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Accounting for Sinking Fund Investments. There are three classes of entries in connection with accounting for sinking funds.
(a) Those relating to the original payments to the sinking fund trustee; and (b) those relating to subsequent payments to the sinking fund trustee.
Those relating to the transactions consummated by the trustee. These entries are recorded at the time of the trustee's periodic report.
3. Those relating to the redemption of the debt and the final disposition of the accounts relating to the sinking fund.
The usual plan is to create a reserve out of profits equal to the amount of the sinking fund. The funds are placed in the hands of a trustee for investment. The income from the trustee's investments is usually considered an addition to the fund. The following are illustrative of the three classes of entries explained above:
First Class. At the time the original payments are made to the trustee, two entries are required. 1. Sinking Fund Trustees.. Cash....
XXXXX. XX To record original payment to sinking fund trustee-sinking fund being created according to terms of trust agreement to retire the first mortgage bonds of the
tion of bonds. All subsequent payments to the sinking fund trustee should be recorded in exactly the same manner as the original payments.
Second Class. Upon receipt of the trustee's report, it would be necessary to set up entries for all completed transactions of the trustee. These may include purchase of securities, collection of interest on securities, sale of securities, expenses incurred, etc. The trustee may purchase securities at a discount or premium, in which case the transaction involves the proper treatment of such discounts and premiums. This has already been discussed at some length and the same principles apply to sinking fund accounting as to general accounting. Assuming that bonds purchased by the trustee are to be recorded at par the following entry shows the proper procedure:
Sinking Fund Bonds...
Sinking Fund Trustee..
Sinking Fund Income (Discount).. To record the purchase of bonds with accrued interest at less than the par value.
If the bonds have been purchased at a premium, the Sinking Fund Income account should be debited for the amount of such premium. The Sinking Fund Income account should be debited for accrued interest at the time of the purchase of bonds, for the premium when bonds are bought above par, and for expenses in connection with the sinking fund. The account should be credited for discount on bonds purchased below par and for interest collected on the bonds. Of course, separate accounts may be kept with Sinking Fund Income and Sinking Fund Expense, if desired. At the end of each year the Sinking Fund Income and Expense accounts should be closed into Profit and Loss. This profit and loss, of course, will later be closed into the Surplus account. The following entry is illustrative: Sinking Fund Income...
If the trustee purchases the company's own bonds, which is often done, there is practically no difference in recording the transaction. If the bonds are cancelled at the time of their purchase, the debit would be to the Bond account of the company instead of to Sinking Fund Bonds.
Third Class. When the bonds for which the sinking fund is created mature, the securities of the trustee must be converted into cash to be used for redeeming the bonds. Various entries may be required depending upon the transactions. The following are illustrative: I. Sinking Fund Trustee...
Sinking Fund Bonds...
Sinking Fund Trustee.
To record redemption of bonds.
If the bonds have been redeemed and cancelled, and the trustee has transferred the balance of cash back to the company the only thing left to be done is the closing of the Sinking Fund Reserve account into the Surplus account. This addition to surplus is available for dividends.
2. AUDITING THEORY
Quoting from the Federal Reserve Bulletin:
Listing the Securities
“Under this caption must be listed securities in
The dates of purchases.
Sheets of the companies where no market
quotations are available.
“The securities must be examined by the auditor
than to verify cash receipts and other evidences there-
“Certificates out for transfer must be verified by
"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 must be set up.
“Care must be taken to see that the certificates are made out in favor of the company, or that they are endorsed 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 cannot 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 secured liabilities on the Balance Sheet."
An inexperienced junior must be very careful in auditing securities because of the fact that he is likely to be unfamiliar with the work and in his attempt to conceal his ignorance, will likely make errors that he would not otherwise make. Take all the time necessary to count the securities and prepare lists of them. Don't let anything or anybody interfere with your work, and don't stop until you know that you have a complete record of all securities held by the client, as well as a record of those outstanding, whether in the hands of the banks, stock brokers or out to be recorded. All these can be counted and checked with the list later.
3. AUDITING PROCEDURE While the juniors were at work on the first day of the audit, the senior accountant counted and listed the securities. Reference to the Trial Balance will show that the only securities that are involved will be found in connection with the accounts, Sinking Fund and Investment of Surplus.
The surplus was found to be invested in 44% Liberty Bonds on May 9, 1918, being a part of the Third Liberty Loan, the interest on these bonds falls due on March 15 and September 15 each year. These were counted and there were found to be ten $1,000 Bonds with all coupons, not yet due, attached.
Verification of the sinking fund revealed that on January 2, 1918, there was set aside $15,000 in cash and deposited with the Merchants National Bank, who has been named as trustee for the fund. This is in agreement with the bondholders and it is understood that the President of the Merchants National Bank may invest this surplus in first real estate mortgages, paying not less than 6% interest, and the amount of the mortgage is in no event to exceed two thirds of the appraisal value of the real estate. After going over the matter with the President of the bank, it was found that the entire sum had been loaned to Harrison G. Matthews. A first mortgage was obtained dated January 10, 1918, with interest at 6% payable annually, and is based on city property valued at $25,000. This valuation being the basis for taxes. The loan is evidenced by a note secured by a first mortgage on the property.
THE LAW OF NEGOTIABLE INSTRUMENTS
Some contracts are "assignable" while others are “negotiable." We shall discuss here those conditions which make a contract negotiable. A negotiable contract is usually spoken of as a “negotiable instrument." There are three principal classes of negotiable instruments-notes, drafts and checks. It is essential that the accountant understand the essentials of negotiable instruments, hence the following discussion is based upon the essentials and non-essentials as stated in the Negotiable Instruments Law.*
Essentials of Negotiability. An instrument to be negotiable must conform to the following requirements:
1. Must be in writing and signed by the maker or drawer.
Must contain an unconditional promise or order to pay a sum certain in money.
*The Negotiable Instruments Law is a statute which was prepared by a commission on Uniform State Laws to modify and make uniform the Law of Negotiable Instruments throughout the United States. For the most part, it modifies the preexisting law. This law has been adopted without important amendments by all the states and the District of Columbia.