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AUDITING CHAPTER 13 Accounts Payable, Prepaids, & Accrued Liabilities

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1 AUDITING CHAPTER 13 Accounts Payable, Prepaids, & Accrued Liabilities
By David N. Ricchiute

2 TOPICS Relationship assertions & audit procedures
Relationship audit risk, nonfinancial measures, substantive tests Substantives tests for A/P Substantive tests for prepaid expenses, accrued liabilities Expense recognition & earnings manipulation2 Audit sampling & A/P Computer-assisted audit techniques for A/P GBW 8th ed., Ch. 13

3 ASSERTIONS & OBJECTIVES
Management assertions: Recorded Purchases & A/P Exist Include all transactions (completeness) Represent rights, obligations of entity Are valued appropriately Are presented & disclosed properly GBW 8th ed., Ch. 13

4 AUDIT RISKS Payment problems Overstated purchases Understated payables
Insufficient cash Overstated purchases Understated payables GBW 8th ed., Ch. 13

5 OBJECTIVES & PROCEDURES: Existence/Occurrence
Objective: determine whether all payables exist & all purchases occurred Exist Confirm with creditors Transactions occurred Cutoff testing for proper period GBW 8th ed., Ch. 13

6 OBJECTIVES & PROCEDURES: Completeness
Objective: determine whether all purchases, payables are actually presented Complete Test for unrecorded liabilities Analytical procedures Test cutoff FOB shipping point FOB destination GBW 8th ed., Ch. 13

7 OBJECTIVES & PROCEDURES: Rights & Obligations
Objective: determine whether payables & other recorded liabilities are bona fide obligations Rights & obligations Confirm with creditors Test for unrecorded liabilities GBW 8th ed., Ch. 13

8 OBJECTIVES & PROCEDURES: Valuation, Allocation
Objective: determine whether payables are reported at appropriate dollar amounts Valuation, allocation Verify A/P trial balance Confirm with creditors Test for unrecorded liabilities GBW 8th ed., Ch. 13

9 OBJECTIVES & PROCEDURES: Presentation, Disclosure
Objective: determine whether payables are properly classified, described, disclosed Presentation, disclosure Compare statement presentation, disclosure with GAAP requirements GBW 8th ed., Ch. 13

10 NONFINANCIAL MEASURES OF RISK
Examples for payables: Failure to get low price provider Unfavorable price variances Significant lag in product development GBW 8th ed., Ch. 13

11 AUDIT RISK MODEL AR = CR x IR x DR
Detection risk (DR): likelihood that error could occur & not be detected Based on Control risk (CR) Likelihood of material error Inherent risk (IR) Strategies & threats GBW 8th ed., Ch. 13

12 DETECTION RISK DR = ____AR___ IR x CR
Nature, extent, timing substantive tests Nature: more/less persuasive tests Extent: larger/smaller samples Timing: balance sheet date or interim GBW 8th ed., Ch. 13

13 ASSERTIONS & PROCEDURES Purchases & Payables-1
Valuation Verify mathematical accuracy A/P Foot, cross-foot aged trial balance Compare trial balance total to GL Trace sample vendor accounts to voucher packages Examine supporting documents GBW 8th ed., Ch. 13

14 ASSERTIONS & PROCEDURES Purchases & Payables-2
Existence, Obligations, Valuation Consider confirming year-end payables with creditors Existence, Occurrence, Completeness Test cut-off for recording in proper period GBW 8th ed., Ch. 13

15 ASSERTIONS & PROCEDURES Purchases & Payables-3
Completeness, Valuation, Obligations Test for unrecorded liabilities Existence, Occurrence, Completeness, Valuation Perform analytical procedures GBW 8th ed., Ch. 13

16 ASSERTIONS & PROCEDURES Purchases & Payables-4
Presentation & Disclosure Review statements to determine Payables, other liabilities properly classified, described Disclosures adequate GBW 8th ed., Ch. 13

17 SUBSTANTIVE TESTS: Payables Confirmation
Not commonly confirmed unless Controls inadequate Concern with liabilities overstatement Main concern for payables: understatement Confirmation not effective for detecting unrecorded liabilities Not listed on trial balance Not in sample GBW 8th ed., Ch. 13

18 TESTING UNRECORDED LIABILITIES
Four sources Year-end A/P trial balance Cash disbursements journal Canceled voucher packages File unmatched receiving reports GBW 8th ed., Ch. 13

19 CAPITALIZED COSTS: AOL
In fiscal 1995, 1996, AOL capitalized advertising costs in an account called “Deferred Membership Acquisition Costs,” & amortized costs over a 24 month period $77 million, 19% assets $314 million, 33% assets Is this the proper accounting treatment? What was the effect on the financial statements? GBW 8th ed., Ch. 13

20 ASSERTIONS & PROCEDURES: Prepaid Expenses
Examples: Prepaid insurance, rent, advertising, & supplies Existence, rights, obligations Examine insurance policies Completeness: Insurance coverage exceeds replacement cost Cutoff testing from A/P Valuation Recalculate unexpired premiums GBW 8th ed., Ch. 13

21 ASSERTIONS & PROCEDURES : Accrued Liabilities
Examples: accrued taxes, warranty costs, rent, interest Occurrence, obligations, valuation Examine property tax bills Compare provisions to prior year: reasonableness Additions/disposals assets Completeness Unusual fluctuations GBW 8th ed., Ch. 13

22 EXCESS RESERVES: W. R. Grace
From 1991 – 95, Grace recorded $20 million in excess reserves on statements of a health-care subsidiary that produced a large portion of Grace’s consolidated net income. “Extra earnings could be used when they wanted to goose up the numbers.” Specifically, how would they “goose up the numbers?” GBW 8th ed., Ch. 13

23 EARNINGS MANIPULATION Environmental Liabilities
Columbia Transmission in recent years recorded projected compliance costs related to low levels of contamination by PCB-based lubricating oils. . . resulted in additional pre-tax charges of $65 million GBW 8th ed., Ch. 13

24 MANAGEMENT, AUDITOR INCENTIVES
Incentive to understate cleanup costs Examples Arco, Exxon, Phillips’ stock prices declined due to environmental disasters Auditor Incentive for reasonable assurance that material environmental liabilities are disclosed Shareholders may sue if unreported GBW 8th ed., Ch. 13

25 NONSTATISTICAL SAMPLING: Accounts Payable
Assess control risk Select sampling plan Determine Population, sampling unit, sample size Evaluate results Decision rule: if likely error < tolerable error then payables not likely materially misstated GBW 8th ed., Ch. 13

26 COMPUTER-ASSISTED TESTS: A/P Accuracy
Verify footings, cross-footings, extensions of aged trial balance or subsidiary records Compare details of trial balance with subsidiary records Compare details subsidiary records with source documents GBW 8th ed., Ch. 13

27 COMPUTER-ASSISTED TESTS: Summarizing Data
Age A/P according to due dates List debit balances for reclassification to A/R GBW 8th ed., Ch. 13

28 COMPUTER-ASSISTED TESTS: Sample Selection, Comparison
Use random number generator to select sample from aged A/P trial balance Compare charges/credits from subsidiary records with purchases/cash disbursements GBW 8th ed., Ch. 13

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