[Volume XXV
THE CHICAGO BANKER
18
tion of the fact appears on the books, then he should require production of the stock certificates in order to satisfy himself that this is not the case.
As previously mentioned, inventories of merchandise and goods in process of manufacture, are another place in which the window dresser becomes extremely active. While it is, of course, impossible for the auditor to verify quantities, he can none the less, by a scrutiny of the detailed inventories and comparison with prices very often discover instances of “packing.” An interesting case came before the courts in England a few years ago in which the auditors of a cotton mill were sued for misfeasance, inasmuch as it had been discovered that the values assigned to the raw material on the balance sheet certified by them was grossly overstated. The auditors set up the defense that it was entirely outside of their province to verify quantities, and that they were entitled to rely upon the certificate of the mill superintendent in this matter. It was, however, shown that by taking the inventory at the beginning of the period under investigation, adding the purchases for raw material and deducting the raw material used in manufacture, as shown by the mill’s records, the resulting figure would have been so much less than the quantity claimed to be on hand as per the inventory submitted by the mill superintendent that failure to detect and point out this discrepancy by the auditors amounted to gross negligence. Both the Court of Queen’s Bench and Court of Appeals sustained this contention, though the auditors finally escaped punishment on a final appeal to the House of Lords, their escape being due, however, to other grounds than their lack of culpability in this matter.
The auditor has many ways of testing the genuineness of inventories, which the scope of this paper does not permit my going fully into. I would mention, however, that in this connection he is always careful to see that a liability is stated, in respect of all goods included in the inventory, but not yet paid for. This is a matter in which most commercial houses are extremely careless, goods being received several days before the invoices for same, and the liability consequently not being set up on the books until a later day than that at which the goods were included in the inventory. As regards the values assigned to goods in process of manufacture, this is almost invariably based upon the cost records, if any are kept by the company, and of course it becomes the duty of the accountant to scrutinize very carefully the basis on which such cost accounts are kept. It has very frequently been my experience at such examinations to find that an unreasonable percentage was allowed on the value of the goods in process to cover overhead charges.
As regards the accounts receivable, it is a very usual thing to find on careful analysis that included under this heading are a number of balances due from officers, and employees, or from branch houses of the borrower’s own business. It is, of course, obvious that these should be separately stated and that the collectability of same very carefully gone into. In one case which I recently investigated, I found that all goods sent to branch houses were charged to them at selling price and as the company in question had quite a number of such branch houses, all of which owed large balances in current account with the main house, there was a very large shrinkage in the value of the accounts receivable after my examination had been completed.
(Concluded in issue of December 5th)
?5»
Young Bankers after the Prizes
Both St. Paul and Minneapolis bank clerks are after the prizes offered by the national organization for essays on phases of American
meeting. The auditors are by law constituted officers of the company, and are punishable for misfeasance, if they are found to have cried “peace where there was no peace.”
Were such laws operative throughout the United States much of the fraud and financial jugglery which is at present practiced would be rendered impossible, and it is my hope and belief that the time is close at hand when some such legislation will be enacted.
I will now endeavor to show you how the examination of a borrower’s statement by accountants frequently reveals a condition of affairs quite otherwise than that appearing on the face of the statement. You are doubtless aware that the large departmental stores have in their employment gentlemen known as window dressers, to whom quite large salaries are paid for their services in setting out their employer’s wares in the most attractive form. A few lines written by Mr. W. S. Gill, the composer of so many comic operas, are rather pertinent to this point, namely: “Things are not always what they seem; skimmed milk masquerades as cream.” It is a function of the financial window dresser to so manipulate the “skimmed milk” of his employers as to make it look like the “richest cream,” and this in so guileless and childlike a manner as to free both himself and his employer from the charge of deliberate fraud when the deception is discovered; for instance, I have often seen the stocks and bonds of other corporations held by a company stated on its balance sheet in one item, and in analyzing the same I have found it consists of a large number of investments in all kinds of concerns, some good; some indifferent; and some possessing no value other than as “wall paper.” In such cases one would find that the value assigned to each stock has been arrived at on a different basis from that assigned to any other, some being taken at cost; some at par; and others above par. Where market quotations are obtainable the insertion of these is perfectly justifiable, even if such price is considerably above the cost of same, but where no market quotation exists or where, from his examination of the books, the accountant is satisfied that the stock in question is that of a subsidiary company, promoted by the borrower and the market for its shares is being made by the borrower, then only the actual cost of such stock should be taken into consideration.
It is perfectly easy for a large corporation holding a big block of promotion stock in another company, by the usual stock broking methods to raise the market quotation to a very substantial figure, but the fact that such a price is being quoted is not justification for valuing their entire block of unsold stock at this figure. Were any attempt made by them to throw such a large number of shares upon the market at one time or even during several months, it would often be impossible to find buyers at any price at all, and the market quotation would undoubtedly in any event, fall very materially.
As regards these subsidiary companies, it is perhaps harsh to say that the value assigned to their stock should never be more than the actual cost of same to the borrower, but if it is desired to include them at a higher figure, such higher valuation must be amply justified by a showing of the balance sheet of the subsidiary company, and where the holding is large, an examination of the accounts of the subsidiary company itself should be made by the accountant in order to determine whether its surplus is genuine or is not largely composed of water.
Whilst we are on the subject of investments I may point out the common practice of many corporations holding such securities to hypothecate same, in respect of short loans and where there is any suspicion in the auditor’s mind that such is the case, although no indica-
te the liabilities is much easier. All liabilities are current except the liability to stockholders and bonded debts.
In describing the deductions to be drawn by a banker from a scrutiny of the details set out in the borrower’s statement, I have up to the present point assumed that he has been comparing the statement with one previously submitted by the borrower. When, however, the statement undergoing scrutiny is the first of its kind received from the borrower, the inferences to be drawn are not nearly so conclusive, and the reliance which the banker is obliged to place in the absolute truthfulness of the statement is much greater. For this reason it is a growing practice amongst conservative bankers to request borrowers to submit their accounts for examination by public accountants in order that the report of such accountants may furnish the basis for the first loan negotiated with the bank. The objection of borrowers to this course of action is generally grounded upon one of three objections, namely: The expense involved; the delay inevitable in the granting of the loan pending the examination’s completion; the danger that the detailed information obtained by the accountants may be used by them or the bank to the detriment of the borrower and to the advantage of his trade competitors.
These objections are none of them, in my opinion, worthy of serious consideration. In most instances, it must be clearly understood that such an examination as is here spoken of, does not amount to an actual audit. The accountant is generally instructed to assume the clerical accuracy of־the borrower’s books of account and to devote his attention exclusively to an intelligent analysis and grouping of the assets and liabilities shown therein, and the verification of the values assigned to the various assets. The value of such an examination to the bank is obvious and when borrowers fully realize the confidence that their submitting to such an examination inspires in the mind of the banker, they are generally willing to submit to it. If they are not willing it is generally a sure sign that the bank’s money could be more profitably invested eleswhere.
If the first statement submitted by the borrower is examined in the way described by me, it is not absolutely essential that subsequent statements be verified in the same manner, as by careful comparison of one statement with another the banker is generally able to draw his own conclusion and provided that he has what Mark Tw'ain has termed “the solid petrified truth” to build on as regards the first statement, it is almost impossible for the borrower to materially falsify subsequent statements without the banker being able to form a shrewd idea that such is the case. As a public accountant, I naturally, of course, believe that the best interest of both banker and borrower would be served if all commercial houses and corporations submitted their accounts for annual audit by certified public accountants. Were this the case, the question of the delay occasioned by the special examination of borrowers’ statements would be eliminated, as the borrower would always have on file a recent audit report which would be, if signed by reputable accountants, entirely satisfactory to the banker.
Under the English company law, all corporations are compelled to publish an annual statement of their condition, which has to be certified as correct by auditors, who are appointed at a general stockholders’ meeting. The auditors’ certificate is in a statutory form, and if the auditors are unable to give the corporation a “clean bill of health” their certificate merely states that the accounts are “correctly drawn up subject to the remarks contained in our report submitted herewith.” This report is, of course, addressed to the stockholders and is available for their scrutiny at the general