"Strictly speaking a promissory note is a note payable; a trade acceptance is a bill payable; but I am inclined to think that as trade acceptances become more prevalent they will be recorded in a Trade Acceptance account rather than a Bills Payable account.

"The statement that notes payable should always bear interest is not correct. Interest is an immaterial detail which may be found in a bill of exchange or trade acceptance as well as in a note and is not essential to either. In an accounting sense, bills payable are always notes or acceptances payable at a future date, and the term does not include cheques or sight drafts.

"The objection to the term bills payable is that in this country many business men not being accustomed to bills of exchange think the term refers to the bills rendered by their creditors which are payable every month."

1. ACCOUNTING THEORY

Recording Notes Payable in Original Books of Account. Like notes receivable, there are two principal methods of recording drafts and notes. The first method is to record them in the general journal and to keep a memorandum record in an auxiliary notes payable book. This memorandum record does not constitute a posting medium as all posting would be done from the journal. The notes payable book should provide columns showing date given, number, drawer or endorser, maker or drawee, payee, where payable, due date, amount, rate of interest and when paid.

Notes Payable Book as a Posting Medium. The second method is to record drafts and notes in a notes payable book instead of the journal and so arranging the record that it not only shows a complete record of the drafts and notes, but also constitutes a posting medium. In addition to all the columns mentioned under the first method described above, there should also be columns provided to enable the bookkeeper to post the totals to the proper accounts in the ledger. This may vary somewhat depending upon the particular system of accounts in use, but usually there will be columns headed notes payable credit, interest debit, interest credit, purchases ledger debit and general ledger debit.

Notes Payable Account. This account may show individual entries for each note and draft recorded in the books of account. However, if the second method for recording notes is followed, then this account will be a summary account. It will be credited for the total of the notes payable column in the notes payable book and will be debited for the total of the notes payable column on the credit side of the cash book. If no special column is provided in the cash book, then it will be debited for the individual notes recorded therein.

Trade Acceptances Payable. Trade acceptances receivable were discussed on page 66 of Chapter Five. The method of recording trade acceptances payable should be similar to that for recording trade acceptances receivable. Reference to the Model Balance Sheet for credit purposes on page 41 of Chapter Three will show that acceptances made for merchandise and raw material should be stated separately. Therefore, it will readily be seen that if a separate account is kept in the general ledger, it will not be necessary to analyze the Notes Payable account to determine this information. If a separate account is kept, it will either be necessary to record them in the general journal or provide a special trade acceptances book similar to the notes payable book described under the second method on page 167 of this chapter.

Classification of Notes Payable. In preparing a statement for credit purposes, the Federal Reserve Board requires that notes payable be classified in the Balance Sheet as follows: Notes given for merchandise or raw material purchased...

I.

Notes given to banks for money bor-
rowed....

XXXXX.XX

XXXXX.XX

XXXXX.XX

These are known as "unsecured liabilities." Notes and accounts payable, secured by liens on inventories, or by securities deposited as collateral, should be stated separately as "secured liabilities." (See page 41 of Chapter Three.)

2. AUDITING PROCEDURE

Quoting from Federal Reserve Bulletin on Uniform Accounting:

"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 endorsers.

"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."

CONTINGENT LIABILITIES

It has previously been pointed out that a Balance Sheet audit involves the detection of all unstated liabilities as well as verification of those appearing on the books of account. The discovery of contingent liabilities is not a simple matter and is often almost impossible, especially where an attempt has been made to conceal them.

Many an individual or firm has suffered a loss and even became bankrupt because of being compelled to meet obligations which did not arise out of the usual operation of business, obligations which did not in any case appear on the books of account. Almost everyone is familiar with some instance wherein an individual or firm who had endorsed a note only as a matter of accommodation, and later through unforeseen circumstances was compelled to meet it because of the inability or failure of the maker to do so.

The author recalls an experience of an audit of a manufacturing company. During the course of the audit we learned that another company had brought suit on the basis of infringement of patent rights. This company had purchased certain patent rights costing several hundred thousand dollars and had set up the cost as an asset, and was charging this off over a period of years based on the life of the patents. Further investigation revealed the fact that the result of the suit was quite uncertain. The company had been using these patented machines for several years. The plaintiff asked for damages based on the total production of the machines. We called

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.