PRACTICAL AUDITING Prepared by: Roda R.

Santos

Module 8
LIABILITIES

EXPECTED LEARNING OUTCOMES

After reading this chapter, you should be able to

(a) describe the types of transactions in an enterprise's financing cycle;

(b) cite the general internal control procedures relating to liabilities;
(c) state the auditor's principal objectives in auditing liabilities and related expenses;
(d) apply audit procedures to establish management's assertions on liabilities and related
expense balances;
(e) prepare working papers to establish correct balances of liabilities and related expenses;
(f) formulate audit adjustments to bring liabilities and related expenses to correct balances; and
(g) evaluate the appropriateness of the presentation of liabilities and related expenses in the
financial statements.

The Financing Cycle

The financing cycle process refers to transactions and events that generate funds. The
sources of funds are debt and equity financing. Funds are received from creditors and owners
that increase liabilities and equity. Funds obtained are used for operations and for investment
purposes, which provide the entity with earnings. The inflow of funds from operations and
investments are used to repay debt, distribute dividends and/or reacquire own equity instruments.

Liabilities

Liabilities are present obligations of the enterprise arising from past actions, the settlement
of which is expected to result in an outflow from the enterprise of Resources embodying economic
benefits. In a properly classified statement of Financial position, liabilities are classified into
current liabilities and non-current liabilities. Generally, on the statement of financial position, trade
liabilities are separated from non-trade liabilities. Trade liabilities include accounts payable, trade
notes payable, accrued expenses and unearned income. Non-trade liabilities generally arise from
loans and borrowings.
The auditor's primary concern in the audit of liabilities is ensuring that all liabilities of the
entity are properly recognized and measured at fair and reasonable amounts:

Internal Control

To achieve effective internal controls over trade and other payables, duties should be
segregated so that a cash disbursement to a creditor will be made only after involving the
purchasing, receiving, accounting, and finance departments. The function of preparation of
checks must be separated from the function of check issuance to prevent any irregularities on
cash disbursements. Ideally, the individual accounts in the subsidiary ledgers for accounts
payable must be periodically reconciled with periodic statements from vendors. All adjustments
in the trade creditors' accounts (returns, allowances, rebates, commissions, etc.) should require
approval of duly designated approving authority.

An entity should establish and implement policies specifying the decision making
processes relating to borrowings, such as, but are not limited to, the person or body authorized
to borrow on behalf of the entity, the borrowing power of the officer and the limit on such power,
the terms and conditions of the borrowings, the assets that will be used as security or liens for
borrowings, and the procedures for compliance with legal requirements, if applicable. Normally
the entity's legal department reviews the terms of the proposed borrowing arrangements.

The usual forms of long-term borrowings include debentures, secured bonds, and notes
payable. Issuance of these instruments requires a formal decision and authorization by the board
of directors. It is also preferable to appoint an independent trustee to handle the issuance,
redemption and reacquisition of bonds. The designated third-party trustee takes responsibility for
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protecting the borrower's interests and monitoring compliance with debt covenants. Effective
internal control is likewise achieved when the task of making interest payments is designated to
the trustee, the entity issuing a single check to the trustee for the periodic interest payments and
the trustee making the payments to the bondholders.

A system must be in place so that non-compliance with borrowing terms and conditions
could be immediately addressed. This system includes confirmation of balances at periodic
intervals and investigation of any discrepancy between the company's records and the creditors'
records. There must be a procedure for periodic valuation of loans, especially those that are
denominated in foreign currency

Audit Objectives

The auditors' objectives in the audit of liabilities are to:

(1) consider internal control over liabilities;

(2) determine the existence of liabilities;

(3) establish the completeness of recorded liabilities;

(4) determine that liabilities are measured appropriately; ands

(5) determine that the presentation and disclosure of liabilities is appropriate.

Audit Procedures

The auditor should obtain an understanding of the system of internal control of the client
relating to liabilities to determine the nature, timing and extent of the audit procedures necessary
to achieve the audit objectives.

To establish existence and validity of recorded liabilities, the verification may be

undertaken by the following procedures: examination of records, direct confirmation with creditors,
analytical review procedures and obtaining management representation. The nature and timing
of these substantive procedures depend on the auditor's evaluation of the effectiveness of the
internal controls.

The auditor should obtain a schedule of accounts payable at the reporting date, and vouch
a sample of the balances to supporting vouchers, invoices, purchase orders, and receiving reports
to test the existence and accuracy of recorded amounts. The client's schedule of accounts
payable must be reconciled with the vendors' statements to establish accuracy of the yearend
balances. Cutoff accuracy can also be tested by tracing the details of the receiving reports
processed towards the end of the year and noted during the yearend physical count of inventories.

The auditor may consider to make direct confirmations with the trade creditors. Similar to
confirmations of accounts receivable, the auditor shall consider using either the positive form or
the negative form of confirmation. The positive form of confirmation requests the supplier or lender
to respond whether or not the amount indicated in the confirmation request (based on the records
of the client) agrees with the balance in the supplier's records. The negative form requests the
lender to reply only when the amount indicated in the confirmation request (based on the records
of the client) does not agree with the records of the lender.

The auditor shall prefer the use of the positive form over the negative form when Internal
control is ineffective and other forms of reliable evidence are unavailable to establish the accuracy
of accounts payable. Also, it may be appropriate to use the positive form of confirmation request
for suppliers with large balances and also when the auditor concludes that there is reason to
believe that the supplier will disregard the request
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The negative form shall be used when all of the following conditions are present: (a) there
are efficient internal control procedures over the payables; (b) there is no reason to believe that
the lender shall disregard the request and (c) the creditors' balances are small.

In cases when the confirmation procedure may prejudice the status of the client, especially
in cases of legal and other disputes, the auditor has to obtain the consent of the client before
circularizing the confirmation letter. In cases where non-confirmation can be justified, the auditor
has to apply alternative audit procedures to establish existence and accuracy of the recorded
liabilities

Analytical review procedures are normally employed by the auditor to obtain assurance of
the overall reasonableness of accounts payable. Such analytical review procedures include but
are not limited to the computation of the accounts payable turnover, ratio of accounts payable to
purchases, and ratio of accounts payable to current liabilities. Comparison of these computed
ratios with those of the preceding years to identify significant variations may indicate that further
investigations may be necessary.

An auditor should maintain an attitude of skepticism and always consider the possibility
that there are unrecorded liabilities, especially accrued expenses. Thus, audit procedures shall
be directed for the search of unrecorded payables. An analysis of payments made after the
reporting date may show that certain liabilities existed but were unrecorded at the end of the
reporting period. The amount of interest expense must be reviewed for reasonableness of the
amount of interest bearing liabilities. For clients following the voucher system, the unpaid
vouchers file must likewise be reviewed. Other documents, such as minutes of meetings, lease
contracts, statements of accounts from other entities may also indicate the existence of
unrecorded obligations.

Accrued liabilities represent obligations payable sometime during the succeeding period
for services received before the reporting date. The basic auditing steps for accrued liabilities are
as follows:

(1) examine any contacts or other documents (such as statement of accounts that are received
after the end of the reporting period) that provide the basis for the accrual;

(2) determine whether detailed accounting records have been maintained for this type of liabilities;

(3) identify and evaluate the reasonableness of the assumptions that underlie the computation of
the liability:

(4) test the computations made by the client in setting up the accrual, and

(5) determine that accrued liabilities have been treated consistently at the beginning and end of
the period,

Provisions, which are liabilities that are uncertain as to timing or amount or both, may
require special attention. The audit of provisions requires examining the reasonableness and
adequacy of the amounts recognized by the client. In determining whether a provision is required,
the auditor should, among other procedures, make appropriate inquiries of management, review
minutes of the meetings of the board of directors and correspondence with the client's lawyers
and obtain appropriate management's representations. Where provisions are made for liabilities
arising from product warranties and guarantees, service contracts and other similar nature, the
auditor should examine the reasonableness of the basis adopted for measuring the provision,
considering the industry trends or historical company statistics. relevant agreements,

The auditor must review disclosures made in the prior period financial statements relating
to contingencies. Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets,
contingent liabilities may develop in a way not initially expected. Therefore, contingent liabilities
must be assessed continually to determine whether an outflow of resources embodying economic
benefits has become probable. Circumstances may indicate that items considered as
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contingencies in the prior period be considered as actual obligations in the current reporting
period.

The auditor shall, likewise, review unusual payments made during the reporting period
under audit and during the subsequent period to determine whether the appropriate charges are
made in the correct reporting period. In determining whether provisions shall be recognized or
contingencies shall be disclosed, the auditor may consider analyzing the legal expenses for the
period and review invoices and statements of legal counsel. The auditor may also obtain
confirmation from all major law firms dealt with by the client as to the status of pending litigation
or other contingent liabilities.

The auditor should verify that in cases where income is collected in advance, the unearned
portion at the end of the reporting period is not recognized as income. The basis for income
recognition must likewise be reviewed to determine whether it is made in accordance with the
revenue recognition principle as provided in the new IFRS 15.

In the case of long-term liabilities, a reconciliation of the beginning balances to the ending
balances is preferably made to determine the reasonableness of the ending balance.

The auditor shall obtain a copy of the bond Indenture and include it in the le of working
papers. So long as the bonds are outstanding, the copy of the bond indenture shall form part of
the permanent file of the auditor. In the first audit of the client or during period when the bonds
were initially issued, the auditor should obtain an understanding of the major terms of bond issue
and make a summary of the provisions of the agreement. During each audit, the auditors will
perform tests of compliance with the provisions contained in the bond indenture.

The auditor shall be on guard with any violation that may have made the debt payable on
demand. In such a circumstance, the debt shall be classified as part of current liabilities, unless
the client is able to obtain on or before the balance sheet date, a waiver from the creditor to make
a demand of payment within twelve months from the reporting date.

Bond transactions, including sinking fund transactions and year-end balances of bonds
payable and sinking funds, are confirmed directly with the trustee. Under normal circumstances,
the auditor does not communicate directly with the individual bondholders.

The confirmation of the balance of cash deposits with banks simultaneously confirms any
financial obligation with the financing institutions. Bank confirmations establish the existence and
correctness of the balance of notes payable and loans payable to bank. (See module 3 for a
sample of the confirmation form.)

The auditors should verify that interest payments correspond to the terms of recorded
liabilities. Excessive interest payments may indicate the existence of unrecorded notes payable.

The auditor may, in addition to the audit procedures discussed, may perform analytical
review procedures. This may include

(a) comparison of closing balances with the corresponding figures for the previous year;
(b) comparison of the payable turnover ratio of this year with that of the previous year;
(c) comparison of actual ending balances of loans and other borrowings with the budgeted
figures; and
(d) aging the accounts payable and comparing the results with statistical figures, if any.

Any large variations from the previous and from the projected figures may warrant further
investigation.

The auditor shall determine whether the liabilities are properly presented and classified in
the financial statements and the required disclosures have been complied with. Proper
presentation of accounts payable requires that material amounts of accounts with debit balances
be reclassified as assets. Material amounts of payables to related parties should be listed
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separately from accounts payable to trade creditors and the details of the related transactions
should be disclosed in a note to the financial statements in compliance with IAS 24, Related Party
Disclosures. Proper financial statement presentation also requires that interest-bearing debt be
fully described, including interest rates, maturity dates, a schedule of required future payments,
assets pledged, and other major restrictions.