In general terms, liabilities refer to obligations that result from past transactions to pay for assets or rendering of services. Liabilities can be classified into two major groups as follows:
- Current liabilities – liabilities or debts that are payable within a short period of time, usually, within one year;
- Long-term liabilities – liabilities that are payable within a long period of time, usually, more than one year. Auditing procedures relative to liability verification require attention. This unit will, therefore, consider the following topics:
(i) Balance sheet grouping of liabilities;
(ii) Objectives of liability verification;
(iii) Comparing what the auditor looks for in the verification of assets and liabilities;
(iv) Audit programme for liabilities.
At the end of this unit, you should be able to: outline the classification of liabilities in the balance sheet state the objectives of liability verification differentiate the concern of the auditor in liability verification from what he looks for in the audit of assets enumerate the audit programme for liabilities.
3.0 MAIN CONTENT
3.1 Balance Sheet Grouping of Liabilities
A balance sheet will contain many liabilities grouped under various headings. The headings are as follows.
- Share Capital;
- Creditors (long-term): amounts falling due after more than one year. Examples are the followings: (i) Debenture loans(ii) Bank loans and overdrafts;(iii) Payments received on account; (iv) Trade creditors; (v) Bills of exchange payable; (vi) Amounts owed to group companies; (vii) Amounts owed to related companies; – Other credits including taxation – Accruals and deferred income
- Provision for liabilities and charges such as: (i) pension and similar obligations; (ii) taxation, including deferred taxation; (iii) other provisions;
- Creditors (current liabilities): amounts falling due within one year
- Contingent liabilities: liabilities which may happen as a result of some event which may or may not occur. For example, litigation. Thus, the auditor has the duty to verify the following. (a) The existence of liabilities shown in the balance sheet; (b) The correctness of the amount of money of such liabilities; (c) The appropriateness of the description given in the accounts and the adequacy of disclosure; (d) All existing liabilities are actually included in the accounts.
.2 Objectives of Liability Verification
The audit objectives of liabilities are as follows:
- to determine the adequacy of internal control for the processing and payment of suppliers’ invoices;
- to prove that the amount shown on the balance sheet is supported by accounting records;
- to determine that all liabilities existing at the balance sheet date have been recorded;
- to ensure that adequate provision has been made for any known and unknown (contingent) liabilities.
3.3 Verification of Assets versus Verification of Liabilities In the verification of assets, the auditor is guarding against over- statement of asset values, while in the audit of liabilities; the auditor wants to make sure that liabilities are not understated.
Let us note the following:
- liability is a matter of fact whereas valuation of assets is a matter of opinion;
- understatement of liabilities is usually accompanied by under- statement of expenses and over-statement of net profit;
- over-statement of asset values results partly from improper entry in the accounting records, that is, by recording fictitious transactions.
SELF-ASSESSMENT EXERCISE 1
- Identify the classes of liabilities in the balance sheet.
- What is the auditor’s concern in the verification of liabilities?
3.4 Verification Procedures
It is not possible to detail the procedures for verifying all possible liabilities. However, some general principles can be discerned, and these should be applied according to the particular set of circumstances met with in practice. These are as follows.
- Schedule: request or make a schedule for each liability or class of liabilities. This should show the make up of the liability with the opening balance, if any, all charges, and the closing balance.
- Cut-off: verify cut-off. For example, a trade creditor should not be included unless the goods were acquired before the year end.
- Reasonableness: consider the reasonableness of the liability. Are there circumstances which ought to elicit suspicion?
- Internal control: determine, evaluate and test internal control procedures. This is particularly important for trade debtors.
- Provisions date clearance: consider the liabilities at the previous accounting date. Have they all been cleared?
- Terms and conditions: this applies principally to loans. The auditor should determine that all terms and conditions agreed when accepting a loan have been complied with.
- Authority: the authority for all liabilities should be sought. This will be found in the company minutes or directors’ minutes and for some items the authority of the memorandum and articles may be needed.
- Description: the auditor must see that the description in the accounts of each liability is adequate.
- Documents: the auditor must examine all relevant documents. These will include invoices, correspondence, debenture deeds, etc, according to the type of liability.
- Security: some liabilities are secured in various ways, usually by fixed or floating charges. The auditor must enquire into these and ensure that they have been registered.
- Vouching: the creation of each liability should be vouched, for example, the receipt of a loan.
- Accounting policies: the auditor must satisfy himself that appropriate accounting policies have been adopted and applied consistently.
- Letter of representation: obtain from debtors a letter of representation covering debts.
- Interest and other ancillary evidence: the evidence of loans tends to be evidenced by interest payments and other activities which stem from the existence of the loans.
- Disclosure: all matters which need to be known to receive a true and fair view from the accounts must be disclosed. The Companies Acts provisions must be complied with.
- External verification: with many liabilities, it is possible to verify the liability directly with the creditor. This action will be taken with short-term loan creditors, bank overdrafts and by a similar technique to that used with debtors, the trade creditors
- Materiality: materiality comes into all accounting and auditing decisions.
- Post-balance sheet events: these are probably more important in this area than in any other.
- Accounting standards: liabilities must be accounted for in accordance with the accounting standards.
- Risk: assess the risk of misstatement.
Audit Programme for Liabilities
From the foregoing, audit programme for liabilities can be summarised as follows.
- Perform a review of credibility;
- Review and evaluate internal control;
- Perform cut-off procedures;
- Obtain or prepare trial balance of account payables (liabilities) as of the balance sheet date and reconcile with the ledger;
- Select and confirm creditors;
- Search for unrecorded account payables;
- Determine proper balance sheet presentation of liabilities;
- Obtain from client, a letter of representation, covering liabilities.
SELF-ASSESSMENT EXERCISE 2
Design an audit programme for liabilities.
In this unit, you are now aware of the audit programme for liabilities. The auditor is concerned with material misstatement of liabilities, whether it is over-stated or under-stated.
In this unit, you have learnt the following: that liabilities can be classified into two – current liabilities and long-term liabilities; the grouping of liabilities in the balance sheet; the objectives of liability verification; that in the audit of assets, the auditor guards against over- statement of asset values; that in the verification of liabilities, the auditor ensures, particularly, that liabilities are not understated;
the verification procedures and programmes for liabilities.