Trade payables, accruals, provisions and contingencies

A contractor in Port Harcourt shows trade payables of ₦340 million. Nothing in the ledger tells the auditor about a supplier who delivered cement on 29 December, whose invoice arrived in January and was booked in the new year. Nor does it say that a customer has sued for ₦600 million over a collapsed wall, and that the company has told no one.

Liabilities are harder to audit than assets, because the danger is what is missing. The auditor has to look for things that are not recorded.

This topic covers the risks for liabilities and why they are tested for understatement, the audit of trade payables using supplier statements, searching for unrecorded liabilities and purchases cut-off, the audit of accruals, the rules in IAS 37 for provisions, contingent liabilities and contingent assets, and the audit procedures for each, including letters to lawyers. The previous topics covered assets, and the next covers non-current liabilities, equity and directors' emoluments.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence and substantive procedures (25% of marks). It covers:

• substantive procedures for liabilities
• audit of provisions and contingencies (IAS 37)
• the audit of accounting estimates

CAMA 2020 and liabilities

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

Principal risks for liabilities

With directional testing, liabilities, income and equity are usually tested for understatement, which is the completeness assertion. The auditor thinks it much more likely that an entity will understate its liabilities to present a better financial position than overstate them. Because the auditor is looking for something that is not recorded, and not checking something that is, auditing liabilities is often harder than auditing assets. The principal risks are:

• that not all liabilities are included. This is the main risk;
• wrong cut-off between goods inwards and recording of the liability, an income statement assertion that affects payables;
• non-existent liabilities being included, which is rarer and often not treated as a risk; and
• liabilities not properly disclosed.

Trade payables: the general approach

Trade payables are material in many entities, so this area gets significant attention. The approach is similar in some ways to receivables, but direct confirmation of balances with suppliers, though sometimes used, is not a typical test. The auditor normally has another external written source: supplier statements.

A supplier's statement is a printed statement, usually monthly, showing transactions between the supplier and the customer (purchases, returns and payments) since the last statement and the amount owing at its date. These statements and the client's own list of payables are the main records used. Work on purchases, cash payments and inventory, including purchases cut-off, also gives evidence on payables.

Substantive procedures for trade payables

1. Obtain or prepare a list of balances on the supplier accounts in the payables ledger.
2. If the client prepared it, check the arithmetic, perhaps with audit software. Check balances for accuracy and existence by taking a sample from the list and checking to the supplier's account in the ledger.
3. Take a sample of balances from the supplier accounts in the ledger and confirm that they are correctly included in the list. This tests valuation and completeness.
4. Check that the total of the list agrees to the trade payables control account in the main ledger.
5. Select the sample with these points in mind:
   • large balances are not important, since the emphasis is on completeness and understatement, not overstatement;
   • for the same reason, include a number of nil balances and debit balances. A debit balance means the supplier owes the client, perhaps because goods were returned and a credit note issued, or an invoice was over-paid or paid twice; and
   • include major suppliers, identified from knowledge of the business, which may come from the inventory count or work on purchases. In an IT system, audit software can help with the selection.
6. For each supplier in the sample, compare the balance on the list with the supplier's statement. Use the first statement received after the year end, since it will include the position at the year end.
7. If the balances differ, ask the client to reconcile the difference, and check the reconciling items to documents.

For further assurance about completeness the auditor also:

• reviews the list for suppliers who would be expected to be on it but are not, such as regular suppliers of frequently bought items;
• compares the list with last year's list at the same date and asks why any major balance last year is missing this year; and
• does other analytical procedures, such as the ratio of trade payables to purchases compared with previous years, which should be fairly stable.

The search for unrecorded liabilities

This is a specific test for completeness. The auditor looks at what happened after the year end and asks whether it relates to a liability at the year end. The usual work is:

• examine payments made after the year end, from the cash book and bank statements, and check whether each relates to goods or services received before the year end and so should be in payables or accruals;
• examine invoices received after the year end for the same reason;
• review goods received notes just before the year end for goods that were received but not invoiced, and see that they are recorded;
• review unmatched goods received notes and purchase orders outstanding; and
• review the minutes, contracts and correspondence for commitments and claims.

Purchases cut-off

Purchases cut-off ensures that purchases just before or after the year end are in the right year, so that purchases, inventory and payables are correctly recorded. The work done at the inventory count gives evidence of it.

The auditor prepares a list of goods received notes issued immediately before and after the year end and confirms that goods in closing inventory also gave rise to a payable. Goods not in closing inventory did not.

Accruals

Accruals are usually estimates, so the techniques are like those for prepayments. Amounts may be small, in which case little time is spent. As always with liabilities the emphasis is on completeness, and analytical procedures and knowledge of the business are useful. The procedures are:

• obtain or prepare a list of accruals at the year end;
• if the client prepared it, check the arithmetic and agree the amounts to the expense accounts in the main ledger;
• where invoices have been received or payments made after the year end, check that the amount accrued is reasonable. If two months of electricity at ₦3,000 a month is accrued (₦6,000) and an invoice for three months comes in a month after the year end, it should be about ₦9,000;
• compare the list with last year's at the same date and ask about missing items;
• review the list for completeness using knowledge of the business; and
• relate items to other areas, such as accrued bank charges in the bank confirmation.

Accrued wages and salaries may be more material and deserve more attention.

The auditor considers what should be accrued, such as unpaid wages, overtime, holiday pay and bonuses; checks the amounts to personnel and payroll records, including time records, wage rates and payment dates, and to payments made after the year end; confirms that additional costs, such as employer's payroll taxes and pension contributions, are accounted for; and does analytical procedures, such as the ratio of accrued payroll to total payroll cost compared with previous years.

IAS 37: provisions, contingent liabilities and contingent assets

Accounting for these is subjective and may need much audit attention, because amounts can be material. The auditor must check that IAS 37 has been complied with.

Provision. A provision is a liability of uncertain timing or amount. A liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of economic benefits. An ordinary liability has a known amount, such as lease payments on known dates. A provision is, for example, an amount that may be payable under a guarantee or from a legal claim.

The entity knows it has an obligation but not when claims will be made or how much they will cost.

Recognition. A provision is recognised only when:

1. there is a present obligation as a result of a past event;
2. an outflow of economic benefits is probable, meaning more likely than not; and
3. a reliable estimate can be made.

The obligation may be legal, from a contract or law, or constructive, from the entity's actions: through established past practice, published policies or a specific current statement it has shown others that it will accept certain responsibilities, and so created a valid expectation that it will meet them.

A clothing retailer that refunds goods because customers changed their minds has no legal obligation, but if that is its usual practice it has a constructive obligation. The event must be past and must have occurred before the end of the reporting period. No provision is made for future costs where no obligation yet exists. A planned reorganisation without a legal or constructive obligation cannot be provided for.

If the entity has given a guarantee but does not expect to honour it, payment is not probable, so no provision.

Measurement. The amount is the best estimate of the expenditure needed to settle the obligation at the year end, taking risks and uncertainties into account. Events after the year end give useful evidence. The entity should avoid excessive provisions, which could be used to manipulate profit between years, and should avoid underestimating them.

Contingent liability. It is (a) a possible obligation arising from past events whose existence will be confirmed only by the occurrence or non-occurrence of uncertain future events, or (b) a present obligation from past events that is not recognised because an outflow is not probable or the amount cannot be measured reliably. It arises when some, but not all, of the criteria for a provision are met.

Contingent asset. A possible asset arising from past events whose existence will be confirmed only by uncertain future events, such as a possible gain from a lawsuit against a third party.

Where disclosure is appropriate, IAS 37 requires a brief description of the nature of the item and, where practicable, an estimate of its financial effect and an indication of uncertainties, and for contingent liabilities, the possibility of reimbursement.

Audit risks and assertions for provisions and contingencies

The auditor must be satisfied that the client has correctly distinguished between provisions, which are in the statements; contingent liabilities, which are only disclosed; and items that need no disclosure; and likewise for assets. The auditor must also be satisfied about measurement. The key assertions at risk are completeness and occurrence, and valuation, accuracy and allocation.

Substantive procedures for provisions

• Obtain the list of provisions in the draft financial statements.
• For each, confirm that it meets the IAS 37 definition and recognition criteria.
• Review the changes in each provision during the period.
• Review the measurement of the closing balance and discuss with management. Consider expert advice on existence or measurement.
• Review the list for possible omissions, based on knowledge of the business and the industry.
• Compare with previous years and investigate major differences or omissions.
• Relate the testing to other areas, such as correspondence with lawyers.

Substantive procedures for contingencies

• Find out how management identifies contingencies.
• Review the board minutes, where such matters are likely to be discussed.
• Review the business press and trade journals for industry-wide contingencies.
• Review correspondence with lawyers and legal invoices, which may reveal contingencies not disclosed in the draft statements or give more information about those that are.
• Consider direct confirmation from lawyers of matters handled for the client. The letter is sent by management, with an instruction that the reply goes direct to the auditor. Lawyers are likelier to reply if the letter lists specific areas where contingencies may exist and gives management's view of the possible outcome, and asks the lawyers to comment.
• Consider expert advice from sources other than lawyers.

Evidence from events after the year end

Events up to the date of the auditor's report give evidence of conditions at the year end. A lawsuit settled after the year end for a sum different from the provision shows whether the estimate was good. The auditor asks management and reviews the minutes up to the report date, and the written representations include a statement that all known claims and contingencies have been disclosed.

A non-adjusting event, such as a lawsuit arising from an event after the year end, may need disclosure but not recognition.

Related areas

Warranties are provided for from sales history and the terms of the guarantee. Restructuring provisions need a detailed formal plan and a valid expectation in those affected, for example by starting to implement the plan or announcing its main features. Onerous contracts are provided for at the lower of the cost of fulfilling and the cost of terminating.

Environmental and decommissioning costs are provided for where there is a present obligation. Tax disputes are provisions or contingent liabilities, depending on how likely the outcome is. For each type the auditor asks: is there an obligation, is payment probable and can the amount be measured reliably?

Supplier statement reconciliations in practice

Typical reconciling items between a supplier's statement and the client's ledger are:

• invoices in transit, recorded by the supplier but not yet by the client
• payments in transit, recorded by the client but not yet by the supplier
• credit notes issued by the supplier but not yet received or posted
• disputed items
• discounts taken but not agreed

The auditor checks each to documents.

An invoice dated before the year end but recorded after it is an unrecorded liability, and the auditor proposes an adjustment. A payment recorded by the client before the year end but credited by the supplier after it may be a sign of window dressing. Where the supplier's statement shows a higher balance and the client has no explanation, the auditor treats it as a possible misstatement until resolved.

Payables confirmation in higher-risk cases

Direct confirmation is not the usual test. But the auditor does use it when supplier statements are not available, when the control environment is weak, when the client is under financial pressure and may be holding back invoices, or when a supplier is a related party.

The request is best made in the blank form, which asks the supplier to state the balance without being told the client's figure, because the main risk is understatement. Confirmation should cover other things the supplier holds or has agreed, such as consignment stock, deposits and disputed claims.

Other liabilities that need a search

Besides trade payables, the auditor looks for tax liabilities such as value added tax, company income tax and employee taxes; pension and other statutory contributions; unclaimed dividends; customer deposits and deferred income; and amounts due to directors and related parties. For each, the auditor asks whether the liability is complete, by reference to returns filed, the tax authority's correspondence, and payments after the year end.

Unpaid taxes and penalties are a common source of understatement in Nigeria, so correspondence with the tax authorities is read for assessments and disputes that might need a provision or contingent liability disclosure.

Worked examples

1. The liability existed at the year end, so payables are understated by ₦18 million.
2. The auditor checks the goods received note and proposes an adjustment to payables and inventory or purchases.

1. An outflow is not probable, so there is no provision.
2. It is a contingent liability, disclosed in the notes because the possibility is not remote.

1. The practice creates a constructive obligation.
2. A provision for expected refunds at the year end is needed if the amount can be estimated.

1. There is no obligation at the year end.
2. No provision is allowed. It may be disclosed as a later event once announced.

How to score full marks

• Say that liabilities are tested for completeness and start from outside the ledger.
• Name supplier statements and the search for unrecorded liabilities.
• Apply the three IAS 37 recognition tests in turn.
• Give evidence such as minutes, lawyers' letters and later events.

Common mistakes in the exam

• Testing payables for existence with large balances only.
• Confusing a provision with a contingent liability.
• Provisions for future operating losses or reorganisations without an obligation.
• Forgetting disclosure of contingent liabilities.

Quick revision

• Liabilities: completeness. Use supplier statements, later payments and cut-off.
• Provision: obligation, probable, reliable estimate.
• Contingent liability: disclose unless remote. Contingent asset: disclose only if probable.
• Evidence: minutes, lawyers, experts, later events.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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