Chapter 14 - Accounts Payable and Other Liabilities

Chapter 14 Accounts Payable and Other Liabilities

(Review Questions)
1. If a corporation overstates its earnings, are its liabilities more likely to be overstated or
understated? Explain

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 assets—otherwise 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.

2. Lawsuits against CPA firms are most likely to allege that the auditors were negligent in not
detecting which of the following? (a) overstatement of liabilities and earnings, (b)
understatement of assets and earnings, or (c) overstatement of owners’ equity. Explain the
reasoning underlying your choice

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.

3. Assume that a highly placed employee has stolen company assets and is now planning to
conceal the fraud by failing to make an accounting entry for a large transaction. Would the
omission probably be for a transaction creating an asset or a liability? Explain

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.

4. Suggest two reasons why the adjustments proposed by independent auditors more often than
not call for reducing recorded earnings

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

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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.

5. Compare the auditors’ approach to the verification of liabilities with their approach to the
verification of assets

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.

6. The auditors usually find in the client’s possession documentary evidence, such as invoices,
supporting both accounts receivable and accounts payable. Is there any difference in the
quality of such evidence for accounts receivable and for accounts payable? Explain

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.

7. Describe briefly an internal control activity that would prevent a paid disbursement voucher
from being presented for payment a second time

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.

8. The operating procedures of a well-managed accounts payable department will provide for the
verification of several specific points before a vendor’s invoice is recorded as an approved
liability. What are the points requiring verification?

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.

9. List the major responsibilities of an accounts payable department.

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.

10. In achieving adequate internal control over operations of the accounts payable department, a
company should establish procedures that will ensure that extensions and footings are proved
on all invoices and that the propriety of prices is reviewed. What is the most effective means
of assuring consistent performance of these duties?

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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.

11. Which do you consider the more significant step in establishing strong internal control over
accounts payable transactions: the approval of an invoice for payment or the issuance of a
check in payment of an invoice? Explain.

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.

12. For which documents relating to the accounts payable operation would you recommend the
use of serial numbers as an internal control activity?

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.

13. What internal control activity would you recommend to call attention to a failure to pay
invoices within the discount period?

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. During the verification of the individual invoices composing the total of accounts payable at
the balance sheet date, the auditors discovered some receiving reports indicating that the
merchandise covered by several of these invoices was not received until after the balance
sheet date. What action should the auditors take?

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.

15. As part of the investigation of accounts payable, auditors sometimes vouch entries in selected
creditors’ accounts back through the journals to original documents, such as purchase orders,
receiving reports, invoices, and paid checks. What is the principal purpose of this procedure?

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

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find that recording practices and internal control procedures differ significantly from those
described by officials or specified in company manuals

16. Outline a method by which the auditors may test the propriety of cash discounts taken on
accounts payable.

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.

17. Is the confirmation of accounts payable by direct communication with vendors as useful and
important an audit procedure as such confirmation of accounts receivable? Explain.

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, and so on.

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.

18. Whitehall Company records its liabilities in an account payable subsidiary ledger. The
auditors have decided to select some of the accounts for confirmation by direct
communication with vendors. The largest volume of purchases during the year has been made
from Ranchero Company, but at the balance sheet date this account has a zero balance. Under
these circumstances, should the auditors send a confirmation request to Ranchero Company,
or would they accomplish more by limiting their confirmation to accounts with larger year-
end balances?

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.

19. Vendors’ statements and accounts payable confirmations are both forms of documentary
evidence created outside the client organization and useful in audit work on accounts payable.
Which of these two represents higher-quality evidence? Why?

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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.

20. Explain how the auditors coordinate the year-end cutoff of accounts payable with their
observation of the year-end physical inventory.

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.

21. Identify three audit procedures (other than “Search for unrecorded accounts payable”) that are
concerned directly or indirectly with disclosing unrecorded accounts payable.

Audit procedures that are concerned directly or indirectly with disclosing unrecorded accounts
payable are the following:

(1)  Reconcile liabilities with monthly statements from creditors.

(2)  Confirm accounts payable by direct correspondence with vendors.

(3)  Perform a cutoff of inventory purchases.

22. What do you consider to be the most important single procedure in the auditors’ search for
unrecorded accounts payable? Explain.

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.

23. What is the purpose of the auditors’ review of cash payments subsequent to the balance sheet
date?

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.

24. Most auditors are interested in performing as many phases of an audit as possible in advance
of the balance sheet date. The verification of accounts payable, however, generally is regarded
as something to be done after the balance sheet date. What specific factors can you suggest

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that make the verification of accounts payable less suitable than many other accounts for
interim work?

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.

25. What documentary evidence created outside the client’s organization is particularly important
to the auditors in verifying accrued property taxes?

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.

26. What differences should auditors expect to find in supporting evidence for accrued liabilities
as contrasted with accounts payable?

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.

(Multiple Choise Questions)

a. Which of the following procedures is least likely to be completed before the balance sheet
date?

(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. An audit of the balance in the accounts payable account is ordinarily not designed to:

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

c. Which of the following is the best audit procedure for determining the existence of unrecorded
liabilities?

(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. Auditor confirmation of accounts payable balances at the balance sheet date may be
unnecessary because:

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(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. A client erroneously recorded a large purchase twice. Which of the following internal control
measures would be most likely to detect this error in a timely and efficient manner?

(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. For effective internal control, the accounts payable department should compare the
information on each vendor’s invoice with the:

(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. When confirming accounts payable, the approach is most likely to be one of:

(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. In an audit, the valuation of year-end accounts payable is most likely addressed by:

(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.

i.  Ordinarily, the most significant assertion relating to accounts payable is:

(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. The least likely approach in auditing management’s estimate relating to an accrued liability is

to:

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

k. To determine that each voucher is submitted and paid only once, when a payment is approved,
supporting documents should be canceled by the:

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(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 isn’t paid a second time.

l. In performing a test of controls, the auditors vouch a sample of entries in the purchases journal
to the supporting documents. Which assertion would this test of controls most likely test?

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

(Internal Control Strength in Each Department)

a. The department head of the requisitioning department selects the appropriate supplier
(Disagree. Someone independent of requisitioning should select the supplier.)
b. Proper authorization of requisitions by department head is required before purchase orders are
prepared (Agree.)

c. Purchasing department makes certain that a low-cost supplier is always chosen ( Disagree.
Often, factors in addition to cost are considered (e.g., quality, dependability).)

d. Purchasing department assures that requisitions are within budget limits before purchase
orders are prepared (Agree.)

e. The adequacy of each vendor’s past record as a supplier is verified ( Agree.)

f. Secure facilities limit access to the goods during the receiving activity ( Agree.)

g. Receiving department compares its count of the quantity of goods received with that listed on
its copy of the purchase orders (Disagree. A comparison of quantities is not possible because
the quantity is blacked out on the purchase order provided to receiving.)

h. A receiving report is required for all purchases, including purchases of services (Disagree. No
receiving report is ordinarily necessary for purchases of services.)

i. The requisitioning department head independently verifies the quantity and quality of the
goods received (Agree.)

j. Requisitions, purchase orders, and receiving reports are matched with vendor invoices as to
quantity and price (Agree.)

k. Accounts payable department personnel recompute the mathematical accuracy of each invoice
(Agree.)

l. The voucher register is independently reconciled to the control accounts monthly by the
originators of the related vouchers (Disagree. An independent party should perform the
reconciliation.)

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m. All supporting documentation is marked “paid” by accounts payable immediately prior to

making it available to the treasurer (Disagree. Documentation should be marked “paid” by the
individual making the payment).

n. All supporting documentation is required for payment and is made available to the treasurer
(Agree.)

o. The purchasing, receiving, and accounts payable functions are segregated ( Agree.)

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