Unit 1

AUDIT of LIABILITIES
“The auditor's primary concern in the audit of liabilities is ensuring that all
liabilities of the entity are properly recognized and measured at fair and reasonable amounts.”

1.1 THE FINANCING CYCLE

The financing cycle process refers to transactions and events that generate funds. The
sources of funds are debt and equity financing. Funds are received from creditors and
owners that increase liabilities and equity. Funds obtained are used for operations and for
investment purposes, which provide the entity with earnings. The inflow of funds from
operations and investments are used to repay debt, distribute dividends and/or reacquire
own equity instruments.

1.2 LIABILITIES

Liabilities are present obligations of the enterprise arising from past actions, the
settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits. In a properly classified statement of financial position,
liabilities are classified into current liabilities and non-current liabilities. Generally, on the
statement of financial position, trade liabilities are separated from non-trade liabilities.
Trade liabilities include accounts payable, trade notes payable, accrued expenses and
unearned income. Non-trade liabilities generally arise from loans and borrowings.

1.3 INTERNAL CONTROL

To achieve effective internal controls over trade and other payables, duties
should be segregated so that a cash disbursement to a creditor will be made only
after involving the purchasing, receiving, accounting, and finance departments.
The function of preparation of checks must be separated from the function of
check issuance to prevent any irregularities on cash disbursements. Ideally, the
individual accounts in the subsidiary ledgers for accounts payable must be
periodically reconciled with periodic statements from vendors. All adjustments in
the trade creditors' accounts (returns, allowances, rebates, commissions, etc.) should
require approval of duly designated approving authority.

An entity should establish and implement policies specifying the decision making-
processes relating to borrowings, such as, but are not limited to, the person or body
authorized to borrow on behalf of the entity, the borrowing power of the officer and the
limit on such power, the terms and conditions of the borrowings, the assets that will be
used as security or liens for borrowings, and the procedures for compliance with legal
requirements, if applicable. Normally the entity's legal department reviews the terms of
the proposed borrowing arrangements.

The usual forms of long-term borrowings include debentures, secured bonds, and notes
payable. Issuance of these instruments requires a formal decision and authorization by the
board of directors. It is also preferable to appoint an independent trustee to handle the
issuance, redemption and reacquisition of bonds. The designated third-party trustee takes
responsibility for protecting the borrower's interests and monitoring compliance with
debt covenants. Effective internal control is likewise achieved when the task of making
interest payments is designated to the trustee, the entity issuing a single check to the

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trustee for the periodic interest payments and the trustee making the payments to the
bondholders.

A system must be in place so that non-compliance with borrowing terms and conditions
could be immediately addressed. This system includes confirmation
of balances at periodic intervals and investigation of any discrepancy between the
company's records and the creditors' records. There must be a procedure for periodic
valuation of loans, especially those that are denominated in foreign
currency.

1.4 AUDIT OBJECTIVES

The auditors' objectives in the audit of liabilities are to:

1) consider internal control over liabilities;

2) determine the existence of liabilities;
3) establish the completeness of recorded liabilities;
4) determine that liabilities are measured appropriately; and
5) determine that the presentation and disclosure of liabilities is appropriate.

1.5 AUDIT PROCEDURES

The auditor should obtain an understanding of the system of internal control of the client
relating to liabilities to determine the nature, timing and extent of the audit procedures
necessary to achieve the audit objectives.

To establish existence and validity of recorded liabilities, the verification may be

undertaken by the following procedures: examination of records, direct confirmation with
creditors, analytical review procedures and obtaining management representation. The
nature and timing of these substantive procedures depend on the auditor's evaluation of
the effectiveness of the internal controls.

The auditor should obtain a schedule of accounts payable at the reporting date, and vouch
a sample of the balances to supporting vouchers, invoices, purchase orders, and receiving
reports to test the existence and accuracy of recorded amounts. The client's schedule of
accounts payable must be reconciled with the vendors' statements to establish accuracy of
the yearend balances. Cutoff accuracy can also be tested by tracing the details of the
receiving reports processed towards the end of the year and noted during the yearend
physical count of inventories.

The auditor may consider to make direct confirmations with the trade
creditors. Similar to confirmations of accounts receivable, the auditor shall consider
using either the positive form or the negative form of confirmation. The positive
form of confirmation requests the supplier or lender to respond whether or not the
amount indicated in the confirmation request (based on the records of the client) agrees
with the balance in the supplier's records. The negative form requests the
lender to reply only when the amount indicated in the confirmation request (based
on the records of the client) does not agree with the records of the lender.

The auditor shall prefer the use of the positive form over the negative form when internal
control is ineffective and other forms of reliable evidence are unavailable to establish the
accuracy of accounts payable. Also, it may be appropriate to use the positive form of
confirmation request for suppliers with large balances and also when the auditor
concludes that there is reason to believe that the supplier will disregard the request.

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The negative form shall be used when all of the following conditions are present:

a) there are efficient internal control procedures over the payables;

b) there is no reason to believe that the lender shall disregard the request and
c) the creditors' balances are small.

In cases when the confirmation procedure may prejudice the status of the client, especially
in cases of legal and other disputes, the auditor has to obtain the consent of the client before
circularizing the confirmation letter. In cases where non-confirmation can be justified, the
auditor has to apply alternative audit procedures to establish existence and accuracy of the
recorded liabilities

Analytical review procedures are normally employed by the auditor to obtain

assurance of the overall reasonableness of accounts payable. Such analytical
review procedures include but are not limited to the computation of the accounts
payable turnover, ratio of accounts payable to purchases, and ratio of accounts
payable to current liabilities. Comparison of these computed ratios with those of the
preceding years to identify significant variations may indicate that further
investigations may be necessary.

An auditor should maintain an attitude of skepticism and always consider

the possibility that there are unrecorded liabilities, especially accrued expenses.
Thus, audit procedures shall be directed for the search of unrecorded payables. An
analysis of payments made after the reporting date may show that certain liabilities
existed but were unrecorded at the end of the reporting period. The amount of
interest expense must be reviewed for reasonableness of the amount of interest
bearing liabilities. For clients following the voucher system, the unpaid vouchers
file must likewise be reviewed. Other documents, such as minutes of meetings,
lease contracts, statements of accounts from other entities may also indicate the
existence of unrecorded obligations.

Accrued liabilities represent obligations payable sometime during the succeeding period
for services received before the reporting date. The basic auditing steps for accrued
liabilities are as follows:

1) examine any contacts or other documents (such as statement of accounts that

are received after the end of the reporting period) that provide the basis for the
accrual;
2) determine whether detailed accounting records have been maintained for this
type of liabilities;
3) identify and evaluate the reasonableness of the assumptions that underlie the
computation of the liability;
4) test the computations made by the client in setting up the accrual, and
5) determine that accrued liabilities have been treated consistently at the
beginning and end of the period.

Provisions, which are liabilities that are uncertain as to timing or amount or

both, may require special attention. The audit of provisions requires examining the
reasonableness and adequacy of the amounts recognized by the client. In determining
whether a provision is required, the auditor should, among other
procedures, make appropriate inquiries of management, review minutes of the
meetings of the board of directors and correspondence with the client's lawyers
and obtain appropriate management's representations. Where provisions are made
for liabilities arising from product warranties and guarantees, service contracts and
other similar nature, the auditor should examine the reasonableness of the basis

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adopted for measuring the provision, considering the relevant agreements,
industry trends or historical company statistics.

The auditor must review disclosures made in the prior period financial statements relating
to contingencies. Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets,
contingent liabilities may develop in a way not initially expected. Therefore, contingent
liabilities must be assessed continually to determine whether an outflow of resources
embodying economic benefits has become probable. Circumstances may indicate that
items considered as contingencies in the prior period be considered as actual obligations
in the current reporting period.

The auditor shall, likewise, review unusual payments made during the
reporting period under audit and during the subsequent period to determine
whether the appropriate charges are made in the correct reporting period. In
determining whether provisions shall be recognized or contingencies shall be
disclosed, the auditor may consider analyzing the legal expenses for the period and
review invoices and statements of legal counsel. The auditor may also obtain
confirmation from all major law firms dealt with by the client as to the status of
pending litigation or other contingent liabilities.

The auditor should verify that in cases where income is collected in

advance, the unearned portion at the end of the reporting period is not recognized
as income. The basis for income recognition must likewise be reviewed to
determine whether it is made in accordance with the revenue recognition principle
as provided in the new IFRS 15.

In the case of long-term liabilities, a reconciliation of the beginning

balances to the ending balances is preferably made to determine the
reasonableness of the ending balance.

The auditor shall obtain a copy of the bond indenture and include it in the file of working
papers. So long as the bonds are outstanding, the copy of the bond indenture shall form
part of the permanent file of the auditor. In the first audit of the client or during period
when the bonds were initially issued, the auditor
should obtain an understanding of the major terms of bond issue and make a
summary of the provisions of the agreement. During each audit, the auditors will
perform tests of compliance with the provisions contained in the bond indenture.
The auditor shall be on guard with any violation that may have made the debt
payable on demand. In such a circumstance, the debt shall be classified as part of current
liabilities, unless the client is able to obtain on or before the balance sheet
date, a waiver from the creditor to make a demand of payment within twelve months from
the reporting date.

Bond transactions, including sinking fund transactions and year-end balances of bonds
payable and sinking funds, are confirmed directly with the trustee. Under normal
circumstances, the auditor does not communicate directly with the individual
bondholders.

The confirmation of the balance of cash deposits with banks simultaneously

confirms any financial obligation with the financing institutions. Bank confirmations
establish the existence and correctness of the balance of notes payable and loans
payable to bank.

(See chapter 3 for a sample of the confirmation form.)

The auditors should verify that interest payments correspond to the terms of

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recorded liabilities. Excessive interest payments may indicate the existence of
unrecorded notes payable.

The auditor may, in addition to the audit procedures discussed, may

perform analytical review procedures. This may include:

a) comparison of closing balances with the corresponding figures for the

previous year;
b) comparison of the payable turnover ratio of this year with that of the
previous year;
c) comparison of actual ending balances of loans and other borrowings with
the budgeted figures; and
d) aging the accounts payable and comparing the results with statistical
figures, if any.

Any large variations from the previous and from the projected figures may
warrant further investigation.

The auditor shall determine whether the liabilities are properly presented
and classified in the financial statements and the required disclosures have been
complied with. Proper presentation of accounts payable requires that material
amounts of accounts with debit balances be reclassified as assets. Material
amounts of payables to related parties should be listed separately from accounts
payable to trade creditors and the details of the related transactions should be
disclosed in a note to the financial statements in compliance with IAS 24, Related
Party Disclosures. Proper financial statement presentation also requires that interest-
bearing debt be fully described, including interest rates, maturity dates, a
schedule of required future payments, assets pledged, and other major restrictions.

Illustrative Problem

Problem 1
Described below are certain transactions of Jade Corporation during 2018.
1. On April 1, the corporation bought a truck for P6, 000,000 from General Motors
Corporation, paying P1,000,000 in cash and signing a one year, 12% note for the
balance of the purchase price.

2. On May 1, the corporation received proceeds of P18, 760,000 from Manila Bank by
signing a 10% note payable in equal annual installments of P2, 000,000. The payment
is to apply first to interest and then to principal.

3. On August 1, the Board of Directors declared a P300,000 cash dividend that was
payable on September 10, to shareholders of record on August 31.

4. On December 15, the corporation purchased goods from Jack Company for P1,
500,000 subject to cash discount terms 2/10, n/30. Purchases and accounts payable
are recorded by the corporation at net amounts after cash discounts. The invoice was
paid on January 14, 2019.

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 5. Sales during the month of December amounted to P6, 832,000, inclusive of value
added tax. The company made remittance of the VAT in January 2019.

REQUIRED:
(a) Make all journal entries necessary to record the transactions above using appropriate
dates.

(b) Prepare any necessary adjusting entries on December 31, 2018 relative to the above.

(c) How much shall be presented as current liabilities and non-current liabilities as of
December 31, 2018 as a result of the foregoing?

Suggested Answers:

Problem 1 Jade Corporation

A. Transaction Entries
April 1 Truck 6,000,000
Cash 1,000,000
Notes Payable
5,000,000

May 1 Cash 18,760,000

Notes Payable 18,760,000

Aug. 1 Retained Earnings 300,000

Dividends Payable 300,000

Sept. 10 Dividends Payable 300,000

Cash 300,000

Dec. 15 Purchases 1,470,000

Accounts Payable 1,470,000

Dec. 1 – 31 Cash/Accounts Receivable 6,832,000

Sales 6,100,000
Output VAT (VAT Payable) 732,000

B. Adjusting Entries

Dec. 31 Interest Expense 450,000

Interest Payable 450,000
5,000,000 x 12% x 9/12 = 270,000

31 Interest Expense 1,250,667

Interest Payable 1,250,667
18,760,000 x 10% x 8/12

31 Discounts Lost 30,000

Accounts Payable 30,000

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 Current Liab. Non-Current Liab
Accounts Payable P 1,500,000
12% Notes Payable 5,000,000
10% Notes Payable 2,000,000 – 1,876,000 124,000
18,760,000 – 124,000 18,636,000
Interest Payable 450,000 + 1,250,667 1,700,667
VAT Payable 732,000
Total P9,056,667 P18,636,000

Problem 2
The accountant for Hannah Corporation prepared the following schedule of liabilities as of
December 31, 2018.

Accounts payable and accrued expenses

P1,650,000
Notes Payable – trade
1,200,000
Notes Payable – bank
8,000,000
Wages and salaries payable 350,000
Interest payable
?
10% mortgage note payable 6,000,000
12% mortgage note payable 4,500,000
Bonds payable
10,000,000

The following additional information pertains to these liabilities:

a. The bank notes payable included two separate notes payable to First Bank:

(1) A P2,000,000, 8% note issued March 1, 2018, payable on demand. Interest is

payable each six months. Hannah already made the first semi-annual interest
payment on August 31, 2018.

(2) A 2-year, P6,000,000, 11% note issued January 2, 2017. On December 30, 2018,
after paying the accrued interest, Hannah negotiated a written agreement with
the First Bank to replace this note with a 2-year, P6,000,000, 10% note. The new
note was issued January 2, 2019.

b. The 10% mortgage note was issued November 1, 2015, with a term of 10 years. The
terms of the note give the holder the right to demand immediate payment if the
company fails to make a quarterly interest payment within 10 days of the date the
payment is due. As of December 31, 2018, Hannah is two months behind in paying its
required interest payment. Penalty for non-payment of interest changed by the bank
was P120,000.

c. The 12% mortgage note was issued May 1, 2006, with a term of 20 years. Interest is
due annually every June 30.

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REQUIRED:
(a) Compute the interest payable at June 30, 2018.
(b) Prepare the liabilities section of the December 31, 2018 classified statement of
financial position for Sierra Corporation. Include notes as appropriate.

Problem 2 Hannah Corporation

(a) Interest Payable

2,000,000 x 8% x 4/12 P 53,333
6,000,000 x 10% x 3/12 150,000
6,150,000 x 10% x 2/12 102,500
4,500,000 x 12% x 8/12 360,000
10,000,000 x 8% x 6/12 400,000
Total Interest Payable P 1,065,833

(b)

Current Liabilities
Accounts Payable P 1.650,000
Notes Payable – trade 1,200,000
Notes Payable – Bank 2,000,000
10% Mortgage Note Payable (with notes to FS) 6,000,000
Bonds Payable 10,000,000
Interest Payable 1,065,833
Wages and Salaries Payable 350,000
Total Current Liabilities P 22,265,833
Non-Current Liabilities
Refinanced Note Payable, due in 2015 (with note to FS) P6,000,000
12% Mortgage Notes Payable, due in 2023 4,500,000
Total Non-Current Liabilities P10,500,000
Total Non-Current Liabilities P32,765,833

Notes to FS

• The 10% Mortgage Note Payable was issued November 1, 2015, with a term of
10years. Terms of the note give the holder the right to demand immediate payment
if the company fails to make a quarterly interest payment within 10 days of the date
the payment is due. As of December 31, 2018, the entity is already two months behind
in paying its required interest payment. Hence, the note is reclassified as a current
liability.

• The P6,000,000 Note Payable, was originally due on January 2, 2017. On December
30, 2018, The entity negotiated a written agreement with the First Bank to replace
this note with a 2-year P6,000,000 10% note, which was issued on January 2, 2019.

Problem 3
During 2018, Charity, Inc. inaugurated a new sales promotional program. For every 10 cereal
box tops returned to Charity, customers will receive an attractive prize. Charity estimates
that only 30% of the cereal box tops reaching the customer will be redeemed.

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 Units Amount
Sale of cereal boxes 2,000,000 24,000,000
Purchase of prizes 36,000 180,000
Prizes distributed to customers 28,000

The accountant of Charity, Inc. journalized the purchase of prizes as a debit to premium
expense and a credit to cash. He just prepared a memo entry for prizes distributed.
REQUIRED:
Prepare any necessary audit adjusting entries. Apply the requirements of IFRS 15.

Problem 3 (Charity, Inc.)

Expected Premium Claims included in Revenue

(2,000,000 x 30%)/10 x P5 = P300,000

Inventory of Premiums
( 36,000 – 28,000) x P5 = P 40,000

Estimated Premium Claims Outstanding

Expected distribution
(2,000,0000 x 30%)/10 60,000
Actual distribution (28,000)
Still to be distributed 32,000
Cost of each premium x P5
Premium Claims Outstanding P160,000

Audit Adjustment:
Sales 300,000
Estimated Premium Claims Outstanding 300,000

Estimated Premium Claims Outstanding 140,000

Inventory of Premiums 40,000
Premium Expense 180,000

Under IFRS 15, the estimated cost of distribution is included in the transaction price.

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