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Chapter 14 - Accounts Payable and Other Liabilities

CHAPTER 14
Accounts Payable and
Other Liabilities

Review Questions
14-1

Overstated earnings are associated with understated liabilities. To overstate earnings causes an
overstatement of owners' equity. An overstatement of owners' equity must be accompanied by an
understatement of liabilities or an overstatement of assetsotherwise the balance sheet totals
would not be in agreement. As a specific example, a year-end cutoff error could cause an incoming
shipment of merchandise on December 31 to be included in inventory but not to be recorded as a
liability. The result would be overstated earnings and owners' equity offset by understated
liabilities. In more general terms we can say that many transactions involve debits to expense
accounts and credits to liability accounts. If such a transaction is not recorded at all, the earnings
will be overstated and the liabilities understated.

14-2

The correct answer is (c)overstatement of owners' equity. Lawsuits against CPA firms alleging
negligence by the auditors leading to losses by stockholders or creditors almost always involve an
overstatement of owners' equity accompanied by an overstatement of assets or understatement of
liabilities or both. Thus, the financial statements give a misleading picture of health and solvency,
and persons who contribute capital to the business sustain losses because of their reliance upon
overly optimistic financial statements.

14-3

The employee who seeks to conceal fraud by deliberately omitting the recording of a large
transaction would choose a transaction creating a liability rather than one creating an asset. The
prior theft of assets by the employee means that total assets on hand are less than the total of
liabilities and owners' equity. Failure to record a transaction that creates a liability of the same
dollar amount as the theft would cause total assets to equal total recorded liabilities plus owners'
equity. The understatement of liabilities conceals the shortage of assets resulting from the theft.

14-4

Adjustments proposed by the independent auditors more often than not have the effect of reducing
recorded earnings for the following reasons. First, management is normally under some degree of
pressure to report higher earnings. Earnings improvement pleases stockholders, reassures
creditors, facilitates financing, and permits larger bonuses and other compensation. Consequently,
management has an incentive to interpret every transaction in the most favorable light. There is a
tendency to minimize bad news, and to postpone recognition of losses. The auditors may need to
make downward adjustments in earnings and owners' equity to offset this optimistic bias on the
part of management. A second reason is that the legal liability of auditors arises from
overstatement of earnings, owners' equity, and assets, and understatement of liabilities. Lawsuits
against CPA firms almost never arise because of understated earnings.

14-1

Chapter 14 - Accounts Payable and Other Liabilities

14-5

The auditors are concerned about possible understatement of liabilities, whereas their concern in
the audit of assets is the possibility of overstatements. Also, in the audit of liabilities, the auditors
seldom have problems with respect to valuation; while much of the work in the audit of assets deals
with the propriety of asset valuations.

14-6

For accounts payable, the auditors will find in the client's possession such externally created
evidence as vendors' invoices and vendors' monthly statements that substantiate the accounts
payable. The only such external evidence is normally the customer's purchase order.

14-7

The official who signs checks should stamp or perforate the voucher and supporting documents so
that they could not be presented to support payment a second time.

14-8

Before recording a vendor's invoice as an approved liability, the accounts payable department
should determine whether (a) the goods listed on the invoice were ordered and received, (b)
quantities and condition of goods conformed with specifications, (c) prices, credit terms, and
shipment charges conformed with the purchase agreement, and (d) all computations involved are
accurate.

14-9

Major responsibilities of the accounts payable department are the verification of invoices,
distribution of charges to ledger accounts, preparation of journal entries summarizing the month's
transactions, and the maintenance of subsidiary records.

14-10 Proof of extensions and footings on invoices and the review of prices should be evidenced by
entering on the voucher the date of the verification and the signature of the responsible employee.
14-11 The approval of an invoice for payment is the more significant step in establishing strong internal
control over accounts payable transactions. Once an invoice has been approved for payment, the
issuance of a check is very largely an automatic process. If improper cash disbursements are to be
avoided, invoices must not be approved for payment until all aspects of the purchase transaction
have been verified.
14-12 The use of serial numbers as an internal control device is applicable to purchase orders, receiving
reports, vendors' invoices, vouchers, remittance advices, debit and credit memoranda, checks, and
virtually all other documents in regular use in the accounts payable operation.
14-13 Recording invoices at the net amount will clearly disclose any failure to process an invoice within
the discount period, since the extra payment required must be charged to a "Discounts Lost"
expense account.
14-14 Recording of invoices as liabilities prior to receipt of goods suggests lack of internal control and
unsatisfactory procedures for verification of invoices. The auditors should investigate fully the
reasons for this situation. If the accounts payable department does not examine a receiving report
before approving an invoice, what assurance is there that the company receives the goods it pays
for? The auditors should ascertain the disposition of the receiving report when the shipments in
question arrived, and whether the invoices were paid before receipt of goods. One possible explanation is that a year-end adjusting entry was made to include goods in transit before the year-end
cutoff. On the other hand, the company may be guilty of careless processing of invoices.

14-2

Chapter 14 - Accounts Payable and Other Liabilities

14-15 By vouching entries in selected creditors' accounts back through the journals to original documents,
the auditors acquire a firsthand knowledge of internal control in use. They may find that recording
practices and internal control procedures differ significantly from those described by officials or
specified in company manuals.
14-16 The auditors should compute the ratio of cash discounts earned to total purchases for the period.
This ratio should be compared with ratios prevailing in prior years, and any significant variations
fully investigated.
14-17 No, the confirmation of accounts payable is not as useful and important an audit procedure as is
the confirmation of accounts receivable. This statement does not disparage the importance or
usefulness of confirming accounts payable, but recognizes that for accounts receivable
confirmation is generally the most important single audit procedure. The greatest hazard in the
verification of liabilities is the existence of unrecorded liabilities. To confirm the recorded accounts
payable does not prove whether any unrecorded accounts payable exist.
The auditors seek to obtain the best available supporting evidence with a minimum of
effort and expense. In most cases, the best evidence that accounts receivable are correctly recorded
is direct written acknowledgment by the debtor. This is not normally true of accounts payable.
The nature of the supporting evidence in the possession of the company is also a factor.
Receivables records are usually originated entirely by the company. Records of payables are
based, at least in part, on evidence prepared and sent in by outside parties, such as vendors'
invoices, statements, etc.
Confirmation of accounts receivable is a presumptively mandatory audit procedure. In
effect, the burden of proof is on the auditors to justify an omission of the receivables confirmation
procedure and the auditors are, therefore, reluctant to omit it.
14-18 Sending a confirmation request to Ranchero Company would be entirely appropriate even though
the accounting records show a zero balance for this large supplier at year-end. In the verification
of liabilities, emphasis is placed on the possible existence of unrecorded liabilities. The reply from
Ranchero might indicate that a liability exists.
14-19 Accounts payable confirmation requests represent higher quality evidence than vendors' statements
because ordinarily the vendors' statements will have passed through the hands of client personnel
whereas the confirmations are sent directly by vendors to the auditors' office.
14-20 The cutoff of accounts payable is closely connected with the cutoff of purchase invoices in
determining the year-end inventory. When observing the taking of a physical inventory on
December 31, the auditors will make a record of the serial numbers of the last receiving report
issued. This number should be identified with the corresponding vendor's invoice on the list of
accounts payable at December 31. Any invoices associated with later receiving reports should not
be part of the year-end amount for accounts payable. In other words, the year-end cutoff must
assure that a liability is recorded for any goods received on the last day of the year and included in
the physical inventory. Otherwise, income before taxes would be overstated by the full amount of
the omitted invoice.

14-3

Chapter 14 - Accounts Payable and Other Liabilities

14-21 Audit procedures that are concerned directly or indirectly with disclosing unrecorded accounts
payable are the following:
(1)
(2)
(3)

Reconcile liabilities with monthly statements from creditors.


Confirm accounts payable by direct correspondence with vendors.
Perform a cutoff of inventory purchases.

14-22 The most important single procedure in the auditors' search for unrecorded accounts payable is the
review of cash transactions during the first few weeks following the balance sheet date. Close
study by the auditors of cash disbursements subsequent to the balance sheet date may reveal some
items that should have appeared as liabilities on the balance sheet.
14-23 The purpose of the auditors' review of cash payments subsequent to the balance sheet date is to
disclose any accounts payable which existed at the balance sheet date but were unrecorded.
Comparison of the cash payments made after the balance sheet date with the accounts payable trial
balance also furnishes evidence of the existence of the recorded payables.
14-24 The fact that accounts payable may change greatly within a few weeks' time indicates the need for
verifying these accounts on or shortly after the balance sheet date. The search for unrecorded
liabilities is another phase of the examination that cannot be performed satisfactorily in advance of
the year-end.
14-25 Property tax bills are the most important documentary evidence created outside the client's
organization and used by the auditors in verifying accrued property taxes.
14-26 Accounts payable arising from purchases of goods or services are usually evidenced by invoices
and monthly statements received from the suppliers. In contrast, accrued liabilities generally
accumulate on a time basis as a result of the company's obligation to pay salaries, pensions,
interest, rent, taxes, and similar items. Invoices and monthly statements usually are not received
for accrued liabilities
Questions Requiring Analysis
14-27

(a)
The confirmation of accounts receivable is a presumptively mandatory auditing
procedure. In contrast, the confirmation of accounts payable is not a presumptively
mandatory procedure, although it is often followed.
Two reasons may be given for the foregoing differences. First, management fraud
would tend to overstate the assets and understate the liabilities. Confirmation is generally
more effective for tests of existence (overstatement) than completeness (understatement).
Second, the evidence supporting accounts receivable records is usually supplied by the
company's internally produced documents, whereas the evidence supporting accounts
payable, such as vendors' invoices and statements, is produced by outside sources.
For these reasons, the emphasis of the accounts receivable audit is to obtain
evidence supporting the amount recorded. On the other hand, determining that all payables
are recorded is the primary objective of the accounts payable audit. It follows that
confirmations are very useful in supplying supporting evidence for receivables but that
auditing procedures other than confirmation are required to verify that all payables are
recorded.

14-4

Chapter 14 - Accounts Payable and Other Liabilities

(b)

The number of confirmation requests to be made for both accounts receivable and
accounts payable would be determined by the auditors' assessments of control risk.
Accounts receivable to be confirmed on a positive basis would be selected from the
following groups:
(1)

Accounts with large balances to account for a major part of the dollar value of
receivables.
(2)
Accounts placed with collection agencies or accounts with customers that are
bankrupt, in receivership, or in other financial difficulties.
(3)
Accounts in dispute.
(4)
Old or inactive accounts.
(5)
A representative number of accounts with small balances.
(6)
Accounts that have been written off as uncollectible.
(7)
Accounts with credit balances.
The selection of accounts payable for confirmation would be from the following groups:
(1)
(2)
(3)
(4)

Large accounts including important suppliers even though the account balance is
small at balance sheet date.
Accounts for which monthly statements are unavailable.
Accounts with unusual transactions.
Accounts with zero balances that had substantial activity earlier in the year.

14-28 The monthly statements of the six creditors should be compared with the client's voucher register
or accounts payable ledger, and any exceptions should be carefully noted. These exceptions should
be investigated by reference to invoice, debit or credit memoranda, receiving records, correspondence files, or other supporting data.
The auditors should also compare the cash payments to these creditors during the
subsequent period with the items shown by the accounting records as liabilities at the balance sheet
date. This comparison may show that some of the payments in the subsequent period are for
liabilities which existed but were unrecorded at the balance sheet date.
14-29 The subsequent period plays a major part in the auditors' work on accounts payable. One of the
auditors' principal objectives in the examination of accounts payable is to determine that all
liabilities existing at the balance sheet date have been recorded. Few audit procedures can be
carried out at an interim date to accomplish this objective. Instead, the auditors' review of vendors'
statement, confirmation of accounts payable, review of subsequent cash disbursements, and other
procedures designed to disclose unrecorded accounts payable, are all carried out during the
subsequent period.

14-5

Chapter 14 - Accounts Payable and Other Liabilities

14-30 The information available does not include any legitimate reason why accounts payable have
decreased while sales and inventory are almost unchanged from the prior year. The change in these
relationships appears both abnormal and unexplained; therefore, the auditors should pursue the
matter until a conclusive explanation is developed.
Both the decrease in accounts payable and decrease in cost of goods sold could have been
caused by including in the year-end inventory inbound shipments of merchandise for which no
account payable was recorded. Such increases in inventory (without any debit to purchases or
credit to accounts payable) would cause an understatement of cost of goods sold and an
understatement of accounts payable. This would also explain the increase in gross profit. The lack
of perpetual inventory records increases the risk that unrecorded inbound shipments of goods near
year-end may materially overstate earnings and owners' equity while understating liabilities. With
control risk further increased by the apparent weaknesses in internal controls, the possibility of
management fraud should not be ignored. The increase in executive salaries may be an effort to
drain funds from the company while concealing the real state of affairs by the omission of liabilities
from the balance sheet. These are the ingredients from which lawsuits against CPAs by investors
and creditors often arise, hence the auditors should proceed with caution and skepticism.
14-31

14-32

(a)
Unrecorded liabilities subject to discovery during the audit of construction in
progress are unpaid contractor progress billings, unrecorded progress billing retentions,
and unpaid architect fees. Examination of construction contracts, architectural contracts,
and progress billings would disclose the liabilities.
(b)

In the audit of prepaid insurance, the auditors might find unrecorded liens on insured
properties, unrecorded policy loans utilized to pay officers' life insurance premiums,
unpaid premiums, and premiums not accrued. Audit procedures that would reveal these
liabilities are examination of policies and confirmation with insurance agents or carriers.

(c)

Unrecorded royalties payable might be discovered in the review of licensing agreements.

(d)

Unrecorded liabilities subject to disclosure by review of directors' minutes are dividends


declared but unpaid, obligations under employment contracts, "finders fees" due to
consultants who arrange business combinations, and numerous others. By tracing all such
transactions to the accounts, the auditors will ascertain those liabilities that have not been
properly recorded.
(a)
The auditors' objective in the review of the Federal Income Taxes Payable account
is to form an opinion as to whether the current Provision for Federal Income Taxes and the
balance of Federal Income Taxes Payable are properly stated.
The review of federal income tax returns for prior years and reports of internal
revenue agents is a necessary procedure for the auditors to express an opinion as to the
propriety of the Federal Income Taxes Payable account. The auditors must establish that
the client does not have a significant tax liability for prior years. In addition, their review
may disclose other matters of significance to the audit.

14-6

Chapter 14 - Accounts Payable and Other Liabilities

(b)

These reviews should enable the auditors to:


(1)
(2)
(3)
(4)
(5)

14-33

(a)

To determine the status of the liability for federal income taxes of prior years:

(1)

Through inquiry and review of correspondence files, determine which years are
subject to possible additional assessments based on Internal Revenue Service
examinations.
Ascertain that those years for which the statute of limitations has expired have not
been extended by waiver.
Inspect revenue agents' reports of recent years, if any, and ascertain that any
assessments have been paid or provided for. Determine whether assessments
resulting from examination of prior years' returns would give rise to tax
deficiencies or refunds in other open years not yet examined.
Review claims for refund of prior years' taxes, if any, and evaluate their
collectibility.
Review the reconciliation of pretax accounting income with taxable income
reported in returns for open years and ascertain that reconciling items are proper.
Obtain client's permission to correspond with the prior auditors if any unusual
matters are discovered.

(2)
(3)

(4)
(5)
(6)
(b)

Determine whether required returns, including estimated returns, have been filed
on a timely basis and the status of Internal Revenue agent review of these returns.
Note instances of proposed and probable deficiencies, penalties, assessments, or
interest on late payments and establish whether the client has provided for them.
Establish whether disallowances by the revenue agent in prior years indicate
problems for the current year.
Learn of instances of improper financial accounting for revenue or expenses (but
in many cases financial and tax accounting properly differ).
Determine the temporary differences between pretax accounting income and
taxable income and whether they have been properly accounted for and recognized
in the current income tax provision.

To determine the propriety of the provision for income tax on the current year's income:
(1)
(2)
(3)
(4)
(5)
(6)

Reconcile pretax accounting income with taxable income to be reported in the


current year's tax returns and compare with prior year's reconciliation.
Determine whether the computation of taxable income requires giving effect to
adjustments resulting from Internal Revenue Service examinations of prior years.
Review operating or capital loss carryforwards, if any, and determine to what
extent such losses may be offset against taxable income of the current year.
Verify client's calculation of federal income tax for the current year.
Determine that estimated tax has been paid, if required.
Consider the effect on the tax liability of elections that are available to the client in
computing taxable income (accelerated depreciation, consolidated versus separate
returns, deferral of development costs, LIFO method for inventories, etc.) and
discuss with client.

14-7

Chapter 14 - Accounts Payable and Other Liabilities

(7)

If taxable income materially differs from pretax accounting income, make certain
client has provided income tax allocation for any resulting deferral or prepayment.

Objective Questions
14-34

Multiple Choice
(a)
(2)
Because a significant portion of the search for unrecorded
liabilities deals with transactions recorded after year-end, it is least likely to be
completed before the balance sheet date.
(b)

(1)
The auditors do not have as an objective the determination of whether
accounts payable are past due.

(c)

(4)
Examining selected cash disbursements in the period subsequent to the
year-end is the best audit procedure for determining the existence of unrecorded
liabilities. All liabilities must eventually be paid, and will therefore be reflected in
the accounts when paid if not when incurred. By close study of payments made
subsequent to the balance sheet date, the auditors may find items that should have
appeared in the balance sheet.

(d)

(4)
Auditors will usually find in the client's possession externally created
evidence such as vendors' invoices and statements that substantiate the accounts
payable. No such external evidence is on hand to support accounts receivable.

(e)

(2)
The most efficient way in which the duplicate recording of a purchase
transaction may be detected is by reconciling the related payable accounts with
vendors' statements.

(f)

(1)
Each vendor's invoice should be compared with the receiving report (to
determine that it was received) and the purchase order (to determine that it was
ordered). Answer (2) is incomplete because of the omission of the purchase order.
Answers (3) and (4) are incorrect because the receiving report, prepared by the
company itself, provides better evidence of what has been received than the
vendor's packing slip.

(g)

(2)
Accounts payable confirmations are ordinarily sent to suppliers with
whom the client has done the most business. This is because the largest potential
for an understatement may exist due to the client having established high levels of
credit. A sample of other accounts will ordinarily also be selected.

(h)

(1)
The best procedure to determine valuation of payables is confirmation.
Examination of cash disbursements in the subsequent period is more directed
towards completeness of payables. Analytical procedures may be useful but
would not be as effective as confirmation with respect to the valuation assertion.

14-8

Chapter 14 - Accounts Payable and Other Liabilities

(i)

(1)
Because an understatement of liabilities overstates income, auditors are
ordinarily most concerned with the completeness assertion for payables. Note,
however, that in circumstances in which a client may be motivated to understate
income (e.g., to minimize taxes), existence becomes a bigger concern.

(j)

(4)
Auditors audit estimates through (1) independently developing an
estimate, (2) reviewing managements process, and (3) reviewing subsequent
events. There often is no one to send a confirmation related to the estimate.

(k)

(3)
The individual who signs the checks should ordinarily be provided with
supporting documents that provide support for the disbursement. That individual
should then manually or electronically cancel the documents so that the amount
isnt paid a second time.

(l)

(2)
Vouching from the purchases journal to the supporting documents
provides evidence with respect to the existence assertion for purchases.

14-35 Simulation
(a) Disagree. Someone independent of requisitioning should select the supplier.
(b) Agree.
(c)
Disagree. Often, factors in addition to cost are considered (e.g., quality,
dependability).
(d) Agree.
(e) Agree.
(f) Agree.
(g)
Disagree. A comparison of quantities is not possible because the quantity is blacked out on
the purchase order provided to receiving.
(h) Disagree. No receiving report is ordinarily necessary for purchases of services.
(i) Agree.
(j) Agree.
(k) Agree.
(l) Disagree. The reconciliation should be performed by an independent party.
(m)
Disagree. Documentation should be marked paid by the individual making the payment.
(n) Agree.
(o) Agree.

14-9

Chapter 14 - Accounts Payable and Other Liabilities

14-36 Simulation
(a)

(9)

Answer (9) is correct because confirming the outstanding year-end balances will
result in replies from suppliers as to those balances.

(b)

(3)

Answer (3) is correct because vouching purchases recorded after year-end may
result in identification of purchases that should have been recorded prior to year
end.

(c)

(6)

Answer (6) is correct because inquiry of management is a basic procedure for


identifying related party transactions which, if material, should be disclosed.

(d)

(7)

Answer (7) is correct because confirming the outstanding year-end balances will
result in replies from suppliers as to proper valuation of recorded receivables.

(e)

Auditing standards state that If, in rare circumstances, the auditor judges it necessary to
depart from a relevant presumptively mandatory requirement, the auditor must document
in the working papers his or her justification for the departures and how the alternative
audit procedures performed in the circumstances were sufficient to achieve the intent of
that requirements.

(a)
(b)
(c)
(d)
(e)

Related party
Related party
Noncompliance with laws
Related party
Illegal act

14-37

Problems
14-38 SOLUTION: Internal Control, Tests of Controls, Substantive Procedures. (Estimated time: 20
minutes)
(a)
(2)

(1)
Reconciliation of vendors' monthly statements with accounts payable is a
procedure that is designed to reduce the risk of understatement or overstatement of
accounts payable.
Matching of vendors' invoices with receiving reports is an internal control
procedure that reduces the risk that the client will pay for goods that were not
received.

14-10

Chapter 14 - Accounts Payable and Other Liabilities

(b)

(2)

(c)

(2)

14-39

(1)
The operating effectiveness of reconciliation of vendors' invoices to
accounts payable may be tested by reviewing the client's documentation of the
reconciliations. This evidence could be supplemented with inquiries of client
personnel regarding the performance of reconciliations during the year.
The matching of receiving reports to vendors' invoices could be tested by vouching
a sample of vendors' payments made during the year to the supporting receiving
reports.
(1)
To compensate for failure of client personnel to reconcile payables to
vendors' statements, the auditors might increase the extent of their procedures for
verification of the amount of accounts payable. Procedures that are designed to
test the accuracy of accounts payable include confirmation, review of unmatched
receiving reports, reconciliation of payables to vendors' statements, and the search
for unrecorded liabilities.
The overstatement of purchases due to payments for merchandise that was not
received is not easy to detect. Vouching large numbers of purchase transactions to
receiving reports is not an efficient approach. Analytical procedures applied to
cost of goods sold or gross margin might also reveal a significant overstatement of
purchases.

SOLUTION: Marina del Rey, Inc. (Estimated time: 15 minutes)


(a)

The two accounts payable for which confirmation is most needed are Dayco, Inc., and
Western Supply. The auditors' objective in sending confirmation requests to creditors is to
select accounts in which large balances could reasonably be expected rather than accounts
for which large balances have been recorded by the client. In other words, the auditors are
searching for unrecorded liabilities, rather than trying to verify a large percentage of
recorded dollar liabilities. With this goal in mind, the two accounts from which the client
has made a large amount of purchases during the year are more likely candidates than the
vendors in which the year-end balances are large but the activity for the year relatively
small.

(b)

If the four companies listed are assumed to be customers and the dollar amounts to
represent year-end balances of accounts receivable and total sales for the year, the answer
would be different. Under these assumptions, the two most important accounts to confirm
would be Western Supply and Landon Co. because they have the largest year-end balances.
In the verification of assets, the auditors are primarily concerned with the possibility of
overstated asset valuations. By confirming a large proportion of the total dollar amount of
accounts receivable, the auditors gain assurance that there is not a material overstatement.
They are less concerned with the unlikely possibility that the client has material amounts of
unrecorded receivables.

14-11

Chapter 14 - Accounts Payable and Other Liabilities

14-40 SOLUTION: Rex Wholesaling (Estimated time: 20 minutes)


Taylor should perform, the following additional substantive audit procedures:
(1)

Foot the client-prepared schedule.

(2)

Tie the general ledger accounts payable controlling account to the client-prepared accounts
payable schedule.

(3)

Examine vendors' statements in support of items on the client-prepared schedule.

(4)

Examine other documents (such as approved vouchers) in support of items on the clientprepared schedule.

(5)

Review the general ledger controlling account for non-cash debits or unusual items, and
investigate them.

(6)

Confirm, with positive confirmation requests, account balances from selected vendors.

(7)

Examine unpaid invoices on hand (to ascertain whether any were erroneously omitted from
the client-prepared schedule of accounts payable).

(8)

Examine documents in support of invoices paid subsequent to the year end (to ascertain
whether the payable was recorded in the appropriate year).

(9)

Inspect receiving reports (to test the accuracy of the year-end cutoff).

(10)

Ascertain whether year-end outstanding checks to vendors were returned with the cutoff
bank statement.

(11)

Review correspondence files with respect to disputed items.

(12)

Review open purchase orders for unusual or old items that may have been received but not
recorded.

(13)

Examine unmatched receiving reports.

(14)

Make certain that the client representation letter includes the proper assertions concerning
accounts payable.

(15)

Investigate and resolve confirmation exceptions and other matters requiring follow-up.

14-12

Chapter 14 - Accounts Payable and Other Liabilities

14-41 SOLUTION: Wilcox Company (Estimated time: 25 minutes)


WILCOX COMPANY
Proposed Adjusting Journal Entry
April 30, 20X2
Marketable Securities
2,125
Inventories
5,863
Unexpired Insurance (35/36 x $1,800)
1,750
Insurance Expense
50
Professional Fees Expense
1,000
Accounts Payable
10,788
To record liability for following unpaid invoices:
Hill & Harper
$ 1,000
Drew Insurance Agency 1,800
Mays and Sage
2,125
Lane Company
5,863
Total
$10,788
14-42

SOLUTION: Scott Corporation (Estimated time: 30 minutes)


(a)

The fact that the client made a journal entry to record vendors' invoices which were
received late should simplify the independent auditors' test for unrecorded liabilities and
reduce the possibility of a need for a further adjustment, but the auditors' test is
nevertheless required. Clients normally are expected to make necessary adjustments to
their accounting records so that the auditors may examine statements that the client
believes are complete and correct. If the client has not journalized late invoices, the
auditors are compelled in their testing to substantiate what will ultimately be recorded as
an adjusting entry. In this examination, the auditors should test entries in the 20X0
voucher register to ascertain that all items that according to dates of receiving reports or
vendors invoices were applicable to 20X0 have been included in the journal entry recorded
by the client.

(b)

No. The auditors should obtain a letter in which responsible executives of the client's
organization represent that to the best of their knowledge all liabilities have been
recognized. However, this is done as a normal audit procedure to afford additional
assurance to the auditors and it does not relieve them of the responsibility for making their
own tests.

(c)

Whenever independent auditors are justified in considering the work done by internal
auditors, they may curtail (but not eliminate) their own audit work. In this case, the CPAs
should have ascertained early in their examination whether Scott's internal auditors were
qualified by being both technically competent and objective. Once satisfied as to these
points, the CPAs should discuss the nature and scope of the internal audit program with the
internal auditors and review their working papers in order that the CPAs may properly
coordinate their own program with that of the internal auditors. If the CPAs find the
internal auditors are qualified and have made tests for unrecorded liabilities, the CPAs may
limit their work in this audit area.

14-13

Chapter 14 - Accounts Payable and Other Liabilities

(d)

Work done by the auditors for a federal agency will normally have no effect on the scope
of the CPAs' audit, since the concern of government auditors is usually limited to matters
which are unrelated to the financial statements. Nevertheless the CPAs should discuss the
government auditors' work program with them, as there are isolated situations where
specific procedures followed to a satisfactory conclusion by government auditors will
furnish the CPAs with added assurance and therefore permit them to curtail certain work in
a particular area. However, government auditors are usually interested primarily in substantiating as valid and allowable those costs that a company has allocated to specific
government contracts or sales to the government, and consequently there is little likelihood
that the auditor for a federal agency at Scott would search for unrecorded liabilities.

(e)

In addition to the 20X1 voucher register, the auditors should consider the following
sources for possible unrecorded liabilities:
(1)
(2)
(3)
(5)
(6)
(7)
(8)
(9)
(12)

Unentered vendors' invoice file.


Status of income tax returns for prior years still open.
Discussions with employees.
(4)
Representations from management.
Comparison of account balances with those of preceding year.
Examination of individual accounts during the audit.
Existing contracts and agreements.
Minutes of the board of directors' meetings.
Attorney's bills and letter of audit inquiry.
(10)
Status of renegotiable business.
(11)
Correspondence with principal suppliers.
Audit testing of cutoff for related accounts, e.g., inventory and plant assets.

14-43 SOLUTION: Video Corporation (Estimated time: 20 minutes)


Procedures that would ordinarily be followed in an annual audit for verification of the liability for
royalties payable would be affected by the materiality of the amount, the assessed level of control
risk, and work done in prior years. Since this is a new contract, the work probably would include:
(1)

Read the licensing agreement and obtain a copy for the permanent file.

(2)

Examine correspondence with the license grantor and review royalty statements already
submitted.

(3)

Review production records (and inventory and shipping records) to ascertain the number of
tubes manufactured under the agreement.

(4)

Calculate the royalties payable, making adjustments as necessary for royalties that have
been paid, and compare to client's liability account.

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Chapter 14 - Accounts Payable and Other Liabilities

(5)

Request a confirmation from the license grantor as to the amount of the royalties due at the
balance sheet date.

In-Class Team Case


14-44 SOLUTION: Bozarkana Company (Estimated time: 30 minutes)
(The data required for this problem could be obtained using either generalized audit software or
manually. Obtaining the data electronically would in general seem to be a more efficient
approach.)
(a)

(b)

(1)

Thirty vouchers may be randomly selected, either manually or electronically.


Because you need the name and address for purposes of confirming, the vendor
number from the voucher register may be matched (joined) to the vendor number
in the vendor master file. When this has been accomplished, you will be able to
access the vendor name and address for purposes of sending the confirmation.
Note that the use of generalized audit software will make this relatively simple as,
once the thirty vouchers are selected, one could electronically join the voucher
numbers to obtain the needed information.

(2)

Because you need to confirm by balance payable per vendor, it will be necessary
to total the voucher register by vendor number, and then perform the procedures
outlined in (1) above.

(3)

The cash disbursements file must first be totaled by vendor number. A list of
vendor numbers with whom Bozarkana has transacted more than $500,000 may
then be prepared. That list of vendor numbers should then be compared to the
voucher register, and any numbers not included in the voucher register represent
the desired accounts. Those vendor numbers should be joined with the vendor
master file to obtain the needed name and address.
(1)
One approach is to select receiving reports issued shortly before and after
year-end and search for dates shipped prior to year-end. The numbers of those
receiving reports may then be compared to the receiving reports in the voucher
register. Any not included would likely be unrecorded as of year-end. However, if
they were included on vouchers that already had been paid at year-end (which is
doubtful because these are year-end transactions), they also would not be included.
(2)
The cash disbursements file for the first week of January should be
searched for disbursements in excess of $300,000. Since the cash disbursements
file includes a voucher number, and since vouchers are issued sequentially, it will
be possible to select those vouchers issued after year-end. The voucher register
will include the receiving report number for those items. Those receiving report
numbers can be compared to the receiving report file to determine which (if any)
of these items had been shipped prior to year-end.

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Chapter 14 - Accounts Payable and Other Liabilities

Chapter 14 Appendices
Audit Case Exercises

14A1

a.
Control

Error or Fraud Controlled

1. Computer matches information

from vendors invoices with


purchase order and receiving data.
2. The computer assigns numbers to

receiving report
3. The check signer mails checks.

Prevents payment of invoices for


goods not ordered or received.
Controls the recording of
purchases to ensure completeness.
Prevents abstraction of cash by
individuals maintaining the
accounts payable records.

b.
Control

Error or Fraud Controlled

1. Computer matches information


from vendors' invoice with purchase
order and receiving data.

Review a sample of exception


reports for evidence of application
of the control by the computer,
and/or enter test data to evaluate
the control's operating
effectiveness.

2. The computer assigns numbers to


receiving reports.

Observe that the computer assigns


numbers to receiving reports.

3. The check signer mails checks.

Inquire about the procedure for


mailing checks.

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Chapter 14 - Accounts Payable and Other Liabilities

14A2
Control

Error or Fraud Controlled

1. Approved vendors are selected by


purchasing manager who also
purchases goods.

The purchasing manager may be


getting kickbacks from vendors
and/or may have a conflict of
interest.

2. Vendors statements are not


reconciled to the accounting
records.

Accounts payable records may be


misstated due to recording errors.

14A-3

Audit ProgramTest of ControlsAcquisition Cycle


Client: Keystone Computers & Networks, Inc.
Financial Statement Date: 12/31/X5
Procedure
1.
2.

3.
4.

5.
6.
7.

Observe and inquire about the segregation of duties for purchase transactions.
Observe the purchasing manager when entering purchase orders and enter several test
transactions to determine that:
a.
Password is entered to purchase order.
b.
The system compares the vendor to the authorized vendor list.
Observe that the system assigns a sequential number to each purchase order.
Observe the receiving clerk when entering receiving information and enter several test
transactions to determine that:
a.
Clerk looks up purchase order in system before receiving goods.
b.
Password must be entered to enter receiving information.
Observe that the computer assigns sequential numbers to receiving reports.
Observe the accounts payable clerk when entering vendor invoice information and enter
several test transactions to determine that the password must be included to enter invoices.
Test the procedures for review and follow-up on the exception report from computer
matching of purchase order, receiving, and invoice information. Use the following
procedures:
a.
Inquire about the procedures.
b.
Select a sample of exception reports and inspect them for evidence of follow-up on
the exceptions. Use the following parameters:
(1)
Risk of assessing control risk too low10%.

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Chapter 14 - Accounts Payable and Other Liabilities

8.
9.

(2)
Tolerable deviation rate10%
(3)
Expected deviation rate0%.
Observe that unsigned checks are assigned sequential numbers by the computer.
Test the procedures for approval of disbursements by:
a.
Inquiring about the review of disbursements by the treasurer when the checks are
signed.
b.
Review file of authorized disbursement listings for completeness as indicated by
the check numbers.
c.
Select a sample of authorized disbursement listings and examine them for evidence
of the treasurers approval. Use the following parameters:
(1)
Risk of assessing control risk too low10%.
(2)
Tolerable deviation rate7%.
(3)
Expected deviation rate0%.

14-18