Chapter 14 Accounts Payable and Other Liabilities McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Sources of Accounts Payable Short-term obligations arising from purchase of goods and services in ordinary course of business; examples: Acquisition of merchandise on credit Receipt of services such as advertising, repairs Invoices and statements from suppliers usually evidence accounts payable Interest-bearing obligations are not included in accounts payable; they are included as bonds, notes, etc. 14-2

Sources of Accrued Liabilities Sometimes called accrued expenses Examples: Salaries, interest, rent Accumulate over time and management must make accounting estimate at year-end. Note that if management does not make such an estimate, no entry will occur since the related transactions (e.g., interest) may have occurred months ago 14-3

Objectives for the Audit Accounts Payable and Purchases Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to accounts payable. Obtain an understanding of internal control over accounts payable. Assess the risks of material misstatement and design tests of controls and substantive procedures that: Substantiate the existence of accounts payable and the client’s obligation to pay these liabilities and establish the occurrence of purchase transactions Establish the completeness of recorded accounts payable Verify the cutoff of transactions affecting accounts payable Establish the proper valuation of accounts payable and the accuracy of purchase transactions Determine that the presentation and disclosure of accounts payable are appropriate 14-4 5 5 5

Primary concern Possibility of understatement or omission of liabilities Exaggerates the financial strength of company Conceals fraud as effectively as overstatement of assets Accompanied by understatement of expenses and overstatement of net income 14-5

Controls Over the Acquisition Cycle Segregation of duties--purchases and disbursements Approval of purchase orders Numerical control of purchase orders and receiving reports Matching of details of vendors’ invoices to purchase orders and receiving documents Approval of vendors’ invoices Pre-numbered checks Reconciliation of details of individual disbursements to controlling accounts Reconciliation of vendors’ statements to accounts Reconciliation of bank accounts Use of budgets and analysis of variances Use of chart of accounts and review of account coding 14-6 2 2 2

Acquisition Cycle--Documents Purchase order Receiving report Vendor’s invoice Vendor’s statement 14-7 3 3 3

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Audit Documentation Working papers Lead schedule for accounts payable Trial balances of various types of accounts payable Confirmation requests for accounts payable Listing of unrecorded accounts payable 14-9

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Risks of Material Misstatement Controls against misstatements Auditors found serially numbered receiving reports are prepared Serially numbered vouchers are prepared Payments made promptly on due dates Immediately recorded in accounting records Independent employee reconciles subledger to general ledger 14-11

Risks of Material Misstatement Risks of misstatements Subsidiary records not in agreement with general ledger Receiving reports and vouchers used haphazardly Purchase transactions often not recorded until payment is made Many accounts payable long past due Risks such as these indicate the need for extensive substantive procedures 14-12

Accounts Payable Audit Steps (1 of 4) A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to accounts payable. B. Obtain an understanding of internal control over accounts payable. C. Assess the risks of material misstatement and design further audit procedures. 14-13

Accounts Payable Audit Steps (2 of 4) D. Perform further audit procedures—tests of controls. 1. Examples of tests of controls. a. Verify a sample of postings to the accounts payable control account. b. Vouch to supporting documents a sample of postings in selected accounts of the accounts payable subsidiary ledger. c. Test IT application controls. d. If necessary, revise the risks of material misstatement based on the results of tests of controls. 14-14

Accounts Payable Audit Steps (3 of 4) E. Perform further audit procedures—substantive procedures for accounts payable. 1. Obtain or prepare a trial balance of accounts payable as of the balance sheet date and reconcile with the general ledger. 2. Vouch balances payable to selected creditors by inspection of supporting documents. 3. Reconcile liabilities with monthly statements from creditors. 4. Confirm accounts payable by direct correspondence with vendors. 14-15

Accounts Payable Audit Steps (4 of 4) E. Substantive procedures (continued) 5.Perform analytical procedures for accounts payable and related accounts. 6. Search for unrecorded accounts payable. 7. Perform procedures to identify accounts payable to related parties. 8. Evaluate proper balance sheet presentation and disclosure of accounts payable. 14-16

Summary of Substantive Tests of Accounts Payable 14-17 6 6 6

Contrasting Confirmation of Accounts Payable and Accounts Receivable Accounts Payable Accounts Receivable Primary Audit Completeness Existence Objective Other Evidence External evidence Internal evidence Available held by client (i.e.., (i.e., sales invoices, vendors’ invoices receiving reports) and statements) Confirmation Generally No Yes Required? 14-18 7 7 7

Search for Unrecorded A/P Be alert during reconciliations, confirmations and analytical procedures for unrecorded liabilities Examine transactions recorded following year-end Compare cash payments after year-end to a/p trial balance Examine cash disbursements over specific dollar amounts during subsequent period 14-19

Potential Sources of Unrecorded A/P Unmatched invoices and unbilled receiving reports Vouchers payable entered in the voucher register subsequent to balance sheet date Invoices received after balance sheet date Consignments in which client acts as a consignee 14-20

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Adjusting entry needed? Misstatements and omissions are judged based on impact on the financial statements Materiality Effect on net income Need to consider cumulative effect on the financial statements 14-22

Amounts withheld from employees’ pay Income taxes withheld from employees’ pay but not remitted as of balance sheet date Trace amounts withheld to payroll summary sheets Test computations of taxes withheld and accrued Determine that taxes have been deposited in accordance with law 14-23

Sales Tax Payable Required to collect sales tax imposed by state and local governments Not an expense, just collecting agent Liabilities until remitted Verify liability by reviewing tax return Test reasonableness of amount Test invoices for correct tax charge 14-24

Unclaimed wages Subject to misappropriation Concerned with adequacy of internal control Should not be left for more than a few day Prompt deposit in special bank account Analyze unclaimed wages to determine Credit represents all unclaimed wages after each payroll distribution Debits represent authorized payments 14-25

Customers’ Deposits Deposits on returnable containers or to guarantee payment of bills Review procedures followed in accepting and returning deposits Verify list of individual deposits and compare to general ledger account Generally do not confirm 14-26

Accrued Liabilities (1 of 3) Obligations payable sometime during the succeeding period for services or privileges received before balance sheet date Examples: Interest payable, accrued property taxes Accounting estimates Review and test management’s process of developing the estimate Review subsequent events Independently develop estimate to compare 14-27

Accrued Liabilities (2 of 3) Basic audit steps 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 underlie 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). 7. For significant estimates, perform a retrospective analysis of the prior year’s estimates for evidence of management bias. 14-28

Accrued Liabilities (3 of 3) Accrued Property Taxes Accrued Payrolls Pension Plan Accruals Postemployment Benefits other than Pensions Accrued Vacation Pay Product Warranty Liabilities Accrued Commission and Bonuses Income Tax Payable Accrued Professional Fees 14-29

Presentation Current liability Long-term liability Accrued expenses Deferred income tax for next year Deferred credits for rent Deposits on contracts Long-term liability Deferred income tax - noncurrent 14-30

Time of Examination Most effective when performed immediately after the balance sheet date Little value if done before because concern with understatements Some can be done at interim: Accrued property taxes Amounts withheld from employees’ pay 14-31