AUDIT OF LIABILITIES
auditing the cycle. One focus account in the
Module 3-1
Audit of the Acquisition and Payment Cycle
The objective in the audit of acquisition and
payment cycle is to evaluate whether the
accounts affected by the acquisition of
goods and services and the cash
disbursements for those acquisitions are
fairly stated in accordance with the
accounting standards.
The classes of transactions included in the
purchasing cycle include:
1. Acquisition of goods and services.
2. Cash disbursements.
3. Purchase returns and allowances and
purchase discounts.
There are many accounts are affected by the
purchasing cycle, thus, considerable audit
effort and resources are also allocated in
audit of purchasing cycle is the accounts
payable account since this account will be
affected (either credited or debited) for each
class of transaction listed above. However,
companies may also purchase goods and
services by directly paying in cash, check, or
electronic fund transfers. But even if the
purchases are paid for directly by cash, most
companies process and apply the same set of
controls in processing cash purchases as
with processing account purchases such as
the voucher system. In a voucher system –
proper approval must be made first by the
appropriate persons before any payment is
processed. A form is used to indicate and
track the authorization at different
organizational levels as well as to collect the
necessary documents and attachments to
support the payment.
Module 3-2
Business Process and Documents in the
Acquisition and Payment Cycle
(SEE SEPARATE DOCS)
Module 3-3.1
Designing Tests of Controls and Substantive
Tests of Transactions
In a typical audit, the most time-consuming
accounts to verify using substantive tests of
details of balances are accounts receivable,
inventory, property, plant and equipment,
accounts payable, and expense accounts. All
the mentioned accounts except accounts
receivable are included in the purchasing
cycle. Thus, if the auditor can rely on the
internal controls in reducing the extent of
substantive tests of details in these areas, the
net time saved by the audit could be
significant. Test of controls and substantive
tests of transactions in the purchasing cycle
will receive considerable amount of
attention, especially when the client has
effective internal controls.
The tests of controls and substantive tests of
transactions for the purchasing cycle are
divided into two (2) broad areas:
1. Test of purchases concerning: (a)
processing purchase orders, (b)
receiving goods and services and (c)
recognizing the liabilities.
2. Tests of cash disbursements, particularly
the processing and recording of cash
disbursements.
Understanding Internal Controls
The auditor obtains an understanding of
internal controls over the purchasing cycle
by performing risk assessment procedures,
studying the client’s flowcharts, reviewing
internal control questionnaires, and
performing transaction walkthrough for the
acquisition and cash disbursement
transactions.
Assess Planned Control Risk
In assessing the control risk, the auditor
shall look at the key internal controls
embedded in each of the business process
described earlier.
Authorization of Purchases.
Proper authorization for acquisition ensures
that goods and services are acquired and are
for authorized company purposes and avoids
acquisition of excessive or unnecessary
items. Most companies require varying
levels of authorization depending on the
nature of goods and services to be acquired
or the amount of purchase. For example,
acquisition of an item of property, plant and
equipment in excess of a specified amount
require approval by the board of directors.
Acquisition of infrequent items such as
insurance policies and long-term service
contracts, require approval by certain
officers; supplies and services less than a
designated amount are approved by
supervisors and department heads; and
ordering of some types of raw materials and
supplies are triggered automatically when
they fall below a predetermined level.
After the purchase requisition has been
approved, a purchase order to acquire the
goods or services is prepared. It is issued to
a supplier for a specified item at a certain
price to be delivered at or by a designated
time. The purchase order, either in written or
electronic form, is considered as a legal
document, representing an offer to buy
goods or services.
Most companies establish a separate
purchasing department to ensure the quality
of goods and services for a reasonable price.
For effective internal control, the purchasing
department should be separate from those
who authorize the acquisition or receive the
goods. Purchase orders should be
prenumbered to permit easier accounting for
all outstanding purchase orders and should
be designed to minimize the likelihood of
unintentional omissions on the form when
goods are ordered.
Separation of Asset Custody from Other
Functions.
Most companies have a receiving
department which received the goods from
the supplier. Upon receipt of the goods, the
receiving department prepares a receiving
report, copies of which are sent to the
warehouse and to the accounts payable
department for their information uses.
Goods should be physically controlled from
the time of their receipt until their use or
disposal. The personnel from the receiving
department should be separate from the
warehouse and the accounting department.
There should be adequate records to transfer
the responsibility over the goods each time
they are moved, e.g., from receiving to
warehouse and from warehouse to
production. This is often done using
perpetual records either manually or using a
barcode system.
Timely Recording and Independent Review
of Transactions.
In some companies, the recording of liability
is made on the basis of the receipt of goods
or services. In others, the recording of the
payable is deferred until the receipt of the
invoice from the supplier. In either case, the
accounts payable department is responsible
to verify the accuracy of the acquisitions.
This is done by performing a critical control
procedure called the three-way matching,
where the information is matched among the
purchase order, the receiving report, and the
supplier’s invoice to determine that the
descriptions, prices, quantities, terms and
freight on the supplier’s invoice are correct.
The accounts payable department also
verifies the mathematical accuracy of the
calculations and the appropriateness of
account distribution. The accounts payable
department also account for all receiving
reports to assure that the completeness
assertion is satisfied.
The personnel who record the purchases
should not have access to cash, securities,
and other assets. Adequate documents and
records, proper procedures for record
keeping, and independent checks on
performance are also necessary controls in
the accounts payable function.
Authorization of Payments
The most important controls over cash
disbursements include the following:
 The checks are signed, or electronic
fund transfers are approved by an
individual with proper authority.
 Separation of responsibilities for signing
checks and making transfers and
performing accounts payable function.
 Careful examination of supporting
documents by the person who signs the
checks or authorizes electronic
payments.
Checks should be prenumbered to make it
easier to account for all checks. Provide
physical control over blank, voided, and
signed checks. There should also be a
process of cancelling supporting documents
once they are paid to prevent reusing them
as support for another payment at a later
time. This is usually done by stamping the
voucher and supporting documents as paid
by the signer of the check or approver of
electronic fund transfers.
Determine Extent of Test of Controls
After identifying key controls and
deficiencies, auditors assess control risk.
When an auditor intends to rely on controls
to support a preliminary control risk
assessment below maximum, the auditor
performs tests of controls to obtain evidence
that controls are operating effectively. If the
controls are proven to be operating
effectively after performing the tests of
controls, the auditor can reduce the amount
of procedures from substantive tests.
Module 3-3.2
Designing Tests of Controls and Substantive
Tests of Transactions
The table below shows a summary of key
internal controls, test of controls and
substantive tests of transactions for each
transaction-related audit objectives.
Module 3-4.1 Designing Tests of Details of
Balances for Accounts Payable
Accounts payable are important for audits of
the acquisition and payment cycle as they
represent unpaid obligations for goods and
services received. They include obligations
for various goods and services and are
typically identified through supplier
invoices. Accounts payable should be
distinguished from other liabilities, such as
accrued liabilities and interest-bearing
obligations. If tests of controls and related
substantive tests are satisfactory, auditors
may reduce tests of details of balances but
still usually perform some tests due to their
materiality for most companies. The
following discussion includes the steps in
designing tests of details of balances for
accounts payable:
Identify Significant Risks and Assess the
Risk of Material Misstatement for
Accounts Payable
Auditors assess accounts payable as having
medium to high inherent risk due to its
significant balance and the potential for
understatements in the account balance.
Recent changes in the acquisition and
payment cycle, such as improvements in
supply-chain management activities and the
use of technology and e-commerce, can
create significant business risks for the
client. These changes may provide suppliers
with greater access to accounts payable
records, potentially leading to misstatements
if access is not controlled properly.
Additionally, improving logistics may make
it difficult to establish effective cutoff of
accounts payable balances at year-end.
Set Performance Materiality
Auditors often set a high performance
materiality for accounts payable due to the
significant balance, multiple vendor
balances, and expensive audit costs
associated with the account. These factors
also result in a higher assessed inherent risk.
Assess Control Risk and Design and
Perform Tests of Controls and Substantive
Tests of Transactions
After setting performance materiality and
assessing the risk of material misstatement
for accounts payable, auditors assess control
risk based on their understanding of internal
control. The effectiveness of internal
controls related to accounts payable can
affect the auditor's substantive tests. For
example, if the client has highly effective
internal controls, verification of accounts
payable should require little audit effort.
However, if internal controls are weak,
extensive tests of details of accounts payable
are necessary. Each month, an independent
person or computer program should
reconcile vendors’ statements with recorded
liabilities and the accounts payable master
file with the general ledger. After assessing
control risk, the auditor designs and
performs tests of controls and substantive
tests of transactions for acquisitions and
cash disbursements.
Design and Perform Substantive Analytical
Procedures
Analytical procedures are important for
uncovering misstatements in accounts
payable, and auditors should compare
current-year expense totals with prior years
to detect misstatements in both expense
accounts and accounts payable.
Misstatements in an expense account often
result in an equal misstatement of accounts
payable due to double-entry accounting.
Comparing current expenses with prior years
is an effective analytical procedure for
analyzing accounts payable when expenses
are expected to be relatively stable from year
to year.
Design and Perform Test of Details of
Balances of Accounts Payable
The overall objective in the audit of
accounts payable is to determine if the
balance is fairly stated and properly
disclosed. Audit objectives for accounts
payable include existence, completeness,
accuracy, cutoff, detail tie-in, classification,
rights and obligations, and presentation. The
main focus of auditing liabilities is on
understated or omitted liabilities rather than
overstatements, which is the focus for
auditing assets. CPAs must emphasize both
types of misstatements to avoid potential
legal liability. Auditors should design tests
to detect material understatements of
earnings and owners’ equity, including those
arising from material overstatements of
accounts payable. The same balance-related
audit objectives used for verifying accounts
receivable are applicable to liabilities, with
minor modifications.
The realizable value objective is not
applicable to liabilities, and the rights aspect
of the rights and obligations objective is not
applicable to liabilities. Auditors focus on
searching for understatements rather than
overstatements when auditing liabilities.
Actual audit procedures for accounts
payable vary based on the entity, materiality
of accounts payable, internal controls, and
inherent risk.
Module 3-4.2 Designing Tests of Details of
Balances for Accounts Payable
Search for Unrecorded Liabilities
Auditors perform search for unrecorded
liabilities tests to uncover potential
understatements in liability accounts, such
as accounts payable. The extent of these
tests depends on assessed control risk and
materiality. Typical audit procedures for
these tests include:
 Examining supporting documentation
for subsequent cash disbursements to
ensure inclusion in accounts payable
 Examining supporting documentation
for invoices not paid several weeks after
year-end to determine if they were
obligations at year-end
 Tracing receiving reports issued before
year-end to related vendors' invoices to
test for unrecorded obligations
 Tracing vendors' statements with a Inventory In Transit
balance due to the accounts payable trial
balance to ensure inclusion Auditors need to distinguish between FOB
 Sending confirmations to vendors with destination and FOB shipping point basis for
which the client does business, including inventory acquisitions. For FOB destination
zero balance confirmations, to test for basis, only inventory received on or before
omitted amounts, transactions, and the balance sheet date should be included in
misstated account balances. inventory and accounts payable at year end.
For FOB shipping point basis, inventory
and related accounts payable must be
recorded in the current period if the
Cutoff Tests and Physical Observation of shipment dates were on or before the
Inventory balance sheet date. Auditors can determine
the basis by examining vendors’ invoices
Cutoff tests are performed to ensure and should examine invoices for
transactions are recorded in the correct merchandise received shortly after year end
period, and the emphasis is on detecting for FOB shipping point basis. This is
understatements in accounts payable. It is important when the amounts are material.
appropriate to examine supporting
documentation as a test of overstatement of
accounts payable in some cutoff procedures.
Cutoff tests should be coordinated with the
physical observation of inventory if the
client counts inventory at year-end to ensure
accurate accounts payable cutoff.
Misstatements in accounts payable and
inventory can lead to understatement or
misstatement in the balance sheet and
income statement.
During the physical observation of
inventory, the auditor should review the
procedures in the receiving department and
record the last receiving report number of
inventory included in the count. After the
physical count date, the auditor should test
the accounting records for cutoff by tracing
the documented receiving report numbers to
the accounts payable records to ensure they
are correctly included or excluded. This is
important even if the physical inventory
takes place before the end of the year. The
auditor must also verify that all acquisitions
that took place between the physical count
and the end of the year were added to the
physical inventory and accounts payable.