Unit 6: Payable and Other Liabilities

Introduction:
Liabilities are the financial obligations of an enterprise other than owners’ funds. Liabilities
include loans and borrowings, trade creditors and other current liabilities, deferred payment
credits, installments payable under hire purchase agreements, and provisions. Special
considerations may apply in the case of audit of liabilities of specialized entities like banks,
financial institutions and venture capital funds. Liabilities generally constitute a significant
proportion of the total funds of an entity. The audit of liabilities is primarily directed at ensuring
that all known liabilities have been properly accounted for, since material omission or
misstatement of liabilities vitiates the true and fair view of the financial statements. An important
feature of liabilities which has a significant effect on the related audit procedures is that these are
represented only by documentary evidence which originates mostly from third parties in their
dealings with the entity. In any auditing situation, the auditor employs appropriate procedures to
obtain reasonable assurance about various assertions [see Statement on Standard Auditing
Practices (SAP) 5, Audit Evidence]. In carrying out an audit of liabilities, the auditor is
particularly concerned with obtaining sufficient appropriate audit evidence to satisfy himself that
all known liabilities are recorded and stated at fair and reasonable amounts.
Accounts payable are the major source of unsecured short-term financing for business firms.
They result from transactions in which merchandise is purchased but no formal note is signed to
show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the
amount required in accordance with credit terms normally stated on the supplier’s invoice.
Chapter topics:
1. Sources and nature of accounts payable
2. The auditors’ approach in examination of accounts payable
3. Internal controls over accounts payable
4. Audit Procedures
5. Audit of other liabilities

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6.1 Sources and nature of accounts payable
Accounts payable are the major source of unsecured short-term financing for business firms.
They result from transactions in which merchandise is purchased but no formal note is signed to
show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the supplier the
amount required in accordance with credit terms normally stated on the supplier’s invoice.

The term accounts payable (often referred to as vouchers payable for a voucher system) is used
to describe short-term obligations arising from the purchase of goods and services in the ordinary
course of business. Typical transactions creating accounts payable include the acquisition on
credit of merchandise, raw materials, plant assets, and office supplies. Other sources of accounts
payable include the receipt of services, such as legal and accounting services, advertising,
repairs, and utilities. Interest–bearing obligations should not be included in accounts payable but
shown separately as bonds, notes, mortgages, or installment contracts.

6.2 The auditors’ approach in examination of accounts payable

The auditors’ objectives in the examination of accounts payable are to determine that:
1. Internal control over accounts payable and the acquisition and payment cycle is adequate.
2. The recorded accounts payable are valid (occurrence and obligations).
3. All accounts payable are recorded (completeness).
4. Accounts payable schedules are mathematically correct and agree with general ledger
accounts (clerical accuracy).
5. The valuation of accounts payable is proper.
6. The presentation and disclosure of payables is adequate.
The main focus when testing accounts payable is to check for understatement and thus by default
for completeness and Does the creditor list at year and includes:
• All the major suppliers the client dealt with during the year?
• All significant suppliers from creditors list of last year?
• All suppliers revealed by a review of payments after the year end?
• All suppliers revealed by a review of unpaid invoices at and after the year end+ supplier
statement.

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Audit program
Completeness
– Check balances extracted from purchase ledger balances to list of creditors: check a
sample of balances from purchase ledger to schedule/list of creditors.
– Last year brought forward is correct: check whether last year’s closing balances have
been properly brought forward.
– Last year significant suppliers that are not in current year list: investigate any supplier
names that were shown on last year’s payables listing but do not have a balance showing
in this year’s list of balances.
– Cut off before and after year end: select a sample of goods received note just before and
after the year end, trace to invoices and purchases ledger.
– Post balance sheet payments and invoices accounted: review after date invoices and
payments and ensure they have been provided for at the yearend as appropriate.
Accuracy
– Check balances extracted from purchase ledger balances to list of creditors: check a
sample of balances from the schedule to the purchase ledger.
– Count creditors list to creditors control a/c: check the total of the list to the purchases
control a/c.
– Vouch a sample of recorded creditors’ transactions to supporting documents: to agree the
amount.
– Perform cut off tests both before and after the year end: to ensure posting made in the
correct period.
– Reconcile creditors with monthly suppliers’ statements.
– Perform analytical procedures
Valuation
– Confirm with creditors through circularization:
– Ensure adequacy of provision for accrual: invoices not yet received.
– Letter of representation from management confirm in all trade payables: have been
included in financial statement.
– Ageing list of creditors.
– Checks if there are set off: between receivable ledger and payable ledger.

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 – Perform analytical procedures: on payables, com paring age analysis with previous
periods and payables days.
Existence
– Carry out creditors circularization:
– Vouch a sample of recorded creditors’ transaction to supporting documents. ( invoices,
goods received etc)
– Check whether last year closing balance has been brought forward: e.g this year’s
opening balance exists in balance sheet.
– Review payments to suppliers just after year end.
Beneficial ownership
– Confirm with creditors- circularization.
– Vouch to supporting documentation.
–
Occurrence
– Select a sample of transactions from purchase ledger, trace to invoices, PO and ensure the
goods/services have been received
Presentation and disclosure
– Compliance with accounting standards and companies act.
– Creditors are properly classified as to type and expected date of realization.
– Debit balances disclosed under current assets.
– Related party transactions properly disclosed.
– Note: additional evidence can be obtained from supplier statement reconciliation.

6.3 Internal control over accounts payable

A control is any action taken to mitigate or manage risk and increase the probability that the
organization’s process will achieve its goal or objectives.

In thinking about internal control for accounts payable, it is important to recognize that the
accounts payable of one company are the accounts receivable of other companies. It follows that
there is little danger of errors being overlooked permanently since the client’s creditors will
generally maintain complete records of their receivables and will inform the client if payment is

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not received. This feature also aids auditors in the discovery of irregularities, since the
perpetrator must be able to obtain and respond to the demands for payment.

Discussion of internal control applicable to accounts payable may logically be extended to the
entire purchase or acquisition cycle. In an effective purchasing system, a stores, or inventory
control department will prepare and approve the issuance of a purchase requisition that will be
sent to the purchasing department. A copy of the purchase requisition will be filed numerically
and matched with the subsequently prepared purchase order and finally with a copy of receiving
report.

The purchasing department, upon receiving the purchase requisition, will

(1) Determine that the item should be ordered and
(2) Select the appropriate vendor, quality, and price. Then, a serially numbered purchase order is
issued to order the goods. Copies of the purchase order should be sent to stores, receiving, and
the accounts payable department. The copy sent to receiving is generally “blind” in that the
quantities are not included so as to encourage receiving department counting of quantities.

The receiving department should be independent of the purchasing department. When goods are
received, they should be counted and inspected. Receiving reports should be prepared for all
goods received. These documents should be serially numbered and prepared in a sufficient
number of copies to permit prompt notification of the receipt of goods to the stores department,
the purchasing department, and the accounts payable department.
Within the accounts (vouchers) payable department, all forms should be stamped with the date
received. Vouchers and other documents originating within the department can be controlled
through the use of serial numbers. Comparison of the quantities listed on the invoice with those
shown on the receiving report and purchase order will prevent the payment of charges for goods
in excess of those ordered and received. Comparison of the prices, discounts and terms of
shipment as shown on the purchase order and on the vendor’s invoice provides a safeguard
against the payment of excessive prices.

The separation of the function of invoice verification and approval from the function of cash
disbursement is another step that tends to prevent errors and irregularities. Before invoices are

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approved for payment, written evidence must be presented to show that all aspects of the
transaction have been verified. The official who signs checks should stamp or perforate the
voucher and supporting documents so that they cannot be presented to support payment a second
time.

Another control procedure that the auditors may expect to find in a well-managed accounts
payable department is the regular monthly balancing of the detailed records of accounts payable
(or vouchers) to the general ledger controlling account. These trial balances should be preserved
as evidence of the performance of this procedure and as an aid in locating any subsequent errors.

6.4 Audit Procedures

The following procedures are typical of the work required in many engagements for the
verifications of accounts payable.

A. Consider internal control for accounts payable

1. Obtain an understanding of the internal control
One approach used by auditors in becoming familiar with a client’s system of internal control for
accounts payable is to prepare a flowchart or to use flowcharts prepared by the client. In some
engagements, the auditors may choose to prepare a narrative description covering such matters as
the independence of the accounts payable department and the receiving department from the
purchasing department. The auditors might use a questionnaire to obtain a description of
accounts payable controls. Typical of the questions are the following. Is an accounts payable trial
balance prepared monthly and reconciled to the general ledger controlling account? Are monthly
statements from vendors reconciled with accounts payable ledgers or unpaid vouchers?

2. Assess control risk and design additional tests of controls

Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost-justified restrictions of
substantive tests.

3. Perform additional tests of controls

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A number of tests of controls relating to accounts payable have already been discussed in the
previous sections. In this section we briefly recap several tests.

a) Verify a sample of postings to the accounts payable controlling account.

The validity of the amount in the general ledger controlling account for accounts payable is
established by tracing postings for one or more months to the voucher register and cash
payments journal. Any postings to the controlling account from the general journal during this
test period should also be traced.
b) Vouch to supporting documents a sample of postings in selected accounts of the accounts
payable subsidiary ledger.
Testing the accuracy of the voucher register or the accounts payable ledgers by tracing
specific items back through the cash payments journal, purchases journal, and other journals
to original documents (Such as purchase orders, receiving reports, invoices, and paid checks)
is necessary to determine the adequacy of the internal control.

4. Reassess Control risk and design Substantive tests

Completion of the above audit procedures enables the auditors to perform a final assessment of
control risk for each of the major financial statement assertions about accounts payable. The
internal control assessment provides the basis for selecting the necessary substantive tests for
verification of accounts payable at the balance sheet date.

B. Substantive tests
5. Obtain or prepare a trial balance of accounts payable as of the balance sheet date and
reconcile with the general ledger.

One purpose of this procedure is to prove that the liability figure appearing in the balance sheet
is in agreement with the individual items comprising the detail records. A second purpose is to
provide a starting point for substantive testing. The auditors will use the list of vouchers or
accounts payable to select a representative group of items for careful examination.

6. Vouch balances Payable to Selected creditors by inspection of supporting documents

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Another substantive test of the validity of the client-prepared trial balance of accounts payable is
the vouching of selected creditors’ balances to supporting vouchers, invoices, purchase orders,
and receiving reports.

7. Reconcile liabilities with monthly statements from creditors

In some companies, it is a regular practice each month to reconcile vendor’s statements with the
detailed records of payables. If the auditors find that this reconciliation is regularly performed by
the client’s staff, they may limit their review of vendors’ statements to determining that the
reconciliation work has been satisfactory. If the client’s staff has not reconciled vendors’
statements and accounts payable, the auditors may do so.
8. Confirm accounts Payable by direct correspondence with vendors
Confirmation requests should be mailed to vendors from whom substantial purchases have been
made during the year, regardless of the size of their accounts at the balance sheet date. Even
accounts payable with zero balances at year-end should be confirmed if they represent major
suppliers.

Confirmation of accounts payable is not a mandatory procedure as is the confirmation of

receivables. One reason is that the greatest hazard in the verification of liabilities is the existence
of unrecorded liabilities. To confirm the recorded accounts payable does not prove whether any
unrecorded accounts payable exist. Another factor to be noted in comparing the confirmation of
accounts receivable and accounts payable is that the auditors will find in the client’s possession
externally created evidence such as vendors’ invoices and statements that substantiate the
accounts payable. No such external evidence is on hand to support accounts receivable.

9. Perform analytical procedures for accounts Payable and related accounts

To gain assurance as to the overall reasonableness of accounts payable, the auditor may compute
ratios such as accounts payable divided by purchases and accounts payable divided by total
current liabilities. These ratios are compared with ratios for prior years to disclose trends that
warrant investigation.

10. Search for unrecorded accounts Payable

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Throughout the audit the auditors must be alert for any unrecorded payables. For example, the
preceding three steps of this program, reconciliation, confirmation, and analytical procedures,
may disclose unrecorded liabilities.

In addition to the prior audit steps, when searching for unrecorded accounts payable the auditors
will audit transactions that were recorded following year-end. A comparison of cash payments
occurring after the balance sheet date with the accounts payable trial balance is an excellent
means of disclosing unrecorded accounts payable. All liabilities must eventually be paid, and
will, therefore, be reflected in the accounts at least by the time they are paid.

11. Search for accounts payable to related parties

Payables to a corporation’s officers, directors, stock-holders, or affiliates require particular
attention by the auditors since they are not the result of arm’s length bargaining by parties of
apposing interests. Here the auditors should consider the possibility that these payables relate to
purchases of inventory or other asset items for which there may be valuation questions. The
independent auditors must search for such payables. All material payables to related parties must
be disclosed in the financial statements.

12. Evaluate proper balance sheet presentation and disclosure of accounts payable
Proper balance sheet presentation of accounts payable requires that any material amounts
payable to related parties (directors, principal stockholders, officers, and employees) be listed
separately from amounts payable to trade creditors.

Other Liabilities
Notes payable is discussed in the next section. In addition to the accounts payable previously
considered, other items classified as current liabilities include.
1. Amounts withheld from employees’ pay.
2. Sales taxes payable.
3. Unclaimed wages.
4. Customer’s deposits
5. Accrued liabilities

Amounts withheld from employees’ pay

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Income taxes withheld from employees’ pay and not remitted as of the balance sheet date
constitute a liability to be verified by the auditors. Accrued employer payroll taxes may be
audited at the same time. This verification usually consists of tracing the amounts withheld to the
payroll summary sheets, testing computations of taxes withheld and accrued and determining
that taxes have been deposited or paid in accordance with the federal and state laws and
regulations.

Sales taxes Payable

In most sections of the country, business concerns are required to collect sales taxes imposed by
state and local governments on retail sales. These taxes do not represent an expense to the
business; the retailer merely acts as a collecting agent. Until the amounts collected from
customers are remitted to the taxing authority, they constitute current liabilities of the business.
The auditors’ verification of this liability includes a review of the client’s periodic tax returns.
The reasonableness of the liability also is tested by a computation applying the tax rate to total
taxable sales. In addition, the auditors should examine a number of sales invoices to ascertain
that customers are being charged the correct amount of tax. Debits to the liability account for
remittances to the taxing authority should be traced to copies of the tax returns and should be
vouched to the paid checks.

Unclaimed wages
The auditors will analyze the unclaimed wages account for the purpose of determining that:
1. The credits represent all unclaimed wages after each payroll distribution and
2. The debits represent only authorized payments to employees, remittances to the state
under unclaimed property laws, or transfers back to general cash funds through approved
procedures.

Customers’ deposits
Many companies require that customers make deposits on returnable containers. A review of the
procedures followed in accepting and returning deposits should be made by the auditors with a
view to disclosing any shortcomings in internal control. In some instances, deposits shown by the
records as refunded to customers may in fact have been abstracted by employees.

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As a general rule, the auditors do not attempt to confirm deposits by direct communication with
customers; but this procedure is desirable if the amounts involved are substantial or the internal
control procedures are considered to be deficient.

Accrued liabilities
Most accrued liabilities represent obligations payable sometime during the succeeding period for
services or privileges received before the balance sheet date. Examples include interest payable,
accrued property taxes, accrued payrolls and payroll taxes and income taxes payable.

Because accrued items are based on client estimates of amounts which will subsequently become
payable, subjective factors may make it difficult to establish control over them. As a result, these
estimates may be particularly susceptible to misstatement, especially in circumstances in which
management is under pressure to show increased earnings.

The basic auditing steps for accrued liabilities are:

1. Examine any contracts or other documents on hand that provide the basis for the accrual.
2. Appraise the accuracy of the detailed accounting records maintained for this category of
liability.
3. Identify and evaluate the reasonableness of the assumptions made that underline the
computation of the liability.
4. Test the computations made by the client in setting up the accrual.
5. Determine that accrued liabilities have been treated consistently at the beginning and end
of the period.
6. Consider the need for accrual of other accrued liabilities not presently considered (that is,
test completeness).
Table 2.12: summary of assertions, objectives and procedures for accounts payable and related
accounts
Financial report assertions Specific audit objective Common audit procedures to
achieve objectives
Existence Accounts payable and accrued .confirmation
liabilities are valid obligations to .Vouching
suppliers at the balance date
Completeness Accounts payable and accrued .cut off period liability search
liabilities include all obligations .general procedures
owned to suppliers at the balance

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 date
Occurrence Transactions giving right to .select transactions from accounts
accounts payable occurred during payable listing and agree to
period. supporting documentation (e.g.
supplier’ invoices)
Rights and obligations Accounts payable and accrued .confirmation
liabilities are obligations owed to .general procedure
by the entity
Measurement Accounts payable are recorded in .cut-off
the correct amount and period. .check clerical accuracy of
accounts payable listing
.agree dollar value of accounts
payable to supporting documents
(e.g. suppliers’ invoices)
Valuation Accounts payable and accrued .recompilation
liabilities are presented at the .analytical procedure
appropriate amount.
Disclosure Accounts payable and accrued .inquiry and scanning
liabilities are properly described .general procedures
and classified in the statement of
financial position and related
disclosures are adequate

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