Liabilities are the financial obligations of an enterprise other than owners’ funds. Liabilities include loans and borrowings, trade creditors and other current liabilities, deferred payment credits, instalments, payable under hire purchase agreements, and provisions. Besides liabilities, this Guidance Note also deals with contingent liabilities, i.e., obligations relating to past transactions or other events or conditions that may arise in consequence of one or more future events which are presently deemed possible but not probable. An important feature of liabilities which has a significant effect on the related audit procedure is that these are represented only documentary evidence which originates mostly from third parties in their dealings with the entity. Verification of liabilities is as important as that of assets, for, if any liability is omitted (or understated) or overstated, the Balance Sheet would not show a true and fair view of the state of affairs of the concern. For example, if the liability for certain expenses if found to have been omitted or understated, it would signify that against the revenue for the relative period, the full amount of expenses has not been charged. As a result, the figure of profit as disclosed the Profit and Loss Account would be larger the amount of the liability which has been omitted. Moreover, since the liability would not be included in
the balance sheet, it would also be incorrect. Conversely, where a fictitious liability for expenses is adjusted in the accounts or when a liability is overstated, the result will be that the revenue would bear an increased charge which would have the effect of artificially reducing the profits. This will falsify the figure of profit or loss disclosed the Profit and Loss account. Besides, on account of the inclusion of the liability, the Balance Sheet also will be false, since it would include an undisclosed ‘secret reserve’.
The auditor must, therefore, apart from vouching the entries in regard to the adjustment of liabilities, verify at the close of the year that the liabilities stated in the Balance Sheet are in fact payable and all its liabilities that could be traced the exercise of the diligence and care on the part of the auditor have been accounted for. He must also obtain a certificate from a responsible official stating that to the best of his knowledge and belief, all liabilities, whether for purchases (supplies) or expenses or any other account existing at the date of the Balance Sheet have been included in the books of account; also that all the contingent liabilities have either been disclosed in footnote to the Balance Sheet have been provided for. It has been held, inter alia, in the case of the Westminster Road Construction Engineering Co. Ltd. (1932), that the auditor must take care to satisfy himself that all the expenses and liabilities which the company could be expected to have incurred have been brought into accounts. In the course of his judgment in this case, the learned judges observed : “If the auditor found that a company in the course of its business was incurring liabilities of a particular kind and that the creditors sent in their invoices after an interval and that liabilities of the kind in question must have been incurred during the accountancy period under audit when he was making his audit, sufficient time has not elapsed for the invoices relating to such liabilities to have been received and recorded in the company’s books, it becomes his duty to make specific inquiries as to the existence of such liabilities and also before he signed a certificate as to the accuracy of the Balance Sheet to go through the invoice files of the company in order to see that no invoice relating to liabilities has been omitted. The evidence has established to my satisfaction that no experienced auditor would have failed to ascertain the existence of the liabilities omitted from this Balance Sheet.