attention to this action in our report and advised that a fund be set aside out of profits until such time as the court had reached a decision. Several months later our client lost the suit and was forced to pay several thousand dollars damages. It will be seen, therefore, that contingent liabilities are likely to become real and an auditor must be very careful to make every effort to detect them.

Auditing Procedure. (Federal Reserve Bulletin.)

"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:

Endorsements. "Inquiry of the officers or partners of the concern should be made as to whether any endorsement of outside paper has been 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 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."

It will be seen, therefore, that there are two different methods for classifying contingent liabilities. Those based upon "specific hypothecation of current assets" should be listed on the credit side of the Balance Sheet among the secured liabilities. These are contra entries because the hypothecated items also appear among the current assets.

Such contingent liabilities as accommodation endorsements, actions or suits pending against client, guaranties, etc., should at least be mentioned in a footnote on the liability side of the Balance Sheet and should be accurately outlined in the report to the client.

ACCRUED LIABILITIES

All accrued liabilities should be classed as current liabilities in the Balance Sheet. These are not difficult to ascertain as they can be accurately determined and the amount calculated from the accounting records.

Auditing Procedure. (Federal Reserve Bulletin.)

"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, to 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 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 accrues 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 equal to the amount of the accrued tax must be shown on the Balance Sheet.

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 liability.

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."

LEGAL PHASES

(Note. In connection with the discussion of contingent liabilities on account of accommodation endorsements, it is appropriate to quote from the negotiable instruments law which regulates endorsements of negotiable instruments.)

What Constitutes Negotiation. An instrument is negotiated when it is transferred from one person to another in such manner as to constitute the transferee the holder thereof. If payable to bearer it is negotiated by delivery; if payable to order it is negotiated by the endorsement of the holder and completed by delivery.

Endorsement; How Made. "The endorsement must be written on the instrument itself or upon a paper attached thereto. The signature of the endorser, without additional words, is sufficient endorsement.

Kinds of Endorsement. "An endorsement may be either special or in blank, and it may also be either restrictive or qualified, or conditional.

Special Endorsement. "A special endorsement specifies the person to whom, or to whose order the instrument is to be payable; and the endorsement of such endorsee is necessary to the further negotiation of the instrument.

Blank Endorsement. "An endorsement in blank specifies no endorsee, and an instrument so endorsed is payable to bearer and may be negotiated by delivery.

Restrictive Endorsement. "An endorsement is restrictive, which either:

I.

2.

Prohibits the further negotiation of the instrument; or Constitutes the endorsee the agent of the endorser; or 3. Vests the title in the endorsee in trust for or to the use of some other person.

But the mere absence of words implying power to negotiate does not make an endorsement restrictive.

Qualified Endorsement. "A qualified endorsement constitutes the endorser a mere assignor of the title to the instrument. It may be made by adding to the endorser's signature the words 'without recourse' or any words of similar import. Such an endorsement does not impair the negotiable character of the instrument.

Conditional Endorsement. "Where an indorsement is conditional, a party required to pay the instrument may disregard the condition and make payment to the endorsee or his transferee, whether the condition has been fulfilled or not. But any person to whom an instrument so endorsed is negotiated will hold the same, or the proceeds thereof, subject to the rights of the person endorsing conditionally.

Striking out Endorsement. "The holder may at any time strike out any endorsement which is not necessary to his title. The endorser whose endorsement is struck out, and all endorsers sudsequent to him, are thereby relieved from liability on the instrument."

A. THEORY QUESTIONS

1. What steps should an auditor take to insure, so far as possible, that accounts presented to him for audit contain all the liabilities of the company? Inst. Ex. 1917.

2. Outline the work which should be done in connection with notes and bills payable in an audit for credit purposes of a merchandising company. Inst. Ex. 1918.

3. How would you ascertain whether a Balance Sheet contains all the liabilities for purchases of supplies and raw material? C. P. A. Ind. 4. What are contingent liabilities? Should they be embraced in a Balance Sheet? Give an example. C. P. A. Ind. 5. State three kinds of contingent liabilities. How should they be shown on the Balance Sheet? C. P. A. Mass.

6. (a) What different methods should be employed in books of account for keeping track of notes endorsed for accommodation and notes endorsed in the regular order of business?

(b) How would you indicate in books of account the contingent liability arising in each case? C. P. A. Mich. 7. Describe the voucher system and state some of the advantages and disadvantages of the system. Inst. Ex. 1918.

8. You find that a group of accounts receivable have been assigned to secure a loan. Does that affect the value of any other creditor's claim in case of failure before the loan is paid? Should any reference to the fact be made in your report? How would you set up that fact in the Balance Sheet?