Audit - Ch. 14 - Accounts Payable and Other Liabilities
Vendors' Statements
received monthly, should be reconciled promptly with the accounts payable ledger or list of open vouchers, and any discrepancies fully investigated. In some industries, it is common practice to make advances to vendors, which are recovered by making percentage deductions from invoices. When such advances are in use, the auditors should ascertain that procedures are followed to assure that deductions from the invoices are made in accordance with the agreement.
Accrued Liabilities
(sometimes called accrued expenses) generally accumulate over time, and management must make accounting estimates of the year-end liability. Such estimates are often necessary for salaries, pensions, interest, rent, taxes, and similar items.
Examples of Tests of Controls for A/P
1) Verify a sample of postings to the accounts payable control account. 2) Vouch to supporting documents a sample of postings in selected accounts of the accounts payable subsidiary ledger. 3) Test IT application controls.
Examples of test of controls continued:
1) Verify a Sample of Postings to the Accounts Payable Control Account: -------The validity of the amount in the general ledger control account for accounts payable is established by tracing postings to the voucher register and cash disbursements journal. This work is performed before the balance sheet date as part of a general test of postings to all records. 2) Vouch to Supporting Documents a Sample of Postings in Selected Accounts of the A/P Subsidiary Ledger. -------Testing the voucher register or the accounts payable ledgers by vouching 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 operating effectiveness of certain controls. If the functions of purchasing, receiving, invoice verification, and cash disbursement are delegated to separate departments and controls appear adequate, the vouching of individual items from the ledgers to the original records may provide the auditors with sufficient evidence to assess control risk for certain assertions (e.g., existence) related to accounts payable as being at a low level. ------The auditors also may perform tests by following the audit trail in the opposite direction. By tracing a representative sample of entries from the source documents to the accounts payable ledger, the auditors can verify that accounts payable are completely and accurately recorded on a timely basis. 3) Test IT Application Controls
Examples of Substantive Procedures for A/P
-Obtain or prepare a trial balance of accounts payable as of the balance sheet date and reconcile with the general ledger. -Vouch balances payable to selected creditors by inspection of supporting documents. -Reconcile liabilities with monthly statements from creditors. -Confirm accounts payable by direct correspondence with vendors. -Perform analytical procedures for accounts payable and related accounts. -Search for unrecorded accounts payable. -Perform procedures to identify accounts payable to related parties. -Evaluate proper balance sheet presentation and disclosure of accounts payable.
Assess the RMM and design further audit procedures:
Based on their understanding of the client and its environment, including internal control over accounts payable, the auditors develop their planned assessed levels of the risks of material misstatement for the assertions about accounts payable. To support these assessments, the auditors may need to obtain additional evidence of the operating effectiveness of various controls. This evidence is obtained by performing tests of controls. In designing these tests, the auditors should decide which ones will result in sufficient reductions in substantive procedures to justify the time spent performing them. The auditors' assessment of control risk, along with their assessment of inherent risk, will be used to plan the nature, timing, and extent of substantive procedures for accounts payable.
Audit procedures for detecting understated liabilities differ from those used to detect overstated assets. Overstating an asset account usually requires an *improper entry in the accounting records*, as by the recording of a fictitious transaction. Such an improper entry can be detected by the auditors through verification of the individual entries making up the balance of an asset account.
By way of contrast, *understating a liability account is generally possible merely by failing to make an entry for a transaction creating a liability. The omission of an entry is less susceptible to detection than is a fictitious entry.* If the omission is detected, it is much easier to pass it off as an accidental error. Auditors have long recognized that the most difficult type of fraud to detect is one based on the nonrecording of transactions.
Purchase Requistion
Document generated by a user department or storeroom-personnel to notify the purchasing department of items it needs to order, their quantity, and the timeframe
Internal Control over A/P
In thinking about internal control over 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 because the client's creditors will generally maintain complete records of their receivables and will inform the client if payment is not received* The self-interest of creditors constitutes an effective control in accounting for payables that is not present in the case of accounts receivable.
Audit Documentation for A/P
The principal working papers are a lead schedule for accounts payable, trial balances of the various types of accounts payable at the balance sheet date, and confirmation requests for accounts payable. The trial balances are often in the form of copies of client electronic files. In addition, the auditors may prepare a listing of unrecorded accounts payable discovered during the course of the audit, as illustrated later in Figure 14.6. The auditors also will document the controls and risk assessments for accounts payable.
Accounts Payable
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.* Invoices and statements from suppliers usually support accounts payable arising from the purchase of goods or services and most other liabilities
Auditors Primary concern with auditing A/P In the audit of liabilities, the auditors are primarily concerned with the possibility of *understatement*, or omission, of liabilities. An understatement of liabilities will exaggerate the financial strength of a company and conceal fraud just as effectively as an overstatement of assets.
Furthermore, *the understatement of liabilities is usually accompanied by the understatement of expenses and an overstatement of net income*. For example, delaying the recording of bills for December operating expenses until January overstates income while understating accounts payable. Therefore, audit procedures for liabilities should have as a primary objective the determination of the completeness of recorded payables.
Obtain an understanding of internal control over A/P: One approach used by auditors in becoming familiar with a client's internal control over 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.
After the auditors have prepared a flowchart (or other description) of internal control, *they determine whether the client is actually using the controls described to them; that is, they determine whether the controls have been implemented. The auditors will typically perform a walk-through of several purchase transactions and observe the implementation of the various controls.* **As the auditors verify their understanding of internal control, they will *observe and inquire about the segregation of duties for purchases and cash disbursements.* They also will inspect the various documents and reconciliations that are important to the client's internal control over accounts payable. ---For example, the reconciliations of monthly statements from vendors to the payables ledger will be inspected. Budgets for cash disbursements will be inspected and the auditors will review the evidence of the follow-up on variances from budgeted amounts of disbursements. These procedures may serve as tests of controls
4. Confirm Accounts Payable by Direct Correspondence with Vendors. Although confirmation of accounts payable is a widely used procedure, it is generally considered less necessary than is the confirmation of accounts receivable. One reason is that for accounts payable the auditors will find in the client's possession externally created evidence such as vendors' invoices and statements that substantiate the accounts payable. Generally only limited external evidence (e.g., the customer's purchase order) is on hand to support accounts receivable.
Another reason for the difference in significance attached to confirmation of accounts payable is that the greatest risk in the audit of liabilities is the possibility of unrecorded amounts. While confirmation can provide evidence about completeness, it is a more effective procedure for establishing existence and valuation of an item. To make the confirmation procedure more effective at addressing the completeness of accounts payable, the auditors will often use a blank form, as illustrated by Figure 14.5. This form asks the vendor to fill in the amount of the liability rather than to confirm a recorded amount. **Also, accounts payable confirmation requests should be sent 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 to suppliers whose accounts show zero balances). Other accounts that often are confirmed by the auditors include those for which monthly statements are not available, accounts reflecting unusual transactions, accounts with parent or subsidiary corporations, and accounts secured by pledged assets.
Use the Understanding of the Client and Its Environment to Consider Inherent Risks, Including Fraud Risks, Related to A/P: After they obtain an understanding of the client and its environment, the auditors are in a position to identify and assess inherent risks of accounts payable. Many of these risks arise from business risks faced by management, such as the risk of payment of unauthorized payables, and the failure to capture all accounts payable for financial reporting purposes.
If any of the inherent risks identified by the auditors are related to fraud, the auditors will make certain that they understand the programs and controls established by management to control the risk. They also will determine that the controls have been implemented. Finally, the auditors will design appropriate responses to these fraud risks and all other risks of material misstatement.
The auditors' objectives in the audit of accounts payable are to:
1) Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to accounts payable. 2) Obtain an understanding of internal control over accounts payable. 3) Assess the risks of material misstatement and design tests of controls and substantive procedures that: a) Substantiate the existence of accounts payable and the client's obligation to pay these liabilities, and establish the occurrence of purchase transactions. b) Establish the completeness of recorded accounts payable. c) Verify the cutoff of purchase transactions. d) Establish the proper valuation of accounts payable and the accuracy of purchase transactions. e) Determine that the presentation and disclosure of information about accounts payable are appropriate.
2. Vouch Balances Payable to Selected Creditors by Inspection of Supporting Documents.
*In situations in which there is a risk of inaccurate recording of transactions, the auditors should consider vouching selected creditors' balances to supporting vouchers, invoices, purchase orders, and receiving reports.* For companies that use a voucher system, the verification of the individual vouchers is made most conveniently at the balance sheet date, when the vouchers will be together in the unpaid voucher file. The content of the unpaid voucher file changes daily; as vouchers are paid, they are removed from the file and filed alphabetically by vendor. Consequently, it is important that the client maintain a list of year-end unpaid vouchers. *This listing should show the names of vendors, voucher numbers, dates, and amounts. Electronic systems may be able to allow generation of these data at any point.*
3. Reconcile Liabilities with Monthly Statements from Creditors.
If the client's staff has not reconciled vendors' statements and accounts payable, the auditors may do so on a selected basis. *When the risk of material misstatement for accounts payable is high, the auditors may control incoming mail to assure that all vendors' statements received by the client are made available to the auditors.* Among the discrepancies often revealed by reconciliation of vendors' statements are charges by the vendor for shipments not yet received or recorded by the client. Although conceptually all goods on which title has passed should be included in inventory (thus items shipped FOB [free on board] shipping point as of year-end and not yet received should be included), normal accounting procedures often do not provide for recording invoices as liabilities until the merchandise has been received. In-transit shipments on which title has passed should be listed and a decision reached as to whether they are sufficiently material to warrant year-end adjustment.
*An assessment of low control risk for accounts payable often means that the auditors have found that serially numbered receiving reports are prepared promptly by the client for all goods received, that serially numbered vouchers are prepared and recorded in the voucher register, and that payments are made promptly on the due dates and immediately recorded in the cash payments journal and accounts payable subsidiary ledger.* Finally, at the end of each month, an employee who does not participate in processing accounts payable compares the individual accounts in the accounts payable subsidiary ledger with vendors' statements and also compares the total of the subsidiary record with the general ledger control account. This strong internal control would enable the auditors to minimize substantive procedures for accounts payable.
On the other hand, an assessment of high control risk for accounts payable often means that the auditors have found that the subsidiary record of accounts payable is not in agreement with the general ledger control account, that receiving reports and vouchers are used haphazardly, that purchase transactions often are not recorded until payment is made, and that many accounts payable are long past due. In this situation, the auditors should undertake extensive substantive work if they are to determine that the balance sheet amount for accounts payable includes all liabilities in existence at the balance sheet date
SUBSTANTIVE PROCEDURES FOR A/P 1. 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 determine that the liability figure appearing in the balance sheet is in agreement with the individual items comprising the detailed records. A second purpose is to provide a starting point for substantive procedures. The auditors will use the list of vouchers or accounts payable to select a representative group of items for careful examination.
The client company usually furnishes the auditors with a year-end trial balance. The auditors should verify the footing and the accuracy of individual amounts in the trial balance, generally using an electronic spreadsheet. If the schedule of individual items does not agree in total with the control account, the cause of the discrepancy should be investigated. In most situations, the auditors will arrange for the client's staff to locate such errors and make the necessary adjustments. Agreement of the control account and the list of individual account balances is not absolute proof of the total indebtedness; invoices received near the close of the period may not be reflected in either the control account or the subsidiary records, and other similar errors may exist without causing the accounts to be out of balance.
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 (either physically or electronically) to stores, receiving, and the accounts payable department. The copy sent to receiving is generally "blind" in that the quantities are not included in order to encourage counting of quantities by the receiving department. But the fact that a vendor's packing slip (with quantities) is almost always included when goods are received may decrease the effectiveness of this control.
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. ** Vouchers and other documents originating within the department can be controlled through the use of serial numbers. **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 fraud
