The auditor will have to use his own judgment in each individual case to decide whether or not he must con sult the public records to verify the amount of such outstanding obligations.
6. Verification of bonds outstanding.—There is usually little difficulty in determining the liability of a corporation for mortgage or debenture bonds out standing, because of the safeguards which the bond holders themselves have provided against the fraudu lent overissue or misuse of these instruments.
In connection with sinking funds created to retire mortgage debts, the auditor must read the indenture and see that all the provisions to which the obligor agrees under the contract have been carried out. The auditor must also see that all interest accrued, even tho not as yet payable, on all bonds outstanding, appears in the proper place in the accounts.
7. Service liabilities outstanding.—Some business organizations receive payments in advance on account of sales or services which they agree to render. For example, a restaurant may sell commutation tickets, or a railroad may have outstanding service liabilities for transportation. In some cases, the determination of the amount of the outstanding service liabilities is a difficult matter. Trading stamp and premium com panies are other examples of concerns which have out standing liabilities of this character. The failure of purchasers to take advantage of the service or to re deem coupons, or the failure to use portions of railway tickets will result in a profit. The auditor must be on his guard to see that the full liability outstanding for undelivered service of this nature is provided for in the accounts, or that improper credit has not been taken in the income account for lapses or failure to re deem coupons or tickets.
8. Liability on uncompleted contract$.—A busi ness undertaking may enter into a contract agreeing to receive a certain quantity of raw material at cer tain specified dates in the future, payment to be made either upon delivery or upon a specified date after delivery. If the effect of these contractual obliga tions is ignored in preparing a balance sheet, bankers, stockholders or creditors may be deceived. The audi tor must therefore make an investigation to determine first the amount of these unfulfilled contracts; and second, the nature of the liability of the concern under the various contracts. In light of these considera tions, he will be able to determine whether or not men tion of them should be made in the balance sheet. If the contracts are such as are taken in the ordinary course of business, and if they will not materially affect the financial standing of the undertaking, they are usually ignored.
9. Liability for containers or returnable packages. —It is the custom in certain lines of business to allow customers to return containers which were charged to them at the time the goods were shipped. The con
tainers may be returnable at any time at the option of the customer, or there may be a time limit fixed for their return. The auditor should satisfy himself that the amount of the liability set up for containers which are returnable is adequate.
10. Auditor's duty regarding reserves.—The audi tor will determine whether or not the amount set aside as a reserve for depreciation of fixed or working assets is sufficient to meet the depreciation actually sustained, and whether the reserve for bad debts is ade quate for the possible loss on doubtful accounts and notes receivable. An auditor must have breadth of view, and if he finds upon consultation with his clients that his own estimate for depreciation or for doubtful debts has been made in excess of the actual require ments, he should alter the amount of his provision. On the other hand, the client must bear in mind that the auditor does not always know the purpose for which his balance sheet may be used, and for this rea son he is apt to err on the side of conservatism. If a client has failed to make proper provision for all con tingencies and will not agree with the auditor's esti mate of the amount necessary to be reserved, the auditor may allow the client's figures to stand altho he will be in duty bound to qualify his certificate and state his opinion as to the inadequacy of the amount reserved.
11. Verification of capital stock outstanding.—The auditor will examine the certificate of incorporation of a company as well as its by-laws and minutes. He will note how the stock was paid for. He will make such inquiry as may be necessary to determine whether the proper procedure has been followed as indicated by the resolutions of the board of directors or stock holders. He will also examine the stock certificate book and stock ledger to make sure that no overissue of stock has been permitted, and he will trace the pro ceeds of the sale of stock into the assets. It should be noted that no audit would prevent a dishonest cor porate official from raising the amount of a certificate from that indicated in a stub, and using the certificate as the basis for bank loans. This form of fraud has been perpetrated.
The foregoing covers in a general way the proce dure which an auditor may be expected to employ in the verification of the liabilities and capital outstand ing of a business organization. The auditor will not only use the books of account in his examination, but should alio have access to any other data and memo randa such as contracts, minute book, memoranda of agreement, or correspondence, in order to enable him to assure himself as far as possible, of the accuracy of the statement which he is expected to certify.