Just as verification of assets, it is equally important for an auditor to verify the liabilities appearing in his client’s books. Liabilities are financial obligations of a business other than the owner’s equity. These may be long-term or short-term depending on the time for which resources are procured. For example, loans and borrowings, debentures, or deposits are long-term liabilities since they are created to generate funds for a long period of time, usually more than a year. Similarly, short-term liabilities are obligations created during the normal course of business and are used to generate funds only for a short period of time, for example, bank overdraft, trade creditors, bills payable, and interest payable.
Verification of liabilities is a process of substantiation of liabilities recorded in the books of account of an enterprise. This is done by examination of legal and official documents by the auditor and thereafter, forming an opinion concerning the existence, obligation, completeness, valuation, and disclosure of liabilities of the enterprise.
Why is verification of liabilities important?
The verification of liabilities is just as critical as the verification of assets because if any liability is omitted (or understated) or inflated, the Balance Sheet will not reflect the true and fair state of the business. For example, if the liability for specific expenses is discovered to have been omitted or understated, it means that the whole amount of expenses has not been charged against the revenue for the relevant period. As a result, the profit figure shown on the Statement of Profit and Loss would be increased by the amount of the liability that was excluded. It would also be erroneous because the liability would not be included in the balance sheet.
In contrast, if a fictitious liability for expenses is adjusted in the accounts, or if liability is overstated, the revenue will bear a higher charge, which will have the effect of artificially reducing profits. The profit or loss figure disclosed by the Statement of Profit and Loss will be distorted as a result. Furthermore, due to the inclusion of the liability, the Balance Sheet will be false as well, because it will include an undisclosed ‘secret reserve.’
The auditor must, therefore, in addition to vouching the entries in regard to the adjustment of liabilities, verify at the end of the year that the liabilities revealed in the client’s Balance Sheet are in fact payable and that all liabilities that could be traced by the auditor’s diligence and care have been accounted for.
He should also obtain a certificate from an authorized official specifying that, to the best of his knowledge and belief, all liabilities, either for purchases/supplies or expenses or any other account that have existed at the date of the Balance Sheet, have been included in the books; and that all contingent liabilities disclosed in the footnote to the Balance Sheet have been provided for.
Objectives of verification of liabilities
For verification of liabilities, an auditor is needed to ensure that they adhere to the following objectives:
Existence: An auditor is required to check that the liabilities shown in the balance sheet of the client are actually payable or not.
Obligation: The liabilities must represent an obligation of the enterprise to third parties and they should have been created for legitimate purposes.
Completeness: All the known liabilities of the enterprise should have been properly accounted for. The auditor should check that all liabilities are properly recorded and contingent liabilities, if any, are also disclosed by way of a footnote to the balance sheet. Contingent liabilities are those liabilities whose incurrence depends upon the happening or non-happening of a future event. For example, a pending or threatened litigation against the entity, discounted bills receivable, etc.
Valuation: The liabilities should be stated in the financial statements at fair and reasonable figures. The auditor has to ensure that they are correctly valued.
Disclosure: There should be proper disclosure of liabilities in the financial statements. The auditor should check that liabilities are classified and disclosed in the balance sheet in accordance with recognized accounting principles and relevant statutory requirements.
Procedures for verification of liabilities
Verification of liabilities is normally carried out by employing a set of procedures, including:
- examination of records
- direct confirmation procedure
- examination of disclosure
- analytical review procedures
- obtaining management representations
The nature and scope of the procedures to be performed is, however, a matter of professional judgment of the auditor and is also based on his assessment of how effective the entity’s related internal controls are.
Sample audit procedures
To take an example, let us consider the audit procedures to be adopted for verification and valuation of trade creditors. An auditor must follow the below-mentioned procedures for verifying the existence, obligation, completeness, valuation, and disclosure of trade creditors:
- The auditor should obtain a schedule of trade creditors from the company and examine it with Purchases Ledger, Cash Book, Credit Notes, Bills Payable, Goods Inward Book, Returns Outward Book, Invoices, etc.
- The auditor should examine the entity’s cut-off procedures for transactions affecting the trade payable accounts to ensure that they are adequate. For example, during the days prior to the year’s end, the auditor may check documentation relating to the receipt of items from suppliers and verify that the corresponding invoices have been reported as purchases for the current year.
- If there are any odd payments near the end of the year, the auditor should extensively examine them. The auditor should check to see if any entries relating to such payments have been reversed in the following period.
- The auditor can obtain confirmations directly from the creditors in respect of their outstanding dues and compare them with the schedule of creditors.
- If any items of creditors have not been paid for a long time, the auditor must examine them and find out the reasons.
- The auditor should use analytical review procedures such as comparison of closing balances of trade payables & other current liabilities with the corresponding figures for the previous year, comparison of actual closing balances of trade payables with the corresponding budgeted amounts, comparison of current year’s aging schedule of trade payables with that of the previous year, comparison of ratios relating to trade payables with the similar ratios for other firms in the same industry, etc.
- The auditor should examine the possibility of a payment that has already been shown to creditors but has not yet been made, and the cash has been misappropriated.
Further, to verify loans and borrowings, an auditor may adopt the following procedures:
- The auditor should ensure that the loans secured are within the entity’s borrowing capacity. For this, he should examine its Memorandum and Articles of Association and also examine whether the provisions of Sections 179 and 180(1)(c) of the Companies Act, 2013 are complied with.
- To determine the validity and accuracy of the loans, the auditor should examine the appropriate records.
- In the case of loans and advances from banks, financial institutions, and others, the auditor should ensure that the book balances match the lender’s statements. He should also look over any reconciliation statements that the entity has prepared in this regard.
- The auditor should review the key terms of the loan agreements as well as any documents indicating “charge” in relation to such loans. He should particularly look at whether the conditions of the relevant statute concerning the creation and registration of charges have been met.
- Where the entity has accepted deposits, the auditor should check to see if the Reserve Bank of India or other applicable authority’s directives have been followed. He should also see whether the relevant legal provisions, e.g., Section 73 of the Companies Act, 2013 have been complied with.
- If the security’s value is less than the loan’s outstanding amount, the auditor should look into whether the loan is designated as secured only to the extent of the market value of the security.
- The auditor should see whether installments of long-term loans falling due within the next 12 months have been disclosed in the financial statements in parentheses or by way of a footnote and he should verify the correctness of the amounts of such installments.
- The auditor should use analytical review procedures such as comparison of closing balances of loans and borrowings with the corresponding figures for the previous year, comparison of actual closing balances of loans/borrowings with the corresponding budgeted amounts, comparison of ratios relating to loans/borrowings with the similar ratios for other firms in the same industry, etc.
As seen above, verification of liabilities is an important aspect of any audit process as it helps to confirm the accuracy and valuation of liabilities disclosed in the balance sheet. However, it may be clarified that the foregoing is only an illustrative list of audit procedures that an auditor may employ in carrying out an audit of liabilities. The exact nature and extent of the procedures to be applied in a specific situation is a matter of the professional judgment of the auditor.
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