UNIVERSITY OF MINDANAO COLLEGE OF ACCOUNTING EDUCATION

AUDIT OF LIABILITIES

AUDIT OF ACCOUNTS PAYABLE AUDIT OF OTHER CURRENT LIABILITIES

Audit Objectives Amounts withheld from employees’ pay

The auditor’s objectives in the examination of accounts payable are to determine that: Payroll deductions are known to be numerous; among the more important are SSS and Philhealth
Premiums, Pag-ibig Contributions and individual income taxes
1. Internal control over accounts payable and the acquisition and payment cycle is adequate
2. The recorded accounts payable are valid (occurrence and obligations) Payroll taxes withheld from employees’ pay and not remitted as of the balance sheet date
3. All accounts payable are recorded (completeness) represent a liability to be verified by the auditors. The employer’s payroll taxes may be audited at
4. Accounts payable schedules are mathematically correct and agree with general ledger the same time. This verification usually consists of tracing the amounts withheld to the payroll
accounts (clerical accuracy) summary sheets, testing computations of taxes withheld and accrued, determining that taxes have
5. The valuation of accounts payable is proper been remitted or paid in accordance with the regulations of the taxing authorities.
6. The financial statement presentation and disclosure of payables is adequate
Unclaimed Wages
Audit Working Papers
Unclaimed wages, are by their very nature, subject to misappropriation. The auditors, therefore
1. Lead schedule for Accounts Payable and Other Current Liabilities should be concerned with the adequacy of internal control over this item. A list of unclaimed
2. Schedule of Accounts Payable wages should be prepared after each payroll distribution and the payroll checks or pay envelopes
3. Analysis/Schedule of the Other Liabilities accounts should not be left for more than a few days in the payroll department. Prompt deposit in a special
4. List of Unrecorded Obligations discovered during the course of the audit bank account provides much improved control.

Audit Procedures Customers’ deposits

1. Evaluate proper balance sheet presentation and disclosure of accounts payable Many companies require that customers make deposits on returnable containers. Public utilities
2. Vouch balances payable to selected creditors by inspection of supporting documents also may require deposits to guarantee payment of bills or to cover equipment on loan to the
3. Confirm accounts payable balances with Vendors customer. The auditors with a view to disclosing any shortcomings in internal control should make
4. Vouch the paid check and invoice from the vendor to the receiving report a review of the procedures followed in accepting and returning deposits.
5. Review the cut-off of purchases, returns and disbursements
6. Perform search for unrecorded liabilities The verification should include obtaining a list of the individual deposits and a comparison of the
7. Perform analytical procedures total with the general ledger controlling account. If deposits are interest-bearing, the amount of
8. Obtain or prepare a listing of accounts payable as of the balance sheet date and reconcile with accrued interest should also be verified.
the general ledger
9. Recalculate the extensions and footings on creditors’ invoices Accrued Liabilities
10. Trace vendor invoice to voucher register and checks to check register
11. Foot voucher register and trace to general ledger Most accrued liabilities represent obligations payable sometime during the succeeding period for
12. Reclassify debit balances services or privileges received before the balance sheet date. Examples include interest payable,
accrued property taxes, accrued payroll, income taxes payable, and provision for warranties.

Auditing Problems 1
UNIVERSITY OF MINDANAO COLLEGE OF ACCOUNTING EDUCATION

Since accrued items are based on client estimates of amounts which will subsequently become compute the percentage relationship between the amount in the liability account and the
payable, these estimates may be particularly susceptible to misstatement, especially in amount of the year’s sales. The client should be asked for an explanation if this relationship
circumstances in which management is under pressure to show increased earnings. varies sharply from year to year. In general, the auditors should determine that the balance
in the liability account for service guarantees moves in reasonable relationship with the trend
The following sections describe the nature of the audit of various accrued liabilities of sales.

1. Accrued Property Taxes 4. Accrued commissions and bonuses

Since property tax payments are usually few in number and substantial in amount, the Verification of accrued commissions to sales representatives and bonuses payable to
auditor’s working papers should include an analysis showing all of the year’s property tax managerial personnel should include the following audit procedures
transactions. Tax payments should be verified by inspection of the property tax assessments  Examination of basic contracts and tracing of the same to minutes of directors’ meetings.
issued by the local government units and by reference to the related paid checks. If the tax  If the bonus or commission is based on the total volume of sales or some other objective
accruals at the balance sheet date differ significantly from those of prior years, an explanation measure, the auditors should verify the computation of the accrual by applying the
of the variation should be obtained. prescribed rate to the amount used as a base

2. Accrued Vacation Pay (Compensated Absences) 5. Accrued professional fees

This type of liability arises from two situations: (a) an employee entitled by contract to a Fees of professional firms include charges for the services of attorneys, public accountants,
vacation during the past year may have been prevented from taking it by an emergency work consulting engineers, and other specialists who often render services of a continuing nature
schedule, and (b) an employee may be entitled to a future vacation of which part of the cost but present bills only at infrequent intervals. By inquiry of officers and by review of corporate
must be accrued to achieve a proper matching of costs and revenue. minutes, the auditors may learn of professional services received for which no liability has yet
been reflected in the accounts. Review of the expense account for legal fees is always essential
The auditors’ verification of accrued vacation pay consists of the following audit procedures: because it may reveal damage suits, tax disputes or other litigation warranting disclosure in
 Review of the permanent file copy of the employment contract or agreement stipulating the financial statements.
vacation terms
 Verification of the computation of the accrual as to mathematical accuracy and as to AUDIT OF LONG-TERM LIABILITIES
agreement with the terms of the company’s vacation policy
Long term liabilities is defined as obligations existing at the balance sheet date which are not
3. Provision for Warranties reasonably expected to be liquidated during the next normal operating cycle but are to be
liquidated at some later date. Long term liabilities usually are substantial in amount and often
The products of many companies are sold with a guarantee of free service or replacement extend for periods of 20 years or more. Long-term liabilities include such obligations as
during a rather extended warranty period. Under GAAP, the costs of rendering such services  Bonds payable of all types
should be recognized as expense in the year the product is sold rather than in a later year in  Real property mortgages
which the replacement is made or repair service is performed. In applying this principle, the  Chattel mortgages
company will make an annual charge to expense and credit to a liability account based on the  Long-term notes payable
amount of the year’s sales and the estimated future service or replacement. As repairs and  Certain pension plan obligations
replacements take place, the costs will be charged to the liability account.  Obligations under capital leases

The auditors should review the client’s annual provision for estimated warranty costs and

Auditing Problems 2
UNIVERSITY OF MINDANAO COLLEGE OF ACCOUNTING EDUCATION

Audit Objectives terms of 3/12, net 30. BJ has a perpetual inventory system and records accounts
payable net of purchase discounts. No accounts were paid by December 31
The objectives of the audit of long-term liabilities are to: c. On November 15, BJ borrowed cash from a local savings and loan bank in exchange
1. Ascertain the adequacy of internal control structure, policies, and procedures over long-term for a 90-day, P 2,000,000 note discounted at 12 percent
liabilities; d. December sales were P 782,880, including a 10 percent sales tax that must be paid to
2. Verify that all long term liabilities are recorded and are recorded properly (existence and the government during the first quarter of 2007. Sales and sales taxes are recorded
obligation) in separate accounts
3. Verify that interest expense is correctly computed and that all other contractual obligations e. On December 21, a P 550,000 forklift truck was purchased for use in the warehouse.
are satisfied (valuation); and The equipment was paid for with P 150,000 cash and by signing a P 400,000, one-
4. Ascertain the adequacy of disclosure of long-term liabilities in the financial statements year, 10 percent note.
f. During 2006, estimated income taxes of P 78,750 were paid each quarter. On
Audit Working Papers December 31, it was determined that actual income tax expense (for both accounting
and tax return purposes) for 2006 was P 347,500.
1. Copy of the indenture relating to the bond issue that should be placed in the auditor’s
permanent file Required:
2. Analyses of the ledger accounts for notes and bonds payable  Prepare the necessary journal entries to record the above transactions
3. Analyses of related accounts for interest and discount or premium amortization
2. Viva’s Music Emporium carries a wide variety of musical instruments, sound reproduction
Audit Procedures for Long Term Liabilities equipment, recorded music, and sheet music. Viva uses two sales promotion techniques –
warranties and premiums – to attract customers.
1. Review the Contractual Provisions and Supporting Documents of Long-Term Debt
2. Confirm with the creditor the transactions of the period and compliance with the contractual Musical instruments and sound equipment are sold with a one-year warranty for replacement
provisions of parts and labor. The estimated warranty cost, based on past experience, is 2% of sales.
3. Review cut-off to determine that transactions recorded at the end of the year are recorded in
the proper period The premium is offered on the recorded and sheet music. Customers receive a coupon for
4. Obtain or prepare an account analysis for the long term debt, discount, premium, and related each peso spent on recorded music or sheet music. Customers may exchange 200 coupons
interest accounts and P 20 for a cassette player. Viva pays P 34 for each cassette player and estimates that 60%
5. Perform analytical procedures of the coupons given to customers will be redeemed.
6. Review bank confirmation
7. Verify interest computations and amortization of premiums and/or discounts Viva’s total sales for 2006 were P 7,200,000 – P 5,400,000 from musical instruments and sound
reproduction and sound equipment and P 1,800,000 from recorded music and sheet music.
PRACTICE PROBLEMS: Replacement parts and labor for warranty work totaled P 164,000 during 2006. A total of
6,500 cassette players used in the premium program were purchased during the year and
1. Selected transactions of BJ Electronics, Inc. for the year ended December 31, 2006, are listed there were 1,200,000 coupons redeemed in 2006.
below
a. Salaries which are paid on the fifteenth of each month, were P 135,700 for the period The accrual method is used by Viva to account for the warranty and premium costs for
December 16-31, 2006 financial reporting purposes. The balances in the accounts related to warranties and
b. BJ purchased P 275,300 of inventory between December 23 and December 31. premiums on January 1, 2006, were as shown below:
Eighty-five percent of the purchases were on account. All purchases on account have Inventory of Premium Cassette Players P 39,950
Estimated Premium Claims Outstanding 44,800

Auditing Problems 3
UNIVERSITY OF MINDANAO COLLEGE OF ACCOUNTING EDUCATION

Estimated Liability from Warranties 136,000 4. In your initial audit of National Finance Company, you find the following ledger account
balances.
Instructions: Viva’s Music Emporium is preparing its financial statements for the year ended
December 31, 2006. Determine the amounts that will be shown on the 2006 financial 12% Bonds Payable – Due 10 years from 01-01-04 01.02.04 P 5,000,000 Cr.
statements for the following: Bonds Payable Redeemed 10.01.06 P 1,100,000 Dr.
 Warranty Expense Bond Discount 01.02.04 P 500,000 Dr.
 Estimated Liability from Warranties Bond Interest Expense 01.01.06 P 300,000 Dr.
 Premium Expense 07.01.06 P 300,000 Dr.
 Inventory of Premium Cassette Players
 Estimated Premium Claims Outstanding The bonds were redeemed for permanent cancellation on October 1, 2006 at P 108 plus
accrued interest.
3. On April 1, 1996, the Marimar Tool Company was authorized to issue P 8 million of 7%
convertible bonds with interest payment dates of April 1 and October 1. The bonds were sold Compute for the following:
on July 1, 1996, and mature on April 1, 2016. The bond discount totaled P 426,600. The bond  The adjusted balance of bonds payable as of December 31, 2006
contract entitles the bondholders to receive 25 shares of P 15 par value common stock in  The adjusted balance of the bond discount on December 31, 2006
exchange for each P 1,000 bond.  The bond interest expense for the year 2006
 The loss on bond redemption
On April 1, 2006, the holders of bonds with total face value of P 1,000,000 exercised their
conversion privilege. On July 1, 2006, the Marimar Tool Company reacquired bonds, face value 5. On December 30, 2006, BARON, Inc. issued 1,000 of its 8%, 10-year, P 1,000 face value bonds
P 500,000, on the open market. with detachable stock warrants at par. Each bond carries a detachable warrant for one share
of Baron’s common stock at a specified option price of P 25 per share. Immediately after
The balances in the capital accounts as of December 31, 2005, were: issuance, the market value of the bonds without the warrants was P 1,080,000 and the market
Common stock, P 15 par, authorized 3 million shares, value of the warrants was P 120,000. In its December 31, 2006, balance sheet, what amount
Issued and outstanding, 250,000 shares P 3,750,000 should BARON report as bonds payable?
Paid-in capital in excess of par 2,500,000
6. On November 5, 2006, a DEF Corporation’s truck was in an accident with an auto driven by
Market values of the common stock and bonds were as follows: Mr. Dela Cruz. DEF received notice on January 12m 2006 of a lawsuit for P 700,000 damages
Date Bonds (per 1,000) Common Stock (per share) for personal injuries suffered by Mr. Dela Cruz. DEF Corp.’s counsel believes it is probable that
April 1, 2006 P 1,220 P 47 Mr. Dela Cruz will be awarded an estimated amount in the range between P 200,000 and P
July 1, 2006 P 1,250 P 51 450,000, and that P 300,000 is a better estimate of potential liability than any other amount.
DEF’s accounting period ends on December 31, and the 2006 financial statements were issued
Prepare journal entries on the books of Marimar Tool Company for each of the following on March 2, 2007. What amount of loss should DEF accrue on December 31, 2006?
transactions. (Use the straight-line amortization method for the bond discount)
 Sale of the bonds on July 1, 1996 7. On January 1, 2006, Goldlock Inc. issued its 10% bonds in the face amount of P 1,500,000.
 Interest payment on October 1, 1996 They mature on January 1, 2016. The bonds were issued for P 1,329,000 to yield 12%, resulting
 Interest accrual on December 31, 1996, including bond discount amortization in bond discount of P 171,000. Goldlock uses the effective interest method of amortizing bond
 Conversion of bonds on April 1, 2006. discount. Interest is payable July 1 and January 1. For the six months ended June 30, 2006
 Reacquisition and retirement of bonds on July 1, 2006. Goldock should report bond interest expense of?

Auditing Problems 4
UNIVERSITY OF MINDANAO COLLEGE OF ACCOUNTING EDUCATION

AUDIT OF LIABILITIES POST-TEST

LARIO COMPANY issued 10-year bonds on January 1, 2010. The company’s year-end is December Accrued Interest on Bonds
31, and financial statements are prepared annually. The amortization and interest schedule below Balance, 1/1/10 P 75,000 P 75,000
reflects the bond issuance and the subsequent interest payments and charges. Accrual, 12/31/10 75,000 150,000

AMORTIZATION SCHEDULE Treasury Bonds

Redemption price and interest to date on 200 bonds
Interest Interest Amount Carrying permanently retired on December 31, 2010 P 265,000 P 265,000
Date Paid Expense Unamortized Value
01/01/10 - - P 28,253 P 471,747 Based on the preceding information, determine the following:
12/31/10 P 55,000 P 56,610 26,643 473,357
12/31/11 55,000 56,803 24,840 475,160 4. Carrying value of bonds payable at December 31, 2010
12/31/12 55,000 57,019 22,821 477,179 5. Loss on bond redemption
12/31/13 55,000 57,261 20,560 479,440 6. Accrued interest on bonds at December 31, 2010
12/31/14 55,000 57,533 18,027 481,973 7. Bond interest expense for the year ended December 31, 2010
12/31/15 55,000 57,837 15,190 484,810
12/31/16 55,000 58,177 12,013 487,987 The long term debt section of ELMO COMPANY’s statement of financial position as of December
12/31/17 55,000 58,558 8,455 491,545 31, 2009, included 9% bonds payable or P 400,000, less unamortized discount of P 32,000. Further
12/31/18 55,000 58,985 4,470 495,530 examination revealed that these bonds were issued to yield 10%. The amortization of the bond
12/31/19 55,000 59,470 - 500,000 discount was recorded using the effective interest method. Interest was paid on January 1 and
July 1 of each year. On July 1, 2010, Elmo retired the bonds at 105 before maturity.
1. What is the nominal interest rate of the bonds issued on January 1, 2010?
2. What is the effective interest rate of the bonds issued on January 1, 2010? 8. What is the amount of loss to be recognized on the retirement of bonds?
3. On the basis of the schedule presented, what is the journal entry to record the issuance of the
bonds on January 1, 2010? MALOMBE CORP. had outstanding P 6,000,000 of 11% bonds (interest payable July 31 and January
31) due in 10 years. On July 1, it issued P 9,000,000 of 10%, 15-year bonds (interest payable July 1
The following date were obtained from the initial audit of HANSTEEN COMPANY: and January 1 at 97. A portion of the proceeds was used to call the 11% bonds at 103 on August
1. Unamortized bond discount and issue cost applicable to the 11% bonds were P 240,000 and P
15%, 10-year, Bonds Payable, dated January 1, 2009 60,000, respectively.
Debit Credit Balance
Cash proceeds from issue on January 1, 2009 of Prepare journal entries to record the following:
1,000, P 1,000 bonds. The market rate of interest
On the date of issue was 12% P 1,172,044 P 1,172,044 9. Sale of the new issue
10. Retirement of the old issue
Bond Interest Expense
Cash paid, 1/2/10 P 75,000 P 75,000
Cash paid, 7/1/10 75,000 150,000
Accrual, 12/31/10 75,000 225,000

Auditing Problems 5