Chapter 25 - Substantive Test of Liabilities

CHAPTER25
SUBSTANTIVE TEST OF LIABILITIES
TOPIC OVERVIEW:
This chapte r discuss es the audit of liabilities, its objectives and proced ures
as well as the manag ement asserti ons relatin g to liabilities.

LEARNING OBJECTIVES:
After studyin g this chapte r, you should be able to:
1. Identif y the audit objecti ves for liabilities and related accounts.
2. Explain the primar y substa ntive audit proced ures for liabilities and
related accoun ts.
3. Identif y asserti ons addres sed by audit proced ures for liabilities and
related accoun ts.

Introduction
Liabilities are the obligat ions of an enterp rise other than owner 's funds.
Liabilities genera lly constit ute a significant propor tion of the total source s
of funds of an entity and may be classified as curren t or non-cu rrent and
financial or non-financial. An import ant feature of liabilities which have a
significant effect on the related audit proced ures is that these are
represe nted only by docum entary evidence which origina tes mostly from
third parties in their dealing s ·w ith the entity.
When auditin g liabilities, the objective of the audito r would be the same,
regard less of the classification of the liability. The main focus when testing
liabilities is to check for unders tateme nt (that is, the comple teness
asserti on) as well as omissi ons of disclosure, since materi al omissi on or
missta tement of liabilit ies vitiate s the fairnes s of the financial statem ents.
Another area of concer n in auditin g liabilities is off-balance-sheet financing:
commitments, guaran tees, and other potenti al obligations not record ed on
the balanc e sheet. Because of the evolving, complex nature of accoun ting
standa rds for high-level financing transac tions, audito rs need to be
especially alert when auditin g such situatio ns.
In conjunction with the audit of liabilities, the audito rs also obtain eviden ce
about the related accoun ts of finance lease expense, interes t expens e,
interes t payable, premiu m (discou nt) amorti zation and balances.

Audit Objectives
When auditin g liabilities, the princip al objective for the substa ntive tests is
to determ ine the following:

979
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~ct ,. •

" sta tem ~n t ;:

.
ea r· o '''i ·; ;1~,(~ ~:: :e~ ntcli:biliti~s on ~~
Chapter 25 - u
Assei:tfon
ts ue
Existence financial pos itio n . are aut hen tic deb
.
cre dit ors of the ent i . the rep ort 1~g
AH liabilities ow ed by the ent ity at
of fin anc ial
Completeness dat e are inc lud ed on the sta tem ent
osition. sta tem ent of
LiabHities are inc lud ed on the
am ou nts .
Valuation and financial osi tio n at the a ro ria te
t of fin anc ial
AJJocation Liabilities rep ort ed in the sta tem en
ity at the
Rig hts and pos itio n rep res ent obl iga tio ns of the ent
Obligations
re ort in dat e.
pro per ly
sen tati on and Lia bilities and rel ate d acc ou nts are
Pre fin anc ial
clo sur e cla ssif ied, des cri bed , and dis clo sed in the
Dis ord anc e wit h
sta tem ent s, inc lud ing not es, in acc
the a lica ble PFRSs.

Au dit Pr oce du res for Lia bil itie s e

ced ure s for lia bil itie s typ ica lly inc lud
Th e aud ito r's pri ma ry sub sta nti ve pro
the following:
1. Reconciling gen era l led ger and
sub sid iar y led ger ;
ts pay abl e cut -of f;
2. Per for mi ng pur cha se and acc oun
3. Co nfi rm ing liab ilit ies to deb tor s;
ent s suc h as con tra cts , inv oic es,
4. Ins pec tin g sup por tin g do cum
rec eiv ing rep ort s, etc.;
;
5. Sea rch ing for unr eco rde d liab ilit ies
ere st exp ens e, int ere st pay abl e,
6. Te stin g the acc ura cy of int um ;
am ort iza tio n of dis cou nt and pre mi
den om ina ted in for eig n cur ren cie s;
7. Eva~uat~ng val uat ion of liab ilit ies
of de bt agr eem ent s·
8. ReVIewmg com pli anc e wit h ter ms ate d
9 - Per for min g analytical rev iew pro ced ure s to lia bil itie s and rel
accounts; and
of
10. E~aluating pro per financial sta
tem ent pre sen tat ion an d ade qua cy
disclosure.
. .
Audit procedures presented in nti this t b ica l aud it
ook me rel y illu str ate typ
procedures (i.e., primary substa ve ext
ma nuf act uri ng ent ities. It is p;o cedu_res) [or au~ its of merchandising
and of
corporation; however, some disc . _a so pnm ar, Jy fides ign ed for. auddits I
. ship businesses. In actual usswn s are ma de . or par tne rsh ip an so e
tor rac .
propne d
to each client's risk and internal con P ti,ce, aud it pro gra msd mu st be tailore . .
tro . The aud it pro ce ure s comprismg
d"t ma y sub sta ntia lly va fr .
pro gra ms
au I
ry om eng age me nt to the ne xt

980
chapter 25 - Substantive Test of Liabilities
Assertions mentioned in this textbook relate to primary assertion addressed by
the audit procedures discussed. However, some other assertions may also be
addressed.

Reconciliation of Subsidi ary Ledger with General Ledger

First step in the audit of accounts payable is to obtain a
copy of the entity's reconciliation of subsidiary ledger and
general ledger. After obtaining the entity's reconciliation
schedule, the auditor should test the clerical accuracy
(e.g., footing, cross-footing) of the schedule. The auditor then should review
the reconciliation prepare d by the entity between the sub-ledger and the
control account (i.e., general ledger), and investigate reconciling items,
particularly any unusual non-standard journal entries.
One purpose of this procedu re is to determine whethe r the liability figure
appearing in the stateme nt of financial position agrees with the individual
items comprising the detailed records. Another purpose is to provide a
starting point for other substantive procedures.

Purchase and Accoun ts Payabl e Cutoff

The primary purpose of cutoff tests for goods and
services received as well as for supplier credit memos is
Existence to verify that transactions are completely recorded in the
Completeness
Obli ation
correct accounting period. In performing cutoff test,
accounts payable and purchase cutoff is normally
conducted jointly in verifying the purchases (inventory) and payables
recorded. The auditor tests the accounts payable cutoff by performing the
following procedures:
1. Obtain and examine invoices from suppliers and other entities and
other documentation supporting transactions recorded in the
purchase journal and cash disbursements journal immediately before
and after the reportin g date. Determine whethe r the transactions
were recorde d in the proper period; and
2. Review cutoffs in related areas such as purchases and inventories,
paying particul ar attentio n to goods in transit.

Kindly refer to Chapter 11: Exhibit 1: Purchase (Inventory/ Accounts Payable

Cut-oft

Confirmation of Liabilit ies to Debtor s

Confirmation of liabilities to debtors is considered to be
less necessary as compared to confirmation of receivables
Existence to customers because the auditors will normally find in
Valuation the client's possession externally created evidence such as
Obli ation
vendor' s invoices and statements that substantiate the
981
 I·
~C~ha~p~t!e~r~25~-JS~u~b~s
t~a~n~ti~ve~T~es~t~o~f~L~ia
~b~il~it~ie::s:___ _ _
___ _ _ _____
liabilities.
Accounts payable
In some cases, how . be ap pr
ever, it ;a y he n op ri at e to re qu es t ve nd or s to
confirm th e balances th e following co nd it
ow ed to d. io n exists:
l. Controls over th em ;v
e re co r mg o en do rs ' invoices an d re ce iv in g report
ar e ineffective; s
2. There ar e few tran .
3. There are numer
sactions involvm g la rg e am ou nt s,. or
ous old balances.
Upon receipt of co
nfirmation replies,
·m for · th e au di t? r sh ou
m at io n confiirme d by th e cr ed it or to ld ag re e the
up an d resolve any di th e ac co un ti ng re co
fferences noted. rd s, an d follow
Notes payable
As co m pa re d to acco
unts payable, no te s .
no te s an d may be gi payable is su pp or te
ven for a variety of re d by promissory
1. Purchase of mer as on s, for ex am pl e:
chandise in th e or di .
2. In se tt le m en t of na ry co ur se of bu si
a long outstanding am ne ss ;
3. In re tu rn for ount;
loans from affiliate
financial institution; s, sh ar eh ol de rs , ba
or nk s o r other
4. To ra is e money
in th e sh or t te rm
paper"). m on ey m ar ke ts ("
commercial
In verifying notes
payable an d re la te d
confirm th e notes obligation, th e au di
payable or review to r m ay either
am ou nt s owed, te su pp or ti ng do cu m
rms, collateral an en ta ti on as to
compliance w it h th d re st ri ct io ns an
e loan provisions an d th e debtor's
an d as se ts pledged d identify liens, se
as loan collateral. cu ri ty interests,
Upon re ce ip t of co
nfirmation replies,
in fo rm at io n confirm th e au di to r sh ou ld
ed by th e cr ed it or to ag re e w it h the
up an d resolve an y th e ac co un ti ng re co
differences noted. rd s, an d follow
Ins ec ti on o f Supp
orting
i:~Prill}a.rY Aqdit , Account Documentations
s Payable
Ob ectives:
'i>'''
, T he au di to rs sh ou ld
j,
Existence vouch en tr ie s in th e
.
Valuatio or · th
m h vo uc he r register
n . . e pu re as e Jo · urnal
Obli ations
mvmces, rece1v .. to su pp or ti·ng vouc
mg re po rt s an d pu hers,
pu rp os e of th is pr rc ha se or de rs . The
am ou nt s ex is t an d to oc ed ur e is to en su
check th e accuracy re th at recorded
of th e am ou nt s re co
Lease lia bility rd ed .
T he au di to rs sh ou ld
examine th e le as e co
de te rm in e w he th er nt ra ct du ri ng th e cu
le as es ar e ap pr op rr en t year to
op er at in g leases. In ri at el y classified
addition, th e au di to as finance or
r sh ou ld de te rm in e
w he th er finance

982
chapter 25 Substantive Test of Liabilities
(capital) lease obligations are appropriately recorded and required
disclosures are made.
Notes Payable _and Other Obligations (Short-term and Long-term)
The auditors should inspect client's copies of loan agreements (e.g.,
promissory note) or other short_-term lending arrangements ( e.g., factoring)
to obtain an understanding of the pertinent provisions, including the
amount of loans authorized, interest rates, due dates, assets pledged, and
restrictions imposed, and to extract information relevant to the disclosures
of notes payable and other obligations in the financial statements. The
auditor should also contact the lender and/or legal counsel for the entity, as
appropriate, with respect to interpretation of loan agreement terms,
restrictions, and any other information that may be sought regarding special
provisions of notes or loan agreements.

Search for Unrecorded Liabilities

As discussed, the major concern in the audit of liabilities
is to ensure that all liabilities are included in the financial
statement. It is important to note that search for
unrecorded liabilities may only be conducted after the
reporting date and the auditor ordinarily performs the following
procedures:
1. Examine files of unpaid or unrecorded invoices, unmatched purchase
orders, and unmatched receiving reports and ·trace it to the related
journal (e.g., purchase journal) to determine it was properly recorded;
2. Examine significant recorded purchases between the reporting date
and the date of search for unrecorded liabilities to determine if this
purchase should be properly included in the current year financial
statement;
3. Obtain and review minutes of meetings and inspect contracts, to
identify unrecorded liabilities such as liabilities on pending litigations;
4. Review cash disbursements subsequent to the reporting date and
check whether this may represent a liability that should be reported
on the current year; and
5. Request the client to make an appropriate adjusting entry for any
unrecorded liability identified by the auditor.

Test the Computation of Interest Expense, Interest Payable, and

Amortization of Discount and Premium
To test the accuracy of interest expense, interest payable
and amortization of discount and premium, the auditor
ordinarily should obtain th~ interest rate (nominal or
effective rate) and recompute ~e amount reported as
interest expense and payable based on the number of months the obligation
is outstanding during the current year. For long-term debts ( e.g., bonds)
983
 Ch ap
~~ ~-ter 25 ~~
=- ~~ Su bs~~
tan::.
~~ tiv e.:.Te
...st.::of::=
Lia.::
bil..:
itie.:.
s :.: :.. =.
initially iss ue d at a dis co un := -- -- -- -- -- -- -- -- -- --
t or pr em ium , th e au di to r
am ou nt by pr ep ari ng an am ~e co ~p u~ es the
or tiz ati on tab le an d co mp
am ou nts rec or de d. Fo r rec ?n ng it wi th the
ur rin g en ga ge me nt, th e au
am or tiz ati on tab le fro m th e pr di to r ma y us e the
io r wo rk in g pa pe r.
Exhibit: Re vi ew of Su bs e ue
nt Cash Di sb ur se m en t
Search for Unrecorded Liab
ilities
Oi shu rsc mc nl Di sbu rse me
nt Da le Re cip ien t
T· c Re fer enc e ne scr ipt ion
Cash JV4515587 1/2 0/2 01 6 BENECO
Ch eck Pa ym en tof uti hty b1 U- Decem
JV4515609 1/4 /20 16 CO PYLANDIA Pu rch ber ·\
Ch eck ase of ma ch ine
JV4515631 1/1 3/2 01 6 HDMF
Ca sh HDMF rem itta nc e
JV4515653 1/1 3/2 01 6 BIR
Ca sh Wi tho ldi ng tax rem itta nc e
JV4515675 1/1 3/2 01 6 TOYOTA
Ca sh Mo nth ly am ort iza tio n - Decem
JV4515697 1/4 /20 16 PLOT ber\
Ch eck Te lep ho ne bil l
JV4515719 1/4 /20 16 PHIC
Ch eck Ph ilh eal th rem itta nc e
JV4515741 1/4 /20 16 NENENG B. Ca
sh ad va nc e
Cont ...

Cash 1/1 0/2 01 6 6,537.00 De cem be r

Ch eck 1/3 /20 16 67,633.00 No Se eN ote l
Ch eck Jan uar y No
12 /30 /20 15 65,436.00 ok
De cem be r Ye s
Ca sh 12 /30 /20 15 124,854.00 ok
De cem be r Yes
Cash 1/3 /20 16 78,932.00 ok
De cem be r Yes
Ca sh 1/3 /20 16 ok
1,9 99 .00 De cem be r
Ch eck 1/4 /20 16 25,667.00 No Se e Note2
De cem be r Yes
Ch eck 1/4 /20 16 ok
5,0 00.00 Jan aw y Yes ok

No te 1: Should be re co rd ed
by December 2015. To be inc
adjusting journal entry. luded in proposed
No te 2: Should be re co rd ed
by December 2015. To be inc
adjusting journal entry. luded in proposed

Liabilities Denominated in Fo
reign Currencies
Some of th e liabilities of an en .
. tit y m ay be denominated in
foreign cu rre nc y as a re su
Valuation
. lt of purchase or \oan
transactio n from a foreig .
n country. As require· d by PAS 21
The Effects of Changes in Fo .
reign Exchange Rates, th es e
monetary liabilities) should payables (~ ;
be tra ns la te d using th e closin
reporting date. The auditor g rate at e·
ordinarily obtains th e closin
performs th e tra ns la tio n of th
e foreign cu rre nc y de no m in at
g ra te aDd
ed payable,
;he

984

j
Chapter 25 - Substantive Test of Liabilities

auditor should also ensure that any foreign currency transaction gain or loss
should be reported as part of profit or loss.

Revie'!_.~o~ -, liance with ~e Terms of Debt Agreements

· The auditor should review the entity's compliance with
terms, restrictive covenants or other provisions of debt
agreements to determine whether a default or violation of
any debt covenant has occurred. If there has been a
default or violation of any debt covenants, the auditor should ensure that
this is properly disclosed in the notes and the item should be appropriately
presented as current liability in the statement of financial position.

Perform Analytical Review Procedures to Liabilities and Related

Accounts
In addition to the audit procedures discussed above, the
following analytical review procedures may often be
Existence helpful as a means of evaluating the overall
Completeness
reasonableness of liabilities and its related accounts (e.g,
Obligations
Valuation interest expense, interest payable, etc.):
1. Comparison of closing ·balances of loans and
borrowings, creditors, etc., with the corresponding figures for the
previous year;
2. Comparison of the relationship between current year accounts
payable balances and the current year purchases with the
corresponding figures for the previous year;
3. Comparison of actual closing balances of loans and borrowings,
creditors, etc., with the corresponding budgeted figures, if available;
4. Comparison of significant ratios relating to loans and borrowings,
creditors, etc., with the similar ratios for other firms in the same
industry, if available;
5. Comparison of significant ratios relating to loans and borrowings,
creditors, etc. with the industry norms, if available.
6. Comparison of the relationship between the current year accounts
payable and the current year total current liabilities with the
corresponding figures for the previous year;
7. Comparison of the relationship between the current year purchase
discount and the current year total purchases with the corresponding
figures for the previous year;
8. Comparison of the current year interest expense to the product of
interest expense and average principal of debt outstanding; and
9. Comparison of current year finance lease expense with the
corresponding figures for the previous year.

985
 •
Chapter 25 - Substantiv. ,e st of Liabi\ities
e
. . h uld investigate an
After perform ing som e com panson, th e auditor s o y
ct d changes or th e absence of expe ect d
significant differences,
unexpe e
changes. .
lt may be clarified that the ·llustrative list of analytic
foreg.oing is o :~ ;, :; in ca al
review procedures which an rrying out an ~udi~ of
aud1tortimarreview proced
liabilities. The exact nature ures to be applied m a
specific situation is a matterof an a! f c.a al judgment of the auditor.
of pro1ess10n
Evaluate Proper Financ
ial Statement Presentation and Adequacy of
Disclosure of Debt and R
Prim
elated Transacti_ons
ary Audlt The auditor should re financial st at em en t
, Oblectlves: presentation of liabilitie view proper
Presentation s (e.g., current vs. no -current
trade vs. non-trade). Th n '
e auditor should ensu
and disclosure debit balance of acco re ~a~ .a~y
(either due overpaymen unts payable or othe
t to suppliers, errors or r hab1ht1es
appropriately presented irregularities) sh~uld
as non-trade receivable .be
entry in the audit worki th rough a reclass1ficat1o
ng papers. n
The auditor should sa
tisfy himself/herself th
disclosed properly in at the liabilities have
the financial statemen be en
guaranteed by third pa ts. In some cases loan
rties in whose favor th s are
charged. The auditor sh e assets of the entity
ould examine whether ar e
such loans are approp the disclosures concer
riate, e.g., they may be ni ng
disclosure of the fact th classified as secured
at the assets of the entit w ith
of third parties which, y have be en charged in
in turn, have given guar favor
loans have been obtain antees to parties from
ed whom
For contingent liability,
been disclosed: the auditor should exam
ine th at th e following
have
1. Brief description of
the nature of each cont
2. Estimate of the fin ingent liability;
ancial effect or a stat
cannot be made; ement th at such estim
ate
3. Uncertainties whi
4· Possib ch may affect th
ility of any reimbursem e future outcome· an d
ent. '
Add\tiona\ Aud\t Consid
er
Accruals. Accruals occu ations
current nenod b r h h .
. w ere t
.,. ut
invoice) are not avail not yet paid eNoexpend 11
iture has be en incurr
ed in th e
able .
books. Since the supp rt at h . . rma y, sup_porting documents
rdmg of th e accrual (e.g.,
i d t e time of reco
audit procedures shou~d in the
bng bocuments are not
1. Considering the
. ye t avai lable, th e following
2
. Obtaining a schecdu 1ienet'os ow
served by the auditor:
n t
le f sys em (.l f ~ny) for capt
comparing it with pri~r a: uring accruals;
cruals: ensurmg th at it
procedures; is ca-st correctly, and
y ar accruals and perfor
ming other analytical
986
 Chapter 25 - Substan tive Test of Liabilitie s
3. Test checking a sample of accruals for correct calculation: referring to
supporting invoices in the next period; and
4. Agree accruals to payments after year end.
Litigation and claims. Litigations and claims may have a major impact in
the financial stateme nts of a company; thus, it should be properl y accounted
for and disclosed. PSA 501 (Redrafted) requires that auditor s should carry
out procedures to become aware of material litigation or claims involving
the entity. Audit procedures directed to litigations and claims include:
1. Inquiry of management and others within the entity, including, where
applicable, in-house legal counsel;
2. Review of minutes of meetings of those charged with governance and
correspondence with the entity's external legal counsel;
3. Examine legal expense accounts and examining related source
documents such as invoices for legal expenses; and
4. Use any information obtained regarding the entity's business
irlcluding information obtained from discussions with any in-house
legal department.
Contingencies. Contingencies may be assets in the case of gains, or
liabilities·in the case of losses. PAS 37 requires that contingent liabilities be
disclosed while contingent asset need not be disclosed if the possibility of
gain is possible. When auditing contingencies, the auditor must review the
client's records and financial stateme nts for proper disclosure of
contingencies. The auditor is more concerned with the contingent liability
Ooss) because manage ment may not wish to disclose them. For contingent
assets (gain), the auditor should also check for prematu re recording of the
gain. An example of a contingent gain that might be recorde d prematu rely
would be recording the proceeds from a lawsuit the client has anticipated
winning before the lawsuit is resolved.
Early Retirement or Restructuring of Debt. The auditor should review an
early retirem ent of debt or a restruct uring of debt to determi ne whethe r a
gain or -loss on the transact ion should be recognized, and if so, that it has
been appropriately calculated, accounted for, and disclosed in accordance
with the applicable PFRSs.
Subsequent Events. The auditor should review refinancing agreements and
liability transactions subsequ ent to the reportin g date to determi ne their
effects on stateme nt of financial position classification or on disclosure.

. . n

xistence - ✓ Performing purchase and accounts payable

cut-off.
✓ Confirmin liabilities to debtors.
987

lf>ts
Cha pter 25 - Sub stan tive Test of Liab ilitie s

✓ Insp ectin g supp ortin g docu men ts such

cont racts , invoices, rece ivin g repo rts, etc.
as
✓ Perf orm ing anal ytica l revi ew proc edur es to
liabi litie s and rela ted acco unts .
Com plete ness ✓ Reconciling gene ral ledg er and subs idia ry
ledg er.
✓ Perf orm ing purc hase and acco unts payable
cut-off.
✓ Sear chin g for unre cord ed liabilities.
✓ Perf orm ing analytical revi ew proc edur es to
liabilities and rela ted acco unts .
Valu atio n and ✓ Reconciling gene ral ledg er and subs idiar y
Allo catio n ledg er.
✓ Confirming liabilities to debt ors.
✓ Insp ectin g supp ortin g docu men ts such as
cont ract s, invoices, rece ivin g repo rts, etc.
✓ Test ing the accu racy of inte rest expense,
inte rest paya ble, amo rtiza tion of disc ount and
prem ium .
✓ Eva luati ng valu ation of liabilities
deno min ated in foreign curr enci es. '
✓ Perf orm ing anal ytica l revi ew proc edur es to \
liabi litie s and rela ted acco unts .
Righ ts and ✓ Perf orm ing purc hase and acco unts payable
Obli gati ons cut-off.
✓ Con firm ing liabilities to debt ors.
✓ Insp ectin g supp ortin g docu men ts such as
cont ract s, invoices, rece ivin g repo rts, etc.
✓ Sear chin g for unre cord ed liabilities.
✓ Perf orm ing anal ytica l revi ew proc edur es to
liabi litie s and rela ted acco unts . -
Pres enta tion and ✓ Reviewing com plian ce with term s of debt
Disc losu re agre eme nts.
✓ Eval uatin g prop er financial statement
pres enta tion and adeq uacy of disclosure.