Chapter 13

Audit of Long-Lived Assets and Related Expense

Accounts

Copyright © 2010 South-Western/Cengage Learning

Audit Opinion Formulation Process

LO 1 Account Relationships for Long-Lived Assets

LO 2 Performing the Integrated Audit of Long-Lived Assets and Related Expenses

• Phases I and II of the Audit Opinion Formulation Process– Continually update information on business risk

– Analyze potential motivations to misstate long-lived asset and related expense accounts

– Perform preliminary analytical procedures and document how the audit testing should be modified

– Develop an understanding of the internal controls over long-lived assets and related expense accounts

Performing the Integrated Audit of Long-Lived Assets and Related Expenses (continued)

• Phases III and IV of the Audit Opinion Formulation Process– Determine the important controls that need to be tested

– Develop a plan for testing internal controls and perform the tests of key controls on cash and other liquid asset accounts

– Analyze the results of the tests of controls

– Perform planned substantive procedures

– Phases III and IV of the Audit Opinion Formulation Process

LO 3 Risks Related to Long-Lived Assets

• Ways fixed assets can be used to manage earnings:– Change estimated useful lives and residual values

– Capitalize costs that should be expensed, such as repairs and maintenance

– Improperly accounting for asset restructuring or acquisition

– Failing to properly perform asset impairment adjustments

– Account for capital leases as operating leases

Risks Associated with Fixed Assets and Related Expenses

• Incomplete recording of asset disposals

• Environmental liabilities or claims related to violations of safety and protection regulations

• Obsolescence of assets

• Restructuring charges related to changes in the nature of the business

• Incorrect valuation of assets acquired as part of a group purchase

Risks Associated with Fixed Assets and Related Expenses (continued)

• Incorrect recording of assets, hidden by complex ownership structures designed to keep assets (and related liabilities) off the books

• Amortization or depreciation schedules that do not reflect the economic use of the asset

• Failure to properly recognize impairments in value

How does the auditor become aware of the risks?

• Auditor will normally be aware of these risks through review of:– Industry trends, technological advances, and changes in

location of production facilities

– Business plan for major acquisitions

– Major contracts regarding capital investments or joint ventures

– Minutes of board of director meetings

– Company filings with the SEC describing actions, risks, and strategies

LO 4 Analytical Procedures for Possible Misstatements

• Analyze industry trends and changes in product lines– Helps identify assets that are not as useful as in

previous years– Tour the plant and note idle equipment

Analytical Procedures for Possible Misstatements (continued)

• Analyze Depreciation for Consistency and Economic Activity– Review gains/losses on equipment disposals – Tour the plant and note idle equipment– Perform analytical estimate of depreciation– Compare depreciable lives for various asset

categories

LO 5 Evaluating Control Risk and Control Effectiveness

Controls issues for Tangible Assets:– Periodic inventories of physical assets reconciled to the

property ledger

– Ensure all purchases are authorized and properly valued

– Classify new equipment according to expected use and useful life

– Periodic reassessment for appropriateness of depreciation categories

– Identify obsolete or scrapped equipment and write down to scrap value

Evaluating Control Risk and Control Effectiveness (continued)

– Periodic review of management strategy and systematic assessment for impairment of assets

Controls issues for Intangible Assets:– Assure that decisions are appropriately made as to when to

capitalize or expense research and development expenditures

– Develop amortization schedules that reflect the remaining useful life of patents or copyrights associated with the asset

– Identify and account for intangible-asset impairments

Design and Perform Tests of Controls

• Tests of controls include:– Inquiry of relevant personnel– Observation of the control being performed– Examination of documentation corroborating that the

control has been performed, and– Re-performance of the control by the individual testing the

control

• Auditor uses professional judgment to determine the appropriate types of tests of controls

LO 6 Tests of Property Additions and Disposals

• If the beginning balance is established, testing can be limited to additions and disposals during the year

• Additions:–Auditor can usually test existence, rights, and valuation

by the same procedures

–Schedule of property additions is agreed to additions shown in the ledger to ensure schedule is complete

–Auditor vouches recorded additions to vendor invoice and other supporting documentation

Tests of Property Additions and Disposals (continued)

• Visually Inspecting Existence– In case of large additions, auditor will want to

physically verify the existence of asset

Disposals and Fully Depreciated Equipment

• Many organizations do not exercise the same degree of control over asset disposals as they do for acquisitions

• Audit procedures are designed to test that ALL disposals have been recorded– Use generalized audit software to prepare a

printout of fully depreciated (or nearly fully depreciated) equipment and then attempt to locate it

Disposals and Fully Depreciated Equipment (continued)

– Review acquisition documents for trade-ins.– Review the property ledger to make sure that the

traded-in asset has been removed– Ask client about any assets that have been

removed. Trace to the property ledger to make sure asset has been removed

LO 7 Asset Impairment

• There may be significant declines in the value of fixed assets due to technological obsolescence, or new manufacturing techniques

• If there is evidence of asset impairment, valuation must be assessed

• The FASB has developed two approaches to valuing impaired assets:

Asset Impairment (continued)

1.Estimate the future economic benefits to be derived from the asset

2.Obtain an independent assessment of the value of the asset

• For the first approach, auditors perform a recoverability test to determine if asset is impaired.– If future cash flows exceed asset's carrying value,

asset is not impaired

Asset Impairment (continued)

– If future cash flows do not exceed carrying value, asset is impaired.

– Amount of impairment is difference between net present value of future cash flows and asset's carrying value

• For the second approach, the auditor may– Obtain appraisal from independent and qualified

appraisal firm– Review current transactions to determine if there

has been a decrease in purchase price

How are discontinued operations treated?

• Company should write net assets down to net realizable value

• In assessing fair market value, auditor will normally:– Request estimate of value from an investment

broker– Discount estimated future cash flows to develop

estimate of value

How are discontinued operations treated? (continued)

• The nature of the discontinuance decision and the amount of write-down should be fully disclosed in the notes to the financial statements

Depreciation Expense and Accumulated Deprecation

• The procedures used to test deprecation will depend on the controls over depreciation and the risk associated with the engagement and account balance

• Low risk - analytical procedures:– Current estimate of depreciation is calculated and modified

for additions and disposals during the year

– Ratios are computed to determine reasonableness of current deprecation

Depreciation Expense and Accumulated Deprecation (continued)

• High risk - tests the details:– Foot the property ledger and agree to the general

ledger– Recalculate depreciation for sample of items

Intangible Assets

• May be difficult to determine which costs should be capitalized– Especially for internally developed intangibles– Auditor will review client accounting to ensure per GAAP– May be difficult to determine appropriate amortization

period• Expected economic life or legal life, whichever is shorter

• Auditor should review trade publications for competition and new product introductions

• Auditor should make inquiries of client and legal counsel

• Auditor should review client procedures for determining when intangibles become impaired

LO 8 Natural Resources

• May be difficult to determine which costs should be capitalized– Most companies have procedures for identifying

costs– Auditor should test capitalization of new assets by

examining documents

• May be difficult to estimate the amount of the natural resource– Many companies use geologists to estimate

amount of natural resources

Natural Resources (continued)

– Auditor may hire a specialist to review any geological analysis

• Depletion should be based on amount extracted during the year– Depletion is based on units of production approach– Auditor may use analytics like current depletion

compared to prior years– Auditor may analyze production data and then

recompute depletion

Natural Resources (continued)

• May be difficult to estimate reclamation expenses– Auditor should examine the reasonableness of

procedures used by management to estimate cost

LO 9 Leases

• Reasons for leases include:– Finance the use of the asset instead of making an

outright purchase

– Acquire the use of the asset for relatively short periods of time without having to buy and then sell it

– Acquire the use of the asset for an extended period of time but keep the asset and related liability off the balance sheet

– Maintain a flexible operating profile, that is, substitute short-term variable costs for fixed costs

Leases: Audit Approach

• Obtain copies of lease agreements– Review agreements to determine if capital or

operating leases– Review client records to determine if leases

properly accounted for

• Review lease expense account– Select entries and review to make sure they are for

operating lease

Leases: Audit Approach (continued)

• For all capital leases– Determine assets and obligations are recorded at

net present value– Determine the economic life of the asset– Calculate amortization and interest expense– Consider bargain purchase agreements to

determine economic life

Leases: Audit Approach (continued)

• Develop a schedule of all future lease obligations

• Review the client’s disclosure of lease obligations