How to Perform a Search for Unrecorded Liabilities

The reliability of a company’s financial statements depends on their accuracy, providing a fair representation of its financial position to investors and lenders. To ensure this, auditors perform procedures to validate the information presented. One procedure is the search for unrecorded liabilities, which identifies obligations that were omitted from the financial statements at the end of a reporting period. Ensuring all liabilities are properly recorded is necessary for presenting a complete picture of a company’s financial health.

Identifying Potential Unrecorded Liabilities

An unrecorded liability is an obligation a company owes at the end of an accounting period but has not yet entered into its financial records. These omissions can result from delays in receiving supplier invoices or administrative oversights. The risk associated with these items is the understatement of liabilities and expenses, which can paint an overly optimistic picture of a company’s profitability.

This risk directly relates to the “completeness” assertion, where auditors test to ensure all transactions that should be presented are included. If liabilities are missing, the balance sheet will not reflect the full extent of the company’s obligations, and the income statement will overstate its net income.

Common examples include legal services received before year-end but invoiced in the next period, or goods delivered just before the balance sheet date where the invoice arrives weeks later. Other instances include accrued expenses like year-end employee bonuses that have been earned but not yet paid.

Information and Documents for the Search

Before an auditor can search for unrecorded liabilities, a specific set of documents must be gathered from the company. The selection focuses on the period immediately following the balance sheet date, as this is when evidence of prior-period transactions is most likely to surface.

A cash disbursements journal for the period after the fiscal year-end details all payments made after the balance sheet date. By reviewing these payments, an auditor can identify cash outflows that may correspond to liabilities existing at year-end. Another source is the file of unpaid vendor invoices, which contains invoices the company has received but not yet paid. An auditor reviews this file to identify invoices for goods or services received before the end of the reporting period.

Company receiving reports, particularly those dated around the year-end, provide proof of when goods were physically received. Finally, minutes from board of directors’ meetings can reveal approvals for contracts or settlements that might not yet be in the accounting records.

Executing the Search for Unrecorded Liabilities

The search begins by examining cash disbursements made after the balance sheet date. The auditor selects payments from the journal and traces them to supporting vendor invoices and receiving reports. The objective is to determine the transaction date. If an invoice paid in January is for goods received in December, a liability existed at year-end and should have been recorded.

The process extends to a review of the unpaid invoice file as it exists during the audit fieldwork, where the auditor inspects invoices to see if they relate to the period under audit. Analyzing receiving reports from the cutoff period also provides direct evidence of when goods entered the company’s possession. The auditor compares receiving reports from the end of the fiscal year against recorded payables, and a report showing goods were accepted before year-end with no corresponding liability signals a potential omission.

The search also involves direct inquiry with management about any known disputes, pending litigation, or significant commitments. Reviewing minutes of board meetings provides further evidence, as major financial commitments are often discussed and approved at this level. This combination of documentary review and direct inquiry creates a comprehensive approach to uncovering hidden obligations.

Addressing Discovered Unrecorded Liabilities

If a procedure reveals a potential unrecorded liability, the first step is to quantify the exact amount of the obligation. This involves examining source documents, such as the vendor invoice or service agreement, to confirm the value of the goods or services.

Once the amount is determined, the auditor proposes an adjusting journal entry to the company’s management. This entry typically increases an expense account and a liability account like accounts payable or accrued expenses, correcting the financial statements.

The auditor must also assess the materiality of any discovered misstatements, considering both individual items and the aggregate effect of all errors found. All findings, proposed adjustments, and management’s responses are documented in the audit workpapers.