CHAPTER 25

SUBSTANTIVE TEST OF
LIABILITIES

TOPIC OVERVIEW:

This chapter discusses the audit of liabilities, its objectives, and

procedures as well as the management assertions relating to
liabilities.
LEARNING OBJECTIVES:

After studying this chapter, you should be able to:

1. Identify the audit objectives for liabilities and related accounts.
2. Explain the primary substantive audit procedures for liabilities and
related accounts.
3. Identify assertions addressed by audit procedures for liabilities and
related accounts.
INTRODUCTION

Liabilities:
1. are obligations of an enterprise other than owner's funds;
2. generally constitute a significant proportion of the total sources of
funds of an entity and may be classified as current or non-current and
financial or non-financial.

An important feature of liabilities which have 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.
o When auditing liabilities, the objective of the auditor would be
the same, regardless of the classification of the liability. The focus
when testing liabilities is to check for understatement (that is, the
completeness assertion) as well as omissions of disclosure, since
material omission or misstatement of liabilities vitiates the fairness
of the financial statements.

o Another area of concern in auditing liabilities is off-balance-sheet

financing: commitments, guarantees, and other potential
obligations not recorded on the SFP. Because of the evolving,
complex nature of accounting standards for high-level financing
transactions, auditors need to be especially alert when auditing
such situations.
o Audit Objectives
When auditing liabilities, the principal objective for the substantive
tests is to determine the following:

Assertion Category Account Balances Audit Objectives

Existence All recorded liabilities on the SFP are authentic

debts due to creditors of the entity.
Completeness All liabilities owned by the entity at the
reporting date are included on the SFP.
Valuation and Liabilities reported in the SFP represent
Allocation obligations of the entity at the reporting date
 Assertion Category Account Balances Audit Objectives

Rights and Obligations Liabilities reported in the SFP represent

obligations of the entity at the reporting date
Presentation and Liabilities and related accounts are properly
Disclosures classified, described, and disclosed in the
financial statements , including notes, in
accordance with the applicable PFRSs.

Audit Procedures for Liabilities

The auditor's primary substantive procedures for liabilities

typically include the following:
o Audit Procedures for Liabilities

1. Reconciling general ledger and subsidiary ledger;

2. Performing purchase and accounts payable cut-off;
3. Confirming liabilities to debtors;
4. Inspecting supporting documents such as contracts, invoices,
receiving reports, etc.;
5. Searching for unrecorded liabilities;
6. Testing the accuracy of interest expense, interest payable
amortization of discount and premium;
7. Evaluating valuation of liabilities denominated in foreign
currencies;
8. Reviewing compliance with terms of debt agreements;
9. Performing analytical review procedures to liabilities and
related accounts; and
10. Evaluating proper financial statement presentation and
adequacy of disclosure.
o Reconciliation of Subsidiary Ledger (SL) with General Ledger
(GL)

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 prepared 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 procedure is to determine whether the
liability figure appearing in the SFP agrees with the individual
items comprising the detailed records. Another purpose is to
provide a starting point for other substantive procedures.

 However, since most companies nowadays uses automated

accounting system, GL-SL reconciliation is no longer
performed. The auditor will instead reconcile the balance in
the GL against the trial balance as of the reporting date.
o Purchase and Accounts Payable Cutoff

The primary purpose of cutoff tests for goods and services

received as well as for supplier credit memos is to verify that
transactions are completely recorded in the correct accounting
period.

In performing cutoff test, accounts payable and purchase cutoff

is normally conducted jointly in verifying the purchases
(inventory) and payables recorded.
o 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 reporting date.
2. Determine whether the transactions were recorded in the
proper period; and
3. Review cutoffs in related areas such as purchases and
inventories, paying particular attention to goods in transit.
o Confirmation of Liabilities to Debtors

Confirmation of liabilities to debtors is considered to be less

necessary as compared to confirmation of receivables to
customers because the auditors will normally find in the client's
possession externally created evidence such as vendor's invoices
and statements that substantiate the liabilities.
Accounts payable

In some cases, however, it may be appropriate to request

vendors to confirm the balances owed to them when the
following condition exists:
1. Controls over the recording of vendors' invoices and receiving
reports to
are ineffective;
2. There are few transactions involving large amounts; or
3. There are numerous old balances.
Upon receipt of confirmation replies, the auditor should agree
the information confirmed by the creditor to the accounting
records, and follow up and resolve any differences noted.

Notes payable

As compared to accounts payable, notes payable is supported

by promissory notes and may be given for a variety of reasons,
for example:
1. Purchase of merchandise in the ordinary course of business;
2. In settlement of a long outstanding amount;
In verifying notes payable and related obligation, the auditor
may either confirm the notes payable or review supporting
documentation as to amounts owed, terms, collateral and
restrictions and the debtor's compliance with the loan provisions
and identify liens, security interests and assets pledged as loan
collateral.

Upon receipt of confirmation replies, the auditor should agree

with the information confirmed by the creditor to the
accounting records and follow up and resolve any differences
noted.
Inspection of Supporting Documentations

Accounts Payable

The auditors should vouch entries in the voucher register or in

the purchase journal to supporting vouchers, invoices, receiving
reports and purchase orders. The purpose of this procedure is to
ensure that recorded amounts exist and to check the accuracy of
the amounts recorded.
Lease liability

For continuing engagement, the auditor shall inquire with the

management for new contract or revisions in existing lease
contract.

The auditors should next examine the lease contract to

determine whether the contract is a lease or contains a lease
component as prescribed under PFRS 16 Leases. This
consideration shall include:
-Whether the contract identifies, implicitly or explicitly, an asset
(or physically distinct portion of an asset);
-Whether the contract identifies, implicitly or explicitly, an asset
(or physically distinct portion of an asset);
-Whether the entity has the right to obtain economic benefits of
the asset; and
-Whether the entity the right to direct the use of the asset.
For lease contracts entered during the year, the auditor shall test
the initial measurement of the lease liability by obtaining and
examining the documentation of the following:

-Lease payments
-Lease incentives, if any
-Lease term
-Determination of the discount rate used.
-Estimation of any guaranteed residual value
-Exercise price of purchase options and termination penalties
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 of 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 the interest rate (nominal effective rate) and
recompute the 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) initially issued at a discount or
premium, the auditor recomputes the amount by preparing
an amortization table and comparing it with the amounts
recorded.

For recurring engagement, the auditor may use the amortization

table from the prior working paper.
Liabilities Denominated in Foreign Currencies

• Some of the liabilities of an entity may be denominated in foreign

currency because of purchase or loan transaction from a foreign
country.

• As required by PAS 21 The Effects of Changes in Foreign Exchange

Rates, these payables (i.e., monetary liabilities) should be translated
using the closing rate at the reporting date.

• The auditor ordinarily obtains the closing rate and re-performs the
translation of the foreign currency denominated payable. The auditor
should also ensure that any foreign currency transaction gain or loss
should be reported as part of profit or loss.
Review Compliance with the 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
SFP.
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 helpful as a means of
evaluating the overall reasonableness of liabilities and its related
accounts (e.g., 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;
Evaluate Proper Financial Statement Presentation and Adequacy of Disclosure of
Debt and Related Transactions

The auditor should review proper financial statement presentation of

liabilities (e.g., current vs. non-current, trade vs. non-trade).

The auditor should ensure that any debit balance of accounts payable or
other liabilities (either due overpayment to suppliers, errors or
irregularities) should be appropriately presented as non-trade receivable
through a reclassification entry in the audit working papers.
The auditor should satisfy himself/herself that the liabilities have been
disclosed properly in the financial statements.
In some cases loans are guaranteed by third parties in whose favor the
assets of the entity are charged.
The auditor should examine whether the disclosures concerning such
loans are appropriate, e.g., they may be classified as secured with
disclosure of the fact that the assets of the entity have been charged in
favor of third parties which, in turn, have given guarantees to parties from
whom loans have been obtained
For contingent liability, the auditor should examine that the following
have been disclosed:
1. Brief description of the nature of each contingent liability;
2. Estimate of the financial effect or a statement that such estimate
cannot be made;
3. Uncertainties which may affect the future outcome; and
4. Possibility of any reimbursement.
Additional Audit Considerations
Accruals.
Accruals occur where the expenditure has been incurred in the current
period but not yet paid.
Normally, supporting documents (eg, invoice) are not available at the
time of recording of the accrual in the books. Since the supporting
documents are not yet available, the following audit procedures should
be observed by the auditor:

1. Considering the client's own system (if any) for capturing accruals;
2. Obtaining a schedule of accruals: ensuring that it is cast correctly, and
comparing it with prior year accruals and performing other analytical
procedures;
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
statements of a company; thus, it should be properly accounted for and
disclosed.
PSA 501 (Redrafted) requires that auditors 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 including
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 statements for proper disclosure of contingencies.
The auditor is more concerned with the contingent liability
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 statements for proper disclosure of contingencies. The
auditor is more concerned with the contingent liability (loss) because
management may not wish to disclose them. For contingent assets (gain),
the auditor should also check for premature recording of the gain.
An example of a contingent gain that might be recorded prematurely
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 retirement of debt or a restructuring of

debt to determine whether a gain or loss on the transaction 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 subsequent to the reporting date to determine their effects
on SFP classification or on disclosure.
Summary of audit procedures classified per assertion

Assertion Category Primary audit procedures

Existence  Performing purchase and accounts payable cut-
off.
 Confirming liabilities to debtors.
 Inspecting supporting documents such as
contracts, invoices, receiving reports, etc.
 Performing analytical review procedures to
liabilities and related accounts.
Completeness  Reconciling general ledger and subsidiary ledger
 Performing purchase and accounts payable cut-off.
 Searching for unrecorded liabilities.
 Performing analytical review procedures to
 Assertion Category Primary audit procedures

Valuation and Allocation  Reconciling general ledger and subsidiary ledger

 Confirming liabilities to debtors.
 Inspecting supporting documents such as contracts,
invoices, receiving reports, etc.
 Testing the accuracy of interest expense, interest payable,
amortization of discount and premium.
 Evaluating valuation of liabilities denominated in foreign
currencies.
 Performing analytical review procedures to liabilities and
related accounts
Rights and Obligations  Performing purchase and accounts payable cut-off
 Confirming liabilities to debtors
 Inspecting supporting documents such as contracts, invoices,
receiving reports, etc
 Searching for unrecorded liabilities
 Performing analytical review procedures to liabilities and
related accounts.
 Assertion Category Primary audit procedures
Presentation and  Reviewing compliance with terms of
Disclosure debt agreements
 Evaluating proper financial statement
presentation and adequacy of
disclosures.