Audit of Liabilities - Handouts

ACC124AUDITING AND ASSURANCE: CONCEPTS AND APPLICATIONS 1 BSA3
AUDIT OF LIABILITIES
Liabilities are important part of the financial statement of the business as most business is having different
kinds of liabilities. These liabilities are reported either current or non-current in the statement of financial
position. This item in the financial statement is given consideration of the auditors with its characteristics that
most of the liability transaction of the business is evidence by documents coming from third parties.
In performing an audit, the auditor in applying professional skepticism shall understand that management
tends to understate liabilities in their reports. Hence, the auditor is more concern in the completeness of these
items rather than existence. Procedures are to be performing to detect whether there is material misstatement
in liability accounts.
When auditing liabilities, the auditor give consideration to accounts related such as interest expense on notes
payable, bonds payable and liability under finance lease. Liabilities may arise in normal course of business
(trade) or other than the normal course of business (non-trade). All trade payables are recognized as current
while non-trade payable is recognized as either current or non-current in the financial statement.
Audit Objectives
Accounts Payable and related accounts
The objective of auditing accounts payable and related accounts (payment cycle) is to determine whether the
accounts are fairly presented in accordance with practicable reporting standards (criteria). There are three
transactions include in this cycle:
a. Acquisition of goods and services;
b. Cash disbursements; and
c. Purchase returns and allowances and purchase discounts.
The auditor in performing audit procedures shall understand the use of the related documents (evidences)
which includes the following:
1. Purchase requisition. A document used by the employee to request goods and services. This
document is initiated by the department in need of goods or services such as materials (production
staff), and request for repairs (machinery operator). Some company’s make use of computer generated
reorder point to determine when the purchase is made.
2. Purchase order. A document used to place an order of goods and services to selected vendors. The
document shall include the specifications of goods and services ordered such as description, quantity
and information specifically goods or services procured. This may be submitted electronically, provided,
the company has an arrangement to use an electronic data interchange (EDI).
3. Receiving report. A document that is prepared when the goods are received from the vendor. An
adequate control is needed when goods are received from vendor to examine the quantity, condition
and specifications of goods ordered. The receiving report shall indicate the date of the receipt of goods
as most of the companies are recording the transaction upon receipt of goods.
4. Vendor’s invoice. It is a document from a vendor that shows the description, quantity, total cost,
terms of shipment, terms of payment (including discounts) and the date (dates) of billing. The vendor’s
invoice is commonly the basis in recording the transaction for accounts payable.
5. Debit memo. A document from a vendor as an evidence of reduction in the accounts for a goods
return or allowances granted.
6. Voucher. A pre-numbered document used by most companies to record and control the acquisition of
goods. Attachments for this document includes, purchase order, receiving report and vendor’s invoice.
7. Purchases journal. A document that stores information of purchasing transactions which typically
includes the vendor’s name, date of transaction, amount and accounts classification.
8. Accounts payable monster file. A document that records the purchase, payments, returns and
allowances for each vendor. The file is updated on a timely basis and the total shall be in agreement
with the totals in the accounts payable general journal.
Page 1 of 19 Compiled & Adapted

9. Cash disbursement journal. A listing that includes all transactions of disbursements for a period.
The primary objective in auditing accounts payable are to determine whether:

a. All accounts payable on the SFP are real debts due to suppliers or other creditors of the entity for
goods received or services performed.
b. All accounts payable owed by the entity at the SFP date are included in the SFP
c. Accounts payable are stated at the amounts owed at the SFP date
d. The accounts payable on the SFP represents obligations of the entity at the SFP date. The accounts
payable are not secured by lien on assets, security interests, or other collateral unless otherwise
indicated.
e. Accounts payable are properly classified, described, and disclosed in the FSs, including notes, in
conformity with prescribed accounting principles.
Primary Substantive Procedures

1. Agree the AP sub-ledger to the general ledger control accounts and investigate large and unusual
reconciling items.
2. Inquire about or perform review of AP sub-ledger for unusual items, e.g. significant debit balances in
the AP sub-ledger or other unexpected amounts to verify proper classification and valuation.
3. Perform cutoff tests for goods and services received as well s for supplier credit memos to ensure that
transactions are completely recorded in the correct period.
4. Perform a search for unrecorded liabilities at the year-end date by selecting subsequent disbursements
and unmatched invoices and receiving reports.
5. Compare supplier balances post year-end to those at year-end and investigate unusual or significant
changes.
6. Test appropriate valuation of accounts payable in foreign currencies.
Agreement of SL with GL
The auditor shall ask from the management a copy of summary of trade payables commonly on a per supplier
account. The auditor will check the accuracy of the footings and cross footings of the schedule from the client
and inquire with procedures taken to ensure that the schedule is complete. In case of non-agreement, the
auditor will review and reconcile the sub-ledger and control account and investigate reconciling items.
Confirmation replies may be used by the auditor to review and reconcile balances.
Confirmation
The auditor in determining existence of AP including its valuation will decide to use confirmation. Use the audit
risk tables to determine the extent of the sample or document the rationale for the sample selection in the
working papers. An auditor may use either positive or negative confirmation.
Purchases and accounts payable cut-off

Test the cut-off by inspecting the voucher register, receiving reports, vendors’ invoices and other supporting
documents immediately before and after the cutoff date and determine that the transactions were recorded in
the proper period; compare payables cut-off to cut-off in related areas. To ascertain that the transaction is
completely recorded in the correct period, the auditor performed cut-off procedure. In performing cut-off, the
auditor usually does the following:
1. Obtain and examine invoices from suppliers and trace whether the transaction is recorded in the
purchase journal and cash disbursement journal. Determine whether these invoices are recorded in
proper period.
2. Review the cut-off in related areas such as inventory cut-off with consideration given to goods in
transit.
Search for unrecorded liabilities

Perform a search for unrecorded liabilities as of the inventory date and/or year-end by selecting subsequent
disbursements and unmatched invoices and receiving reports to examine. Compare vendors’ invoices to the
initial record of entry (voucher register). Examine payments of balances subsequent to the statement of
financial position date to verify recorded payables. Compare entries in the voucher register to vendors’
invoices. Test the account distributions of purchases in the voucher register by comparing the nature of the
goods or services purchased with the descriptions of the accounts. Ask the client to adjust amounts of
unrecorded liabilities.

Test of posting of voucher
Test the mathematical accuracy of the voucher register. Test posting of items in the voucher register to
supporting documentation. Test the postings of the totals in the voucher register to the general ledger and
subsidiary ledgers.
Payroll application for liabilities

1. The following are the procedures performed by the auditor to test liabilities related to payroll.
2. Examine or prepare a bank reconciliation of the payroll cash account and where needed perform cut-
off procedures.
3. Account for the numerical sequence of paid payroll checks during a specified time period.
4. Compare the payroll at the beginning and end of the period to identify changes in employees and in
pay rates.
5. Compare hours paid with the record of hours worked (e.g. time cards).
6. Trace payroll checks to the payroll register.
7. Agree the record of labor performed (time cards or job tickets) to the labor cost distributions or to the
payroll register.
8. Obtain a list of employees who left during the period from a source other than the payroll department
(e.g. the personnel department), and determine that the former employees were removed from the
payroll on a timely basis.
9. Observe, on a surprise basis, the distribution of payroll checks to employees.
10. Investigate the handling of unclaimed payroll checks.
11. Compare employee data (e.g. name, identification number, department, employee status or group,
location, wage rate, deductions) to authorizations on file (e.g. hiring records, personnel files on wage
rates and reductions, union contracts and authorization for income tax withholding).
12. Compare names, net pay and other data in the payroll register to the cancelled payroll checks or
substitute checks. Examine endorsement(s) on payroll checks or substitute checks and compare them
to specimen signatures in the personnel files; investigate unusual or multiple endorsements.
13. Test the extensions of the wage rates times the hours worked.
14. Test the mathematical accuracy of the individual labor cost distributions.
15. Review that the hours on the record of labor performed (e.g. time cards or job tickets) is recorded in
the payroll register or the labor distribution journal in the correct period.
16. Reconcile the accrued payroll balance to the amount in the payroll register for the corresponding
period.
Provisions, Accrued Liabilities and Other Liabilities and Deferred Income

The primary objectives in auditing provisions, accrued liabilities and other liabilities, and deferred income, and
the related income and expense accounts, are to determine whether:
1. All accrued and other liabilities on the SFP have accrued or are real debts of the entity, and all deferred
income on the SFP represents income that is appropriately deferred to future periods.
2. All liabilities that have accrued at the SFP and all income that is appropriately deferred to future periods
are included on the SFP.
3. Accrued and other liabilities and deferred income are included on the SFP at the appropriate amounts,
and deferred income is being allocated to the periods in which it is earned.
4. The accrued and other liabilities on the SFP represents obligation of the entity at the SFP date which
are not secured by liens on assets, security interests, or other collateral nor have they been assumed
or guaranteed by others unless otherwise indicated.
5. Accrued and other liabilities and deferred income are properly classified, described, and disclosed in the
FSs, including notes, in conformity with prescribed accounting principles.
Primary Substantive Procedures – Provisions, accrued and other liabilities, deferred income
1. Review the schedule of provisions, accrued liabilities and deferred income for correctness and
completeness, agree amounts to the general ledger accounts and ensure proper cutoff.
2. Examine the composition and computation of pension and other employee-related long-term reserves
for reasonableness and consider the use of specialists.
3. Review other liabilities to determine they are appropriate. Determine that the amounts appear to be
reasonable in comparison with prior years and under consideration of your understanding of the clients
business and changes to it.
4. Review lawyer confirmations as required in the GAAP, minutes and other documents to ensure that
appropriate reserves/accruals have been recorded by the client.
5. Search for unrecorded reserves/accruals, e.g., contracts (rent), and sales (warranties and returns).
Income Taxes, Deferred Taxes and Related Income Statement Accounts
The primary objectives in auditing income tax payable, deferred taxes and related income tax expense are to
determine whether:
1. All liabilities for income taxes on the SFP represent amounts owed to governmental entities for income
taxes. All recorded income tax expense has accrued at the SFP date.
2. All liabilities for income taxes owed by the entity and income tax expense that had accrued at the SFP
date have been recorded.
3. Income taxes payable are included on the SFP at the appropriate amounts.
4. The income taxes payable on the SFP represents obligations of the entity at the SFP date.
5. Liabilities for income taxes and the related income tax expense are properly classified, described, and
disclosed in the FSs, including notes, in conformity with prescribed accounting principles.
6. All deferred income taxes and other non-current credits on the SFP represent amounts that have
accrued at the SFP date or that are appropriately deferred to future periods.
7. All deferred income taxes and other non-current credits that have accrued at the SFP date or that are
appropriately deferred to future periods are included on the SFP.
8. Deferred income taxes and other non-current credits are included on the SFP at the appropriate
amounts.
9. Deferred income taxes and other non-current credits are properly classified, described, and disclosed in
the FSs, including notes, in conformity with prescribed accounting principles.
Primary Substantive Procedures – Income Tax

a. Test the reconciliation of the current year book or statutory and taxable income, validate the split
between permanent and timing differences, and compare reconciling items with those in prior years
and examine supporting documents.
b. Test computations of provisions for current and deferred income taxes for the current year and
reconcile to appropriate SFP and IS accounts.
c. Investigate potential impairments of deferred tax assets.
d. Review the movement of income tax account balances from prior year (including those currently
payable or deferred) and valuation allowances for deferred tax assets.
e. Determine whether provision should be made for any tax positions taken by the client or other tax
contingencies, e.g. as a result of related party transactions, that may be challenged by tax authorities.
f. Test the intercompany and other related party transactions have a valid business reason and are
recorded on an arm’s length basis. If n doubt, consider the involvement of appropriate experts.
Reconciliation and re-computation

The auditor in reconciliation shall:
a. Review the income taxes payable and related expense accounts in the general ledger for unusual
items.
b. Examine support for tax payments made and refunds received during the period.
c. Determine whether any tax authority examinations have been completed during the period or are
currently in progress; review completed reports or the status of examinations in progress; determine
whether additional provisions are needed for possible assessments; penalties or interest.
d. Review prior periods’ returns not yet examined by the tax authorities for items similar to those adjusted
or proposed for adjustment by the tax authorities; determine whether additional provisions should be
made.
e. Determine that all required income tax returns have been properly and timely filed by the client.
f. Consult with tax personnel on significant income tax matters; coordinate with the tax department the
review of income tax accruals, provisions, status of tax matters, and related FSs disclosures.
g. Review the deferred income tax and the other non-current credit accounts in the general ledger for
unusual items.
h. Review reconciliation of the amounts credited or charged to deferred income taxes and other non-
current credit accounts during the period with the related income or expense accounts.
i. Review the current period’s books and taxable income to identify differences.
j. Determine the methods of accounting for deferred income taxes and other non-current credits, and the
consistency with which the methods have been applied.

ILLUSTRATION:
Predapul Corporation is in the process of finalizing its income tax return for filing to the BIR. The filing to the
BIR requires the submission of the audited FSs as well as the Statement of Management’s Responsibility.
Relative to this, you were asked by your audit manager to validate the figures presented in the IS against the
annual taxable income of Predapul. Upon examination of the client’s available documents, you noticed that the
taxable income reported in the tax return and the income before tax presented in the FSs is the same. You
also noted the following items which you think should logically cause a difference between the income
reported in the IS and ITR.
Premiums paid on life insurance policy on officers
(beneficiary named in the policy is the company) 300,000
Rent collected in advance 35,000
Excess of tax depreciation over book depreciation 20,000
Fines and penalties paid 30,000
Excess of warranty expense over actual
expenditures 15,000
Excess of estimated uncollectible accounts for
financial reporting over the accounts actually
written off for tax reporting 18,000
Impairment loss recognized on goodwill 90,000
Furthermore, you discovered that the client did not prepare a reconciliation of the statutory income tax in the
Notes to the FSs and there were no deferred tax asset and liability in the SFP. The reported pretax financial
income of Predapul is P1,500,000 and current income tax rate is 30%.
1. How much is the taxable income in 2019?

2. How much is the tax expense (benefit) – deferred?
SOLUTION:
FINANCIAL INCOME 1,500,000
Permanent Difference
Fines and penalties paid 30,000
Premiums paid on life insurance policy on officers 300,000
Impairment loss recognized on goodwill 90,000
Temporary Difference
Excess of tax depreciation over book depreciation (20,000)
Excess of warranty expense over actual expenditures 15,000
Excess of estimated uncollectible accounts for financial reporting
over the accounts actually written off for tax reporting 18,000
Taxable Income 1,968,000
Excess of warranty expense over actual expenditures 15,000

Excess of estimated uncollectible accounts for financial
reporting over the accounts actually written off for tax
reporting 18,000
Total 68,000
Tax Rate 30%
Deferred tax asset (FI<TI) 20,400
Excess of tax depreciation over book depreciation 20,000

Tax rate 30%
Deferred tax liability (FI>TI) 6,000
Deferred tax asset 20,400 Tax expense – Deferred 6,000

Tax expense – Deferred 20,400 Deferred tax liability 6,000
Deferred tax benefit (20,400 – 6,000) 14,400

Notes and Bond payable
It is common to audit the balance in notes payable and bonds payable in conjunction with the audit of interest
expense and interest payable because it minimizes the verification time and reduces the likelihoods of
overlooking misstatements in the balance. Once the auditor is satisfied with the balance in notes payable and
bonds payable and the related interest rates and due dates for each note or bonds, it is easy to test the
accuracy of accrued interest. If the interest expense for the year is also tested at the same time, the likelihood
of omitting a note from notes payable (bonds) for which interest has been paid is minimized. When there are a
large number of notes (bonds) or a large number of interest expense as a part of the audit of the notes
(bonds) payable and related accrued interest. Normally, however, there are only a few notes (bonds) and few
transactions during the year.
The most important controls the auditor should be concerned about in the audit of notes (bonds) payable are:
1. The proper authorization for the issuance of new notes or bonds (or renewals) to ensure that the
company is not being committed to debt arrangements that are not authorized.
2. Controls over the repayment of principal and interest to ensure that the proper amounts are paid.
3. Proper records and procedures to ensure that all amounts in all transactions are properly recorded.
4. Periodic independent verification to ensure that all the controls over notes payable are working.
The objectives of the audit of notes (bonds) payable are to determine whether:
1. Internal controls over notes (bonds) payable are adequate;
2. Transactions for principal and interest involving notes (bonds) payable are properly authorized and
recorded in accordance with practicable standards;
3. The liability for notes (bonds) payable and the related interest expense and accrued liabilities are
properly reported in the SFP; and
4. Disclosures related to notes (bonds) payable and related interest expense were property disclosed in
the financial statements.
There are four important controls over notes (bonds) payable.

1. Proper authorization for the issue of new notes (bonds) payable. Responsibility for the issuance of new
notes (bonds) payable should be vested in the board of directors or high level management personnel.
Generally, signatures of multiple properly authorized officials are required for all loan agreements,
which usually stipulate the amount of loan, interest rate, payment terms and pledges if any. When the
instrument is renewed they need to be subject to the same authorization procedures as those for the
issuance of new instruments.
2. Adequate controls over the payment of principal and interest. At the time the note (bond) was issued,
the accounting department should have received a copy of the note (bond). The accounting
department should provide documents and issue checks when the notes (bonds) become due.
3. Proper documents and records. This includes subsidiary records and control over blank and paid notes
(bonds) by an authorized person. Paid notes (bonds) shall be cancelled and retained under the custody
of authorized personnel/
4. Periodic independent verification. Periodically, the detailed records should be reconciled with the
general ledger and compared with the holder’s records by an employee who is not responsible for
maintaining the detailed records. At the same time, an independent person should re-compute the
interest expense to test the accuracy of the record keeping.
The tests of controls and substantive tests of transactions for liability accounts in the capital acquisition
and repayment cycle consists of test of the control and substantive tests over the payment of principal and
interest and the issuance of new notes or other liabilities payable, and interest expense. A unique aspect of
the capital acquisition and repayment cycle is that auditors normally verify the transactions and balances in
the account.

Purpose of Control Potential Financial Audit Procedure to
Statement Misstatement Determine Existence of
Material Misstatement
1. To ensure that all note Loss of assets through payment Examine note request forms for
liabilities are actual of excess interest rates or the proper authorization and discuss
liabilities of the company diversion of cash to unauthorized terms of note with appropriate
persons. management personnel.
2. To ensure that note Improper disclosure or Reconcile detailed contents of
transactions are recorded misstatements in notes (bonds) master file or other records to
in full and in detail. payable through duplication. control account.
3. To prevent misuse of Misstatement of liabilities and Perform all substantive
notes and funds cash. procedures on extended basis.
earmarked for notes. Trace from paid notes file to
cash receipts to determine that
the appropriate amount of cash
was received when the note was
issued.
4. To ensure that notes are Loss of cash Examine outstanding notes and
not paid more than once. paid notes for similarities and the
potential for reusing the notes.
5. To ensure that all note- Misstatement of notes (bonds) Reconcile master file with
related transaction agree payable outstanding notes payable
with account balances
6. To ensure that only the Misstatement of interest expense Re-compute interest on a test
proper interest amount is and related accrual basis
paid and recorded
ILLUSTRATION (Notes payable)

The following transactions were summarized by your audit staff related to audit of notes payable during 2020:
Notes payable A
March 1, 2020, borrowed P250,000 on a three year, 10 percent (10%), interest bearing note. Interest is paid
yearly.
Notes payable B
May 1, 2020, borrowed cash and signed a P200,000, a four-year, non-interest bearing note. The market rate
of interest for this travel of risk was thirteen percent (13%). Received cash equals to fair value of notes issued
and the difference is charged to interest expense.
Notes payable C
January 1, 2020, purchased an equipment with a list price of P330,000. Paid P30,000 cash and signed a
P300,000, three year, 12% interest bearing note payable in equal payments every December 31 starting 2020
plus interest based on outstanding balance. The market rate of interest for this level was at 14% percent.
You noted that the accountant recorded the transactions at face value of notes and interest expense were all
recorded for interest bearing notes only at nominal interest rate upon payment. No accrual was made and no
interest is recorded for non-interest bearing notes.
Determine the following as a result of your audit?

1. Proposed journal entries for each note during 2020:
2. How much is the interest expense in 2020 and related notes payable?
3. How much is the interest payable at year-end?
4. How much is reported as current notes payables?
5. How much is reported as non-current notes payables?

Notes payable A
Audit notes:
1. No effective interest is given, hence, effective is equal to nominal.
2. Interest is paid yearly, as of year-end no payment is made; therefore, accrued interest is recognized in
the financial statement based on effective interest. The accountant did not record interest expense nor
interest payable at year-end. Adjustment is to be made.
3. The note is payable after three years, thus, the full amount of P250,000 shall be reported as non-
current liability.
Accrued interest:
P250,000 x 10% x 10/12 = 20,833
Proposed adjusting journal entry:

Interest expense 20,833
Interest payable 20,833
Notes payable B
Audit notes:
1. The note is a non-interest bearing, thus, no accrued interest is to be recognized.
2. The note is issued at a different effective rate, discount on notes payable shall be recorded and
amortized over the four year life of the note. The note was recorded by the accountant at face value,
adjustment is to be made.
3. Interest expense based on effective shall be recognized, but the accountant neglected to record
interest expense, adjustment is to be made.
4. The notes shall be reported at its carrying value in the FSs. Since it is payable on lump sum after four
years, the total carrying value is reported as non-current liability
Date Interest (13%) Carrying Value

5/1/2020 - 122,664
12/31/2020 10,631* 133,295
*interest for 10 months only
Audit analysis:
Entry made:
5/1
Cash 122,664
Notes payable 200,000
12/31 No entry
Correct entries:
5/1
Cash 122,664
Discount on notes payable 77,336
12/31
Proposed adjusting journal entry:

12/31

Notes payable C
Audit notes:
1. The notes is interest bearing with nominal and effective rates are different. Nominal interest is lower
than market rate, thus, it results in a discount on notes payable. Adjustment is to be made since the
accountant recorded that transaction at face value. The note is payable in installment of equal amounts
to principal and variable for interest payments every December 31.
2. Since, it is payable in installment, the note can be separated into current and non-current portion at
year-end, where, payment to be made more than one year after year-end are reported as non-current.
3. Interest expense is to be recognized based on effective interest of 14% but the accountant recognized
interest expense based on nominal interest, adjustment is to be made.
Fair value of the note:
(100,000) + (300,000 x 12%) = 136,000 x 1.14^1 119,298
(100,000) + (200,000 x 12%) = 124,000 x 1.14^2 95,414
(100,000) + (200,000 x 12%) = 112,000 x 1.14^3 75,597
TOTAL 290309
Amortization table over the life of the note:

Date Principal 12% Nominal 14% Effective Amortization Carrying value
1/1/2020 290,309
12/31/2020 100,000 36,000 40,643 4,643 194,952
12/31/2021 100,000 24,000 27,293 3,293 98,246
12/31/2022 100,000 12,000 13,754 1,754 -
Audit analysis:
Entries made:
1/1
Equipment 330,000
Cash 30,000
12/31
Cash 136,000
Correct entries:
1/1
Equipment 320,309
Discount on note payable 9,691
Cash 30,000
12/31
Cash 136,000
Proposed adjusting entry:

Equipment 9,691
Requirement 2:
Interest expense in 2020 (Refer to the amortization table)
Note A 20,833
Note B 10,631
Note C 40,643
Total 72107

Requirement 3:
Interest payable is for Note A only amounting to P20,833.
Requirement 4 and 5:
Current Non-current
Note A - P250,000
Note B - 133,295
Note C 96,706 98,246
Total 96,706 481,541
Employee Benefits
Employee benefits are all forms of consideration given by an entity in exchange for service rendered by
employees. Short-term employee benefits are employee benefits (other than termination benefits) that are
due to be settled within 12 months after the end of the period in which the employees render the related
service. Post-employment benefits are employee benefits (other than termination benefits) which are payable
after the completion of employment. Post-employment benefit plans are formal or informal arrangements
under which an entity provides post-employment benefits are formal or informal arrangements under which an
entity provides post-employment benefits for one or more employees. Defined contribution plans are post-
employment benefit plans under which an entity pays fixed contributions into a separate entity (a fund) and
will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient
assets to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits
relating to employee service in the current and prior periods. Defined benefit plans are post-employment
benefit plans other than defined contributions plans.
All short-term employee benefits

When an employee has rendered service to an entity during an accounting period, the entity shall recognize
the undiscounted amount of short-term employee benefits expected to be paid in exchange for that service:
a. As a liability (accrued expense), after deducting any amount already paid. If the amount already paid
exceeds the undiscounted amount of the benefits, an entity shall recognize that excess as an asset
(prepaid expense) to the extent that the prepayment will lead to, for example, a reduction in future
payments or a cash refund; and
b. As an expense, unless another Standard requires or permits the inclusion of benefits in the cost of an
asset
Short-term compensated absences

An entity shall measure the expected cost of accumulating compensated absences as the additional amount
that the entity expects to pay as a result of the unused entitlement that has accumulated at the end of the
reporting period. Accumulating compensated absences are those that are carried forward and can be used in
future periods if the current period’s entitlement is not used in full. Accumulating compensated absences may
be either vesting (in other words, employees are entitled to a cash payment for unused entitlement on leaving
the entity) or non-vesting (when employees are not entitled to a cash payment for unused entitlement on
leaving). An obligation arises as employees render service that increases their entitlement to future
compensated absences are non-vesting, although the possibility that employees may leave before they use an
accumulated non-vesting entitlement affects the measurement of that obligation.
Illustration:
An entity has 100 employees, who are entitled to five working days each of paid sick leave for each year.
Unused sick leave may be carried forward for one calendar year. Sick leave is taken first out of the current
year’s entitlement and then out of any balance brought forward from the previous year. At December 31,
2019, the average unused entitlement is two days per employee. The entity expects, based on past experience
which is expected to continue, that 92 employees will take no more than five days of paid sick leave in 2020
and that the remaining eight employees will take an average of six and a half days each.
The entity expects that it will pay an additional 12 days of sick pay as a result of the unused entitlement that
has accumulated at December 31, 2019 (one and a half days each, for eight employees). Therefore, the entity
recognizes a liability equal to 12 days of sick pay.

Post-employment benefits
Post-employment benefits are classified as either defined contribution plans or defined benefit plans,
depending on the economic substance of the plan as derived from its principal terms and conditions.
Under defined contribution plans: (a) the entity’s legal or constructive obligation is limited to the amount that
it agrees to contribute to the fund. Thus, the amount of the post-employment benefits received by the
employee is determined by the amount of contributions paid by an entity (and perhaps also the employee) to
a post-employment benefit plan or to an insurance company, together with investment returns arising from
the contributions; and (b) in consequent, actuarial risk (that benefits will be less than expected) and
investment risk (that assets invested will be insufficient to meet expected benefits) fall on the employee.
Under defined benefit plans: (a) the entity’s obligation is to provide the agreed benefits to current and former
employees; and (b) actuarial risk 9that benefits will cost more than expected) and investment risk fall, in
substance, on the entity. If actuarial or investment experience are worse than expected, the entity’s obligation
may be increased.
Illustration:
Defined benefit plan
You were engaged in the Audit of F Corporation for the year 2020. During your audit, you were able to obtain
the following information:
Pension Asset/Prepaid, January 1 14,000,00
0
Current Service Cost 5,400,000
Past Service Cost 800,000
Interest Expense 2,000,000
Contribution to the plan 3,000,000
Benefits paid to retirees 4,400,000
Interest income on plan assets 2,700,000
Re-measurement gain on defined benefit 800,000
obligation
Required:
1. The discount rate used was:
2. How much is the Defined Benefit Obligation at December 31, 2020?
3. How much is the retirement benefit expense for 2020 taken to profit or loss?
4. How much is the Fair Value of the Plan Assets at December 31, 2020?
5. The amount reported in the SFP as defined benefit assets or liability is:
Profit or Loss OCI Plan Asset/Plan FPA DBO

Liability
Beginning balances 14,000,000 54,000,000 40,000,000
Service cost:
Past 800,000 (800,000) 800,000
Current 5,400,000 (5,400,000) 5,400,000
Interest cost - net
Interest
expense 2,000,000 (2,000,000) 2,000,000
Interest
income (2,700,000) 2,700,000 2,700,000
Re-measurement
FPA
DBO - gain (800,000) 800,000 (800,000)
Contribution to the
plan 3,000,000 3,000,000
Benefits paid (4,400,000) (4,400,000)
5,500,000 -800000 12,300,000 55,300,000 43,000,000
Interest expense 2,000,000

Interest income 2,700,000

Net Interest Income 700,000
Beginning pension 14,000,000
asset
Discount rate 5%
An entity shall determine the present value of defined benefit obligations and the fair value of any plan assets
with sufficient regularity that the amount recognized in the FSs do not differ materially from the amounts that
would be determined at the end of the reporting period. For practical reasons, an entity may request a
qualified actuary to carry out a detailed valuation of the obligation before the end of the reporting period.
Nevertheless, the results of that valuation are updated of any material transactions and other material changes
in circumstances (including changes in market prices and interest rates) up to the end of the reporting period.
An asset may arise where a defined benefit plan has been overfunded or in certain cases where actuarial gains
are recognized. An entity recognizes an asset in such cases because:
a. The entity controls is a resource, which is the ability to use the surplus to generate future benefits;
b. That control is a result of past events (contributions paid by the entity and service rendered by the
employee); and
c. Future economic benefits are available to the entity in the form of a reduction in future contributions or
a cash refund, either directly to the entity or indirectly to another plan in deficit.
Leases
Under the new standard (IFRS 16), a lease is a contract, or a part of contract, that conveys the right to use an
asset (the underlying asset) for a period of time in exchange for consideration. To be a lease, a contract must
convey the right to control the use of an identified asset, which could be a physically distinct portion of an
asset such as floor of a building.
A contract conveys the right to control the use of an identified asset if, throughout the period of use, the
customer has the right to:
a. Obtain substantially all of the economic benefits from the use of the identified asset; and
b. Direct the use of the identified asset (i.e., direct how and for what purpose the asset is used)
Definition of lease Who benefits?
Identified asset and Right to control the use of the

d identified asset
No substantive No benefits from Right to obtain

Right to direct
rights to substitution substantially all
the use
substitute economic
benefits
At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or
contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time
in exchange for consideration.
Lease term
An entity shall determine the lease term as the non-cancellable period of a lease, together with both:
a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that
option; and
b. Period covered by an option to terminate the lease if the lessee is reasonably certain not to exercise
that option.
In assessing whether a lessee is reasonably certain to exercise an option to extend a lease, or not to exercise
an option to terminate a lease, an entity shall consider all relevant facts and circumstances that create an
economic incentive for the lessee to exercise the option to extend the lease, or not to exercise the option to
terminate the lease. A lessee shall reassess whether it is reasonably certain to exercise an extension option, or

not to exercise a termination option, upon the occurrence of either a significant event or a significant change
in circumstance that:
a. Is within the control of the lessee; and
b. Affects whether the lessee is reasonably certain to exercise an option not previously included in its
determination of the lease terms (as described in paragraph B41 of IFRS 16).
An entity shall revise the lease terms if there is a change in the non-cancellable period of a lease. For example,
the non-cancellable period of a lease will change if:
a. The lessee exercises an option not previously included in the entity’s determination of the lease term;
b. The lessee does not exercise an option previously included in the entity’s determination of the lease
term;
c. An event occurs that contractually obliges the lessee to exercise an option not previously included in
the entity’s determination of the lease term; or
d. An event occurs that contractually prohibits the lessee from exercising an option previously included in
the entity’s determination of the lease term.
Initial recognition and measurement – Right of Use Asset

Lessee is required to initially recognize a lease liability for the obligation to make lease payments and a right-
of-use asset for the right to use the underlying asset for the lease term. The lease liability is measured at the
present value of the lease payments to be made over the lease term.
The right of use asset is initially measured at the amount of the lease liability, adjusted, for lease
prepayments, leas incentive received, the lessee’s initial direct costs (e.g., commissions) and an estimate of
restoration, removal and dismantling costs. Lessee are permitted to make an accounting policy election, by
class of underlying asset, to apply a method like PAS 17’s operating lease accounting and not recognize lease
assets and lease liabilities for leases with a lease term of 12 months or less (i.e. short-term leases). Lessees
also are permitted to make an election, on a lease-by-lease basis, to apply a method similar to current
operating lease accounting to leases for which the underlying is of low value (i.e. low-value assets).
The cost of the right of use asset shall comprise:

a. The amount of the initial measurement of the lease liability;
b. Any lease payments made at or before the commencement date, less any lease incentives received;
c. Any initial direct costs incurred by the lessee; and
d. An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset,
restoring the site on which it is located or restoring the underlying asset to the condition required by
the terms and conditions of the lease, unless those costs are incurred to produce inventories. The
lessee incurs the obligation for those costs either at the commencement date or as a consequence of
having used the underlying asset during a particular period.
At the commencement date, a lessee shall measure the right of use asset at cost.
Subsequent measurement
After the commencement date, a lessee shall measure the right of use asset applying a cost model. To apply a
cost model, a lessee shall measure the right of use asset at cost:
a. Less any accumulated depreciation and any accumulated impairment losses; and
b. Adjusted for any re-measurement of the lease liability.
A lessee shall apply the depreciation requirements in PAS 16 Property, Plant and Equipment in depreciating the
right of use asset. If the lease transfers ownership of the underlying asset to the lessee by the end of the
lease terms or if the cost of the right of use asset reflects that the lessee will exercise a purchase option, the
lessee shall depreciate the right of use asset from the commencement date to the end of the useful life of the
underlying asset. Otherwise, the lessee shall depreciate the right of use asset from the commencement date to
the earlier of the end of the useful life of the right of use asset or the end of the lease term. A lessee shall
apply PAS 36 Impairment of Assets to determine whether the right of use asset is impaired and to account for
any impairment loss identified.
Presentation
Right of use assets are either presented separately from other assets on the STF or disclosed separately in the
notes.

Right of use assets separately from other assets. If a lessee does not present right of use assets
separately in the SFP, the lessee shall:
a. Include right of use assets within the same line item as that within which the corresponding
underlying assets would be presented if they were owned; and
b. Disclose which line items in the SFP include those right of use assets.
Lease Liability
At the commencement date, a lessee shall measure the lease liability at the present value of the lease
payments that are not paid at that date. The lease payments shall be discounted using the interest rate in the
lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the
lessee’s incremental borrowing rate.
Initial recognition – Lease liability

At the commencement date, the lease payments included in the measurement of the lease liability comprise
the following payments for the right of use the underlying asset during the lease term that are not paid at the
commencement date:
a. Fixed payments (including in-substance fixed payments as described in paragraph B42 of IFRS 16), less
any lease incentives receivable;
b. Variable lease payments that depend on an index or a rate; initially measured using the index or rate
as at the commencement date (as described in paragraph 28 IFRS 16);
c. Amounts expected to be payable by the lessee under residual value guarantees;
d. The exercise price of a purchase option if the lessee is reasonably certain to exercise that option
(assessed considering the factors described in paragraphs B37-B40 IFRS 16); and
e. Payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an
option to terminate the lease.
Variable lease payments that depend on an index, for an example, payments linked to a consumer price index,
payments linked to a benchmark interest rate (such as LIBOR) or payments that vary to reflect changes in
market rental rates.
Subsequent to initial recognition

After the commencement date, a lessee shall measure the lease liability by:
a. Increasing the carrying amount to reflect interest on the lease liability;
b. Reducing the carrying amount to reflect the lease payments made; and
c. Re-measuring the carrying amount to reflect any reassessment or lease modifications or to reflect
revised in-substance fixed lease payments.
Interest on the lease liability in each period during the lease term shall be the amount that produces a
constant periodic rate of interest on the remaining balance of the lease liability. After the commencement
date, a lessee shall recognize in profit or loss, unless the costs are included in the carrying amount of another
asset applying other applicable standards, both:
a. Interest on the lease liability; and
b. Variable lease payments not included in the measurement of the lease liability in the period in which
the event or condition that triggers those payments occurs.
Reassessment of the lease liability

A lessee shall recognize the amount of the re-measurement of the lease liability as an adjustment to the right
of use asset. However, if the carrying amount of the right of use asset is reduced to zero and there is a further
reduction in the measurement of the lease liability, a lessee shall recognize any remaining amount of the re-
measurement in profit or loss. A lessee shall re-measure the lease liability by discounting the revised lease
payments using a revised discounts rate, if either:
a. There is change in the lease term. A lessee shall determine the revised lease payments on the basis of
the revised lease term; or
b. There is a change in the assessment of an option to purchase the underlying asset, assessed
considering the events and circumstances in the context of a purchase option. A lessee shall determine
the revised lease payments to reflect the change in amounts payable under the purchase option.
Presentation

Lease liabilities are presented separately from other liabilities. If the lessee does not present lease liabilities
separately in the SFP, the lessee shall disclose which line items in the SFP include those liabilities.
Initial recognition and measurement – Lessor

The accounting by lessors under the new standard is substantially unchanged from today’s accounting in PAS
17. Lessors classify all leases using the same classification principle as in PAS 16 and distinguish between two
types of leases: operating and finance leases. For operating leases, lessors continue to recognize the
underlying asset. For finance leases, lessors derecognize the underlying asset and recognize a net investment
in the lease similar to today’s requirements. Any selling profit or loss is recognized at lease commencement.
Subsequent measurement
For operating leases, lessors recognize income on either a straight-line basis or another systematic basis that
is more representative of the pattern in which benefit from the use of the underlying asset is diminished. For
finance leases, lessors recognize interest income for the accretion of the net investment in the lease and
reduce that investment for payments received. The net investment in the lease is subject to the derecognition
and impairment requirements in IFRS 9 Financial Instruments.
Sale and leaseback transactions

If an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) leases that asset back
from the buyer-lessor, both the seller-lessee and the buyer-lessor shall account for the transfer contract and
the lease applying IFRS 16. An entity shall apply the requirements for determining when a performance
obligation is satisfied in IFRS 15 to determine whether the transfer of an asset is accounted for as a sale of
that asset. If the transfer of an asset by the seller-lessee satisfies the requirements of IFRS 15 to be
accounted for as a sale of the asset:
a. The seller-lessee shall measure the right of use asset arising from the leaseback at the proportion of
the previous carrying amount of the asset that relates to the right is use retained by the seller-lessee.
Accordingly, the seller-lessee shall recognize only the amount of any gain or loss that relates to the
rights transferred to the buyer-lessor.
b. The buyer-lessor shall account for the purchase of the asset applying applicable standards, and for the
lease applying the lessor accounting requirements of IFRS 16.
If the fair value of the consideration for the sale of an asset does not equal the fair value of the asset, or if the
payments for the lease are not at market rates, an entity shall make the following adjustments to measure the
sale proceeds at fair value:
a. Any below-market terms shall be accounted for as a prepayment of lease payments; and
b. Any above market terms shall be accounted for as additional financing provided by the buyer-lessor to
the seller-lessee.
The entity shall measure any potential adjustment on the basis of the more readily determinable of:
a. The difference between the fair value of the consideration for the sale and the fair value of the asset;
and
b. The difference between the present value of the contractual payments for the lease and the present
value of payments for the lease at market rates.
Transfer of the asset is not a sale

If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS 15 to be accounted
for as a sale of the asset:
1. The seller-lessee shall continue to recognize the transferred asset and shall recognize a financial
liability equal to the transfer proceeds. It shall account for the financial liability applying IFRS 9.
2. The buyer lessor shall not recognize the transferred asset and shall recognize a financial asset equal to
the transfer proceeds. It shall account for the financial asset applying IFRS 9.
Illustration 1:
On January 1, 2020, F Corporation enters into a ten-year lease of floor building, with an option to extend for
five years. Lease payments are P600,000 per year during the initial term and P660,000 per year during the
optional period, all payable at the beginning of each year. To obtain the lease, F Corporation incurs initial
direct costs of P250,000, of which P150,000 relates to payment to a former tenant occupying that floor of the
building and P100,000 relates to a commission paid to the real estate agent that arrange the lease. As an
incentive to F Corporation, for entering the lease, the lessor agrees to reimburse to F Corporation the real
estate commission of P100,000 and leasehold improvements of P90,0000.
At the commencement of the lease, F Corporation concludes that it is reasonably certain not to exercise the
option to extend the lease term.
The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 6% per
annum, which reflects the fixed rate at which lessee could borrow an amount similar to the value of the right
of use asset, in the same currency, for a ten-year term and with similar collateral.
1. How much is the initial cost of the right of use asset?

2. How much is the balance of lease obligation at the end of second year?
SOLUTION:
PV Rentals (600,000 x 7.80169) 4,681,015
Initial direct cost (250,000 – 150,000
100,000)
Total cost of right of use asset 150000
January 1, 2020
Right of use asset 4,681,015
Cash 600,000
Lease liability 4,081,015
Right of use asset 150,000

Cash 150,000
Amortization table is as follows:

Payments to
Date Principal Interest (6%) Carrying Value
1/1/2020 4,681,015
1/1/2021 600,000 - 4,081,015
1/1/2022 355,139 244,861 3,725,876
1/1/2023 376,447 223,553 3,349,429
1/1/2024 399,034 200,966 2,950,395
1/1/2025 422,976 177,024 2,527,418
1/1/2026 448,355 151,645 2,079,063
1/1/2027 475,256 124,744 1,603,807
1/1/2028 503,772 96,228 1,100,036
1/1/2029 533,998 66,002 566,038
1/1/2030 566,038 33,962 9
December 31, 2020

Depreciation expense – Right of use asset 483,102
Accumulated depreciation – Right of use asset 483,102

Lease liability 244,861
January 1, 2021
Cash 600,000
December 31, 2020


Beginning balance 4,681,015

Payment of 2020 (600,000)
Accrual of interest – 2020 244,861
Payment of 2021 (600,000)
Accrual of interest - 2021 223,553
Balance end of second 3,949,429
year
Illustration 2:
On January 1, 2020, F Corporation, lessee, enters into a ten-year lease of property with annual lease
payments of P600,000 payable at the beginning of each year. The contract specifies that the lease payments
will increase every two years on the basis of the increase in consumer price index for the preceding 24
months. The consumer price index at the commencement date is 125. The rate implicit in the lease is not
readily determinable. Lessee’s incremental borrowing rate is 6% per annum, which reflects the fixed rate at
which lessee could borrow an amount similar to the value of the right of use asset, in the same currency, for a
ten year term and with similar collateral.
At the beginning of third year of the lease, the consumer price index is 135.
1. How much is the initial cost of the right of use asset?

2. How much is the balance of lease obligation at the end of second year?
3. How much is the balance of lease obligation at the end of third year?
Solution:
PV of rentals (600,000 x 7.80169) 4,681,015
January 1, 2020
Right of use asset 4,681,015
Cash 600,000
Lease liability 4,081,015
December 31, 2020


January 1, 2021
Cash 600,000
December 31, 2021


Beginning balance 4,681,015

Payment of 2020 (600,000)
Accrual of interest – 2020 244,861
Payment of 2021 (600,000)
year
January 1, 2022:
Update the balance of the lease liability and right of use asset.
PV Rentals (648,000 x 6.582381) 4,265,383
Balance of lease liability – 3,949,429
12/31/2021
Increase 315,954
Right of use asset 315,954


Cash 648,000
Right of use asset, beginning 4,681,015

cost
Accumulated depreciation (936,203)
Carrying value before update 3,744,812
Increase in right of use 315,954
New carrying value 4,060,767
Remaining life 8
New depreciation 507,596
December 31, 2022



year
Increase in liability 315,954
Payment 2022 (648,000)
Balance end of third year 3,949,429


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ACC124AUDITING AND ASSURANCE: CONCEPTS AND APPLICATIONS 1 BSA3

Page 1 of 19 Compiled & Adapted

The primary objective in auditing accounts payable are to determine whether:

Primary Substantive Procedures

Purchases and accounts payable cut-off

Search for unrecorded liabilities

Page 2 of 19 Compiled & Adapted

Payroll application for liabilities

Provisions, Accrued Liabilities and Other Liabilities and Deferred Income

Primary Substantive Procedures – Income Tax

Reconciliation and re-computation

Page 4 of 19 Compiled & Adapted

1. How much is the taxable income in 2019?

Excess of warranty expense over actual expenditures 15,000

Excess of tax depreciation over book depreciation 20,000

Deferred tax asset 20,400 Tax expense – Deferred 6,000

Page 5 of 19 Compiled & Adapted

There are four important controls over notes (bonds) payable.

Page 6 of 19 Compiled & Adapted

ILLUSTRATION (Notes payable)

Determine the following as a result of your audit?

Page 7 of 19 Compiled & Adapted

Proposed adjusting journal entry:

Date Interest (13%) Carrying Value

Proposed adjusting journal entry:

Page 8 of 19 Compiled & Adapted

Amortization table over the life of the note:

Proposed adjusting entry:

Page 9 of 19 Compiled & Adapted

All short-term employee benefits

Short-term compensated absences

Page 10 of 19 Compiled & Adapted

Profit or Loss OCI Plan Asset/Plan FPA DBO

Interest expense 2,000,000

Page 11 of 19 Compiled & Adapted

Identified asset and Right to control the use of the

No substantive No benefits from Right to obtain

Page 12 of 19 Compiled & Adapted

Initial recognition and measurement – Right of Use Asset

The cost of the right of use asset shall comprise:

Page 13 of 19 Compiled & Adapted

Initial recognition – Lease liability

Subsequent to initial recognition

Reassessment of the lease liability

Page 14 of 19 Compiled & Adapted

Initial recognition and measurement – Lessor

Sale and leaseback transactions

Transfer of the asset is not a sale

1. How much is the initial cost of the right of use asset?

Right of use asset 150,000

Amortization table is as follows:

December 31, 2020

Interest expense 244,861

December 31, 2020

Interest expense 223,553

Beginning balance 4,681,015

1. How much is the initial cost of the right of use asset?

December 31, 2020

Interest expense 244,861

December 31, 2021