But there's 12 months of expense, so it's ok.

The best way to test accounts payable for understatement is subsequent disbursement testing - select payments made after the date of the financial statements. (Some people prefer confirming accounts payable but I find that to be ineffective.) Look at the supporting documentation and see whether it should be in accounts payable at the balance sheet date. If it should be and is included in payables, then great. If it should be and it isn't, that's a problem, especially if it's material.

Let's assume it's recurring monthly expenses - say utilities. I'm auditing 2020. It's a ready-mixed concrete company, and the plan uses a lot of electricity and water. I'm performing subsequent disbursement testing and select the electric and water bills paid on January 25. I get copies of the bills, and they cover the entire month of December. I check to see if they are in accounts payable, and they aren't. The two bills amount to $60,000. Materiality is $35,000. Problem. 

I go to the controller and say we need to record an audit adjustment for these bills. The controller responds: "That's ok. There are 12 months of utility expenses in the income statement, so we're good." (I've even heard other auditors say that. Not me.)

Really? We're good?

The controller is telling me the utility expense accounts cover December 2019 - November 2020. December 2020 will hit the expense accounts in 2021.

Really? We're good?

This is when I visit our friend the Summary of Significant Accounting Policies. The summary lists out the accounting policies the company selected where it has a choice of various alternatives. I find the "Basis of Accounting" policy and it reads:

The Company maintains its accounting records and prepares its financial statements on the accrual basis in accordance with accounting principles generally accepted in the United States of America (GAAP).

Had the Company selected the cash basis of accounting, the controller would be right. Because that's what they've done here. The expense accounts only reflect the utility expenses paid in 2020. That's cash basis accounting, not accrual basis accounting.

There's a second problem here. Assuming the company has always recognized utility expense this way, they have consistently been one month short in utility expense. They have consistently underreported accounts payable. Cumulatively, they have overstated income and, in turn, equity. They've also overpaid taxes. Basically, they messed up in year one.

The correct answer here is to bite the bullet and correct it now. This is a correction of an error - we're talking material amounts here - and should be presented as such. Nobody likes corrections of an error. It makes the company look bad. If you're a continuing auditor, it makes you look bad. If you're a successor auditor, it kind of makes you look good, but you don't want to look good like that.

Of course, this applies to all expenses, not just utilities. 

Agree? Disagree? Let me know.