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(Reg. No. 45, 1919, Art. 544, 13.) “If bonds are issued by a corporation at a discount, the net amount of such discount is deductible as interest and should be prorated or amortized over the life of the bonds. If, thereafter, the corporation purchases and retires any of such bonds at a price in excess of the issuing price plus any amount of discount already deducted, the excess of the purchase price over the issuing price plus any amount of discount already deducted (or over the face value minus any amount of discount not yet deducted) is a deductible expense of the taxable year. If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price plus any amount of discount already deducted, the excess of the issuing price plus any amount of discount already deducted (or of the face value minus any amount of discount not yet deducted) over the purchase price is gain or income for the taxable year."

Procedure When Bonds Issued at Par Value Are Purchased for Redemption. (Reg. No. 45, 1919, Art. 544, (i.) “If bonds are issued by a corporation at their face value, the corporation realizes no gain or loss. If thereafter the corporation purchases and retires any of such bonds at a price in excess of the issuing price or face value, the excess of the purchase price over the issuing price or face value is a deductible expense for the taxable year. If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.”

Bond Discount Considered Interest. The Treasury Department holds that the discount on bonds sold at less than par is to be treated as interest paid in advance. It would, therefore, seem that it is equally good practice to consider the premium on bonds sold above par to be a deduction against the amount of interest paid.

(Reg. No. 45, 1919, Art. 563.) "If it sells its bonds at a discount, the amount of such discount is treated as interest paid, and if it retires its bonds at a price in excess of the issuing price, such excess may usually be deducted as expense. If the Corporation sells its capital assets for less than their cost or fair market value as of March 1, 1913, the loss sustained is deductible."

Interest on Liberty Bonds Exempt from Income Tax. (Income-Tax Primer, 1919, Ques. 19.) “To what extent is interest received on Liberty bonds exempt from income tax?

(a) All interest received upon Liberty bonds is exempt from normal tax.

(b) In any event, interest upon the 372 per cent Liberty bonds of the first series is exempt from both normal tax and surtax.

(c) In addition, a person is entitled to exemption from tax upon interest received on $5,000 aggregate amount of bonds of later issues and war-savings certificates.

(d) If one originally subscribed for Liberty bonds of the fourth series he is also entitled to an exemption from tax on interest received upon bonds of the previous issues not to exceed one and one-half times the amount of the fourth Liberty bonds originally subscribed for and still owned, not to exceed in the aggregate $45,000.

(e) The interest received on not exceeding $30,000 principal amount of Liberty bonds into which first Liberty bonds may have been converted in the exercise of any privilege arising as a consequence of the issue of the fourth Liberty bonds is exempt.

(f) The interest received on not exceeding $30,000 principal amount of Liberty bonds of the fourth issue is exempt.

The interest upon Liberty bonds, which is entirely exempt from income tax as defined above, should not be included in the gross income of the return, but should be reported in the return."

3. AUDITING THEORY

Quoting from the Federal Reserve Bulletin:

Listing Mortgages and Bonds. “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 Funds. "Sinking fund provisions in mortgages should be carefully noted and care should be taken to see that they are provided for in the accounts of the company, and any default noted in the Balance Sheet.

Redeemed Bonds. “Bonds redeemed during the period or previously should be examined to see that they have been properly cancelled, 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."

4. AUDITING PROCEDURE

Investigation by the senior shows that there is $100,000.00 of the First Mortgage Bonds of the Blank Manufacturing Company outstanding. These are 5%, 20-year bonds. Interest payable semi-annually on January 15 and July 15 of each year. As shown in the Trial Balance, December 31, 1918, (see page 50, Chapter Four) $2,500.00 had been deposited for bond interest.

The policy of the company has been to charge off 5% of bond discount annually, thus distributing it over the life of the bonds on a straight line method without regard to the rate of interest which the bonds bear. The Bond Discount unamortized now stands at $6,000.00 and the Bond Interest account shows a debit balance of $5,000.00, this amount representing the amount of interest paid on January 15 and July 15, 1917.

A. THEORY QUESTIONS Name five classes of bonds, describing briefly each class with regard to issue, purpose, redemption, etc.

C. P. A. Mich. 2. Do unsold bonds of a railroad company constitute a liability? If they do, under what account would they appear in the ledger?

C. P. A. Mich. 3. An issue of Mortgage Bonds of the par value of $100,000.00 and running for five years has been sold at 90, the money to be used in the erection of new buildings. How should the transaction be recorded and why?

C. P. A. Mich. 4. If a bond reads at 4%, but the amount which will be received is 1.05 of the nominal par, what is the actual percentage of cost income?

C. P. A. Mich. 5. If a company sells its own bonds at a premium, is the premium received a legitimate profit of the company?

C. P. A Ohio.

B. ACCOUNTING PROBLEMS 1. (a) A corporation issued First Mortgage Bonds bearing interest at 5%, dated January 1, 1917, to subscribers at $125.00 for each bond, par value $100.00. The bonds are to be paid for in three installments: $25.00 on February 1; $50.00 on March 1; and $50.00 on April 1. The February I and March 1 installments have been paid and the proper entries made on the cash book. You are called in to formulate the journal entries on the two installments. How would you make them? There were issued and sold $100,000.00 par value.

(b) A corporation borrows $120,000.00 for a period of ten years to pay off an existing loan at a higher rate of interest, paying therefore in brokerage and costs $2,750.00. How would you treat this item on the books?

C. P. A. Ind. The Smith and Jones Manufacturing Company issued $200,000.00 of first mortgage 50-year, 5% sinking fund bonds which were marketed at 9812, 1% commission, and expended the entire proceeds in the erection of their plant. The discount and commission were charged to the Unamortized Debt Discount and Expense accounts, to be subsequently charged to Profit and Loss, proportionately, during the life of the bonds.

Five years later, the company was enabled, owing to a disturbance in the financial market, to purchase $50,000.00 of said bonds for Sinking Fund account at 95.

Prepare the necessary journal entries to record correctly the above transactions of the company.

C. P. A. N. Y. (Note. You may assume that the bonds were placed in the hands of a firm of bankers for sale. The bonds purchased for sinking fund account were cancelled by the company.)

2.

3. The Standard Trust Company is appointed by the Peninsular Mining Company as Trustee of a Bond Issue, aggregating $1,000,000.00, all Bonds of $1,000.00 denomination, rate 5% and bearing date January 1, 1914. Bonds mature in ten equal annual installments, beginning January 1, 1917, unless previously converted or retired.

The issue is not purchased by the Trustee, but is sold through Emory Davis & Company, Brokers, the Company realizing 90% and accrued interest less the cost of appraisal of property, printing, trustees' expenses, etc., amounting to $9,310.80.

The entire issue was taken over, and paid for by the brokers on January 20, 1914. Among other things the trust deed provides: Bonds convertible on any interest date for 6% pre

ferred stock at 90%, at option of holder. Bonds may be retired out of surplus on any interest

date at 103, at option of company. Sinking fund for payment of principal only to be based

on production of ore at ten cents per ton.

Trustee to charge 14% of principal on issue, and 74% on coupons.

Interest payable January i and July 1. The company's production for three years is assumed to be, for the purpose of this problem, 1,000,000 tons per year.

January 1, 1916—$100,000.00 are converted to preferred stock.

January 1, 1917-$200,000.00 are redeemed at 103. Formulate all necessary entries in journal form for books of:

(a) Standard Trust Company,
(b) Peninsular Mining Company,

(c) Emory Davis & Company, which may be occasioned by the above transactions up to and including January 1, 1917.

C.P.A. Mich.

(Note. It would be well to review the discussion of securities and the accounting for sinking fund investments before preparing a solution to the above problem. See pages 70-76, Chapter Five.)

PRACTICE DATA

(Note. The following transactions are a part of special practice data designed as a test of your knowledge of the principles of accounting and auditing, and of your ability to apply the knowledge in actual practice. If you have properly learned all of the principles of accounting and auditing

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