Question

During the course of your audit work, you discover the following fact pattern:

- The client accrued a liability for accrued vacation balances using old pay rates for employees.
- The client laid employees off after the balance sheet date but booked an accrued liability for severance costs at the balance sheet date. The plans had not been formulated at that point in time and had not been announced. Under GAAP, the client does not meet the threshold to record a liability.
- The client booked a bonus payable amount, but the amount does not appear to be supportable by the bonus plan offered by the Company, and in fact is higher than what the actual payouts were 30 days past the balance sheet date.
- The Controller indicated the liabilities are simply estimates, and everything is “good enough for government work” and therefore you shouldn’t be worried about it.
- Based on your audit work, you believe the accrued liabilities balance is overstated on a net basis by 18%
- The client exceeded their net income target for the year; all in all, the financials look very strong, even with an overstatement of the accrued liabilities balance.

Questions: (2 pages)

1. What reasons might a client have to overstate liabilities with the given fact pattern above?

2. As an auditor, how would you approach a conversation with the client when you observe/ determine the fact pattern above?

3. Under what circumstances might a client understate these same liability balances?

Answer 1

Answers

1. What reasons might a client have to overstate liabilities with the given fact pattern above?

Liabilities and expenses are overstated to show decrease in net profit of the business. Many times company show untrue inflated amount of obligations and expenses to the shareholders and investors which result in lesser distribution of profit to shareholder. Also the tax liability of company decrease. The portion of salaries and wages that go directly toward producing the products or services you sell are listed at the top of the statement as part of COGS, or cost of goods sold. The portion of wages and salaries that go to other business activities, such as sales and bookkeeping, are listed with your other expenses and are categorized as indirect costs. If your business is healthy and successful, the amounts you spend on salaries, wages and operating expenses add value to your bottom line. Direct labor included in cost of goods sold should go into creating products that you can sell for more than the cost of the materials and payroll that went into them. These sales typically translate into assets that improve your company's net worth.

So from above the two main reasons can be understood for overstate liabilites are

1) To show untrue financial position to shareholders

2) Company spend more on employee benefit expenses

2. As an auditor, how would you approach a conversation with the client when you observe/ determine the fact pattern above?

As an auditor, I will try to tell the management and board of directors that the financial position of company is not correct. As per accounting princple stated in GAAP , A provision should be recognised when: (a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision should be recognised.

Overstated liabities will result in hidden profit

3. Under what circumstances might a client understate these same liability balances?

Company will fraudulently make understatements of liabilities on their balance sheets to show more profits to investors. To overstate the income company will delay the recognization of employee liability. Also to fulfill legal liabilities related to employee benefit, company may understate the employee expenses.