Inquiry of the officers or partners of the concern should be made as
to whether any indorsement of outside paper has b ^ n made and as to any security received
to protect the concern. Such inquiry should be particularly strict if it is known that any
of the officers or partners are interested in other enterprises.
Guaranties.—Similar action should be taken in the matter of guaranties.
Unfulfilled contracts.—Contracts to accept the delivery of goods contracted for before
the date of the balance sheet, may call for the payment of large sums of money within a
short time. In the case of raw materials, for a manufacturer, this might be a perfectly
legitimate reason for seeking a temporary loan pending production and sale, but for a merchant whose balance sheet shows a large stock of goods on hand, it might indicate a real
liability impending with assets of a doubtful character to offset it. In every audit, therefore, the auditor should call for copies of all orders for future delivery, and if such orders
call for stock in excess of the current and reasonable prospective demand, mention should
be made on the balance sheet and a report submitted, the details depending upon the
circumstances of each particular case.
Items other than those arising from the specific hypothecation of current assets to be
listed under item 20 should appear as a footnote on the liability side of the balance sheet,
the total amounts being stated for each subheading and such additional report made as
will convey clear information to the banker.


Under this caption are grouped such items as interest, taxes, wages, etc., which have
accrued to the end of the period under audit, but are not due and payable until a later date.
The verification of such items can be accurately made from the books and records.
Special attention may be directed to the following:
Interest payable.—Many of the liabilities which appear on a balance sheet carry interest.
Such items as bonds and notes payable are obvious, but the auditor should also consider the
possibility of accounts also bearing interest, as enough book accounts, when past due, do
bear interest to warrant inquiry being made. Loan accounts of partners and officers of
corporations almost invariably bear interest; also judgments, overdue taxes, and other liens.
Taxes.—The amount of accrued State and local taxes can be ascertained from an examination of the latest tax receipts; though in some cases, as the period for which the taxes are
paid is not shown on the face of the receipt, it may be necessary to make inquiries of the
proper taxing authorities as to the period covered.
Under the Federal income tax law a tax of 2 per cent is imposed upon the net profits of a
corporation, which must be paid even if the corporation is dissolved before the end of the
year during which the tax is imposed. As the tax is specifically based upon the net profits of
a particular period, although payable some months thereafter, the tax aocrues throughout
the specified period, and if a net profit is disclosed upon the closing of the books at any
date during the year, a reserve of 2 per cent must be shown on the balance sheet as an
accrued tax.
Wages.—Where the date of the balance sheet does not coincide with the date to which
the last pay roll of the period under audit has been calculated, the amount accrued to the
date of the balance sheet must be ascertained and entered as a liability, unless such amount
is trifling. It will suffice to take the proportion of a full week's pay roll (six days) without
reference to possible daily variations.
Water rates, etc.—Where bills for such expenses as water, gas, etc., are not rendered
monthly, the auditor must enter the accrual of the proper proportion since the last bill as a
Traveling expenses and commissions.—It is important to note whether the accounts of all
traveling salesmen have been received and entered before the books are closed. The
auditor should secure a list, and if any report was not so entered, provision should be made
for it unless the amount is likely to be trifling.
Ample provision should be made for all commissions eventually payable on sales which
have been billed to customers. As commissions are frequently not payable to salesmen
until the sales have been collected from the customers, accrued commissions are often
omitted from the books. As they must, however, be paid out of the proceeds of the sales on
which the full profit has already been taken into the accounts, they should be set up as an
accrued liability.
Legal expense.—All concerns have more or less litigation. Before the books are closed the
lawyers should be requested to send in a bill to date. If one is not found, the auditor should
ascertain the amount, if any, probably due and set it up as an accrued liability.

Damages.—If the concern is insured against liability for damages to employees or the
public, a proportion of the premiums paid in advance for the unexpired time covered by the
insurance will appear in " Deferred charges." But there may be claims or suits for other
damages not covered by insurance, and where the auditor finds any evidence which leads
him to suspect there may be liability of this nature he should insist upon being informed of
all the facts. He can then form an opinion as to the amount that should be set up as an
accrued liability, or, if the outcome is uncertain, as a reserve against possible loss.

A copy of the mortgages must be examined and the terms thereof noted. The amount
of bonds registered, issued, and in treasury, rate of interest, and duration of the bonds,
should be shown on the face of. the balance sheet. A certificate should be obtained from
the trust company certifying the amount of bonds outstanding, etc., as verification of the
liability stated in the balance sheet. The interest on the bonds outstanding, shown in the
balance sheet, should be calculated and reconciled with the interest on bonds, as shown in
the profit and loss account.
Sinking-fund provisions in mortgages should be carefully lioted and care should betaken to see that they are provided for in the accounts of the company, and any default
noted in the balance sheet.
Bonds redeemed during the period or previously should be examined to see that they
have been properly canceled, or, if they have been destroyed, a cremation certificate should
be obtained from the trustees.
Mortgages sometimes stipulate that the current assets must be maintained at a certain
amount in excess of the current liabilities, and the auditor must give due consideration to
such matters and any other stipulation in regard to the accounts, or any audit thereof,
that may be referred to in the trust deed, and see that they have been complied with.
Mortgages.—As a mortgage derives its chief value from the fact that upon registry it
becomes a lien, the auditor should verify the existence of such an obligation by inspecting
the public records, not only with reference to such as may be found on the company's books,
but also any that may still appear on the public records as unsatisfied. If the auditor lacks
the necessary facilities for making a search it will be worth his while to arrange with a local
lawyer or title company whereby, for a small fee, any mortgages or judgments entered
against the concern under audit will be reported to him.
In any event the auditor must verify the amount as recorded in the account, the rate,
the due date, and the property covered thereby.
It should be borne in mind that a payment on account of a mortgage must be recorded
or the entire amount will remain as an encumbrance on the property. Therefore, if payments on account appear, the auditor should ascertain if they have been so recorded; if not
the fact should be noted on the balance sheet.
Judgments.—The same procedure should be followed in verifying judgments as in
verifying mortgages. As many business men consider that the entry of an invoice is an
admission of liability, and will not permit the entry of a claim which they propose to fight,
it is sometimes difficult for an auditor to find any evidence of such liens. Even admitting
the fact, they may still refuse to allow the judgment to be entered on the books as a


liability, in which case it is proper for the auditor to include it as a footnote on the balance
sheet as a contingent liability.
Unpaid interest.—When considering the matter of liens it should be noted that interest
unpaid is a lien as well as unpaid principal, so where the auditor finds evidence of interest on
liens being in default, he should add it to the principal in each case.

As a rule trust companies are the transfer agents for the capital stock of large corporations and for verification purposes it is sufficient to obtain letters from them certifying to
the capital stock outstanding.
Where companies issue their own stock, the stock registers and stock certificate books
should be examined and compared with the lists of outstanding stockholders.
On the balance sheet each class, if more than one, of stock must be stated, giving
ampunt authorized, issued, and in treasury, if any. In the case of companies with cumulative preferred stocks outstanding a note must be made in the balance sheet of the dividends
accrued but not yet declared.
If stock has been sold on the installment plan, the auditor should ascertain that the
calls have been promptly met and whether any are in arrears. If special terms have been
extended to any stockholder, approval of the board of directors is necessary and the minutes
should be examined accordingly.
If any stock has been sold during the period under audit, the auditor should verify the
proceeds of the sales.

The auditor should give consideration to the surplus at the beginning of the period.
This item represents the accumulated profits prior to the beginning of the fiscal period under
review, and should be compared with the surplus shown on the balance sheet of the previous
year, and with tiie ledger account, to see that it corresponds, and if it does not, a reconciliation statement should be prepared giving full details of the differences.

The auditor should obtain the profit and loss statement for three years, at lea§t, inincluding the period under audit, and after verifying them by comparison with the ledger
account, prepare a statement in comparative form. This comparison will furnish valuable
information to the banker as to the past progress of the concern under audit.
A satisfactory form of profit and loss account is annexed hereto, but any other form
giving substantially similar information is acceptable.
While it would be impracticable in an ordinary balance-sheet audit, and, at the same
time, somewhat useless to make a detailed check of all the transactions entering into the
composition of the profit and loss account, there are certain main principles to be kept in
view which are briefly outlined below:

Whenever it is possible, the quantities sold should be reconciled with the inventory on
hand at the beginning of the period, plus the production, or purchases, during the period,
less the inventory on hand at end of the period.



Where a good cost and accounting system is in force, the sales records will very probably
be in good shape, but nevertheless, the auditor should satisfy himself from the shipping
records that the sales books were closed on the last day of the fiscal year, and that no goods
shipped after that date are included in the transactions.
When an audit is being made for the first time, the auditor should satisfy himself that
the sales at the beginning of the period were recorded in accordance with the dates of
shipments. Such verifications can be made conveniently by a direct comparison of the
shipping memoranda with the invoices billed.
Allowances to customers for trade discounts, outward freights, reductions in prices,
etc., should be deducted from the sales in the profit and loss account, as the amount of net
sales is the only figure of interest to the bankers.
The future bookings at the close of the fiscal year should be looked into, as a comparison
of orders on hand with corresponding periods of other years furnishes the bankers with an
idea of the concern's business outlook.

The inventory at the beginning of the period, plus purchases during the period, less
inventory at the end of period, gives the cost of sales. In a manufacturing concern the
factory cost of production takes the place of purchases. These items will have already been
verified in auditing the balance sheet, but nevertheless care should be taken to see that this
heading has not been made a dumping ground for charges which would be more properly
embraced under the heading of special charges. The composition of the items entering
into the cost of sales should be traced in totals into the cost ledgers or accounts.

This is obtained by deducting the cost of sales from the net sales.
profits to net sales should be calculated and compared.

The ratio of gross


Under these general headings should be set down the expenses itemized to correspond
with the titles of the ledger accounts kept in each division. In checking the totals of each
account with the statement for the period under audit, special attention to credits in these
accounts should be given to see that none have been made for the sale of capital assets and
for other items which should not appear in expense accounts. The percentages of the
totals of each division and of the aggregate total to net sales should be calculated for each
year for comparison.

This is obtained by deducting the aggregate total of the selling, general, and administrative expenses from the gross profit on sales, and shows the net earnings of the concern
on its real business. Ratio to sales should be calculated for each year for comparison.

Under this heading is embraced any income that may be derived from sources outside
of sales, such as income from investments, interest, discounts, etc. Schedules should be
prepared of each item, and the auditor should satisfy himself of their accuracy and of the
propriety of including them as income.


Under this heading are grouped such items as interest on bonded debt, interest on
notes payable, etc. The same procedure of verification as in the case of other income should
Jbe followed.

Adding other income to gross income and deducting deductions from income gives the
net income or profit and loss for the period, which is the amount that should be carried to
the surplus account.

Items of unusual or extraordinary profit which do not belong strictly to the period
under audit, or can not be; said to be the legitimate result of the ordinary transactions of
the concern, should be entered here and verified with the surplus account. Similarly,
deductions should be treated. Also dividends declared should be entered in the surplus
account and as an item under this caption, inasmuch as it is the usual custom to declare
dividends "from net earnings and surplus/! After adding special credits to and deducting
special charges from the net income we have the total profit and loss for the whole period
from all sources which, added to the surplus balance at the beginning of the period, gives
us the surplus at the end of the period, which should agree with the surplus as stated on the
balance sheet.

These instructions cover audits of small or medium-sized concerns. In large concerns
having, for instance, tens of thousands of accounts or notes receivable, the detail procedure
suggested would be impracticable, and internal check should make it unnecessary. In such
cases only tests can be made, but the auditor must always be prepared to justify his departure
from a complete program by showing that the purposes sought to be accomplished thereby
have been adequately effected by his work.
Any extensive clerical work, such as preparations of lists of notes receivable, etc.,
should be performed by the client's staff, so as to avoid unnecessary employment of professional staff in merely clerical work and consequent undue expense.

The balance sheet and certificate should be connected with the accounts in such a way
as to ensure that they shall be used only conjointly. This rule applies also to any report or
memorandum containing any reservations as to the auditor's responsibility; any qualification as to the accounts, or any reference to facts materially affecting the financial position
of the concern.
The certificate should be as short and concise as possible, consistent with a correct
statement of the facts, and if qualifications are necessary the auditor must state them in a
clear and concise manner.
If the auditor is satisfied that his audit has been complete and conforms to the general
instructions of the Federal Reserve Board, and that the balance sheet and profit and loss

statement are correct, or that any minor qualifications are fully covered by the footnotes
on the balance sheet, the following form is proper:
I h a v e a u d i t e d t h e a c c o u n t s of B l a n k & C o . for t h e period f r o m



I c e r t i f y t h a t t h e a b o v e b a l a n c e sheet a n d s t a t e m e n t of profit a n d loss h a v e b e e n m a d e i n a c c o r d a n c e w i t h t h e p l a n
suggested a n d a d v i s e d b y t h e F e d e r a l R e s e r v e B o a r d a n d i n m y opinion set forth t h e


c o n d i t i o n of t h e firm

a n d t h e results of its operations for t h e period.






of profit


loss for

three years ending


Year ending—


Gross profit on sales




Selling expenses (itemized, to correspond with ledger accounts kept)
Total selling expense
General expenses (itemized to correspond with ledger accounts kept)
Total general expense
Administrative expenses (itemized to correspond with ledger accounts kept)
Total administrative expense



Net profit on sales.
Other income:
Income from investments
Interest on notes receivable, etc

Deductions from income:
Interest on bonded debt
Interest on notes payable.
Total deductions.

Deduct special charges to profit and loss
Profit and loss for period








1a. Cash on hand—currency and coin.,
ib. Cash in bank

,'2^otes and accounts receivable:
3. Notes receivable of customers on hand
(not past due)
5. Notes receivable discounted or sold with
indorsement or guaranty
7. Accounts receivable, customers (not
past due)
9. Notes receivable, customers, past due
(cash value, $)
11. Accounts receivable, customers, past
due (cash value, $
13. Provisions for bad debts
15. Provisions for discounts,
freights, allowances, etc


Bills, notes, and accounts payable:
Unsecured bills and notes—
2. Acceptances made for merchandise
or raw material purchased
4. Notes given for merchandise or raw
material purchased
6. Notes given to banks for money borrowed
8. Notes sold through brokers
10. Notes given for machinery, additions
to plant, etc
12. Notes due to stockholders, officers,
or employees
Unsecured accounts—
14. Accounts payable for purchase (not
yet due)
16. Accounts payable for purchases
(past due)
18. Accounts payable to stockholders,
officers, or employees
Secured liabilities—
30a. Notes receivable discounted or sold
with indorsement or guaranty
20b. Customers' accounts discounted or
assigned (contra)
aoc. Obligations secured by liens on inventories
sod. Obligations secured by securities
deposited as collateral

17. Raw material on hand
19. Goods in process
sx. Uncompleted contracts
Less payments on account
23. Finished goods on hand.

22. Accrued liabilities (interest, taxes,
wages, etc)
Other current liabilities (describe fully): -

-Other quick assets (describe fully):

Total quick assets (excluding all investments).,

Total current liabilities
Fixed liabilities:
24. Mortgage on plant (due date
26. Mortgage on other real estate (due
38. Chattel mortgage on machinery or equipment (due date
30. Bonded debt (due date

25. Securities readily marketable and salable
without impairing the business
37. Notes given by officers, stockholders, or
29. Accounts due from officers, stockholders,
or employees

33. Other fixed liabilities (describe fully):
Total current assets.,
Fixed assets:
31. Land used for plant
33. Buildings used for plant
35. Machinery
37. Tools and plant equipment
39. Patterns and drawings
41. Office furniture and fixtures
43. Other fixed assets, if any (describe fully).

Total liabilities.
Net worth:
34. If a corporation—
(а) Preferred stock (less stock m
(б) Common stock (less stock in
(c) Surplus and undivided profits..

45. Reserves for depreciation.

.Deferred charges:
47. Prepaid expenses, interest, insurance,
taxes, etc
Other assets (49)

36. If an individual or partnership—
(a) Capital
(b) Undistributed profits or deficit..

Total assets.

(d) Book value of good

(«) Deficit

Total fixed assets


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102