Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment McGraw-Hill/Irwin ©2008 The

Chapter 14Chapter 14

Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and

Property, Plant, and Equipment

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved

Balance Sheet

AssetsCashInvestmentsReceivablesPrepaidsInventoryPP and EOther assets -

intangibles

Liabilities and EquityAccounts payableAccrued liabilitiesDebtCommon stockRetained earnings

Other Assets

Prepaid expenses – current

Intangible assets – long term

Property, plant and equipment – long term

14-4

Auditing Prepaid Expenses

Other assets that provide economic benefit for less than a year are classified as current assets and are called prepaid expenses. Examples include:

1.Prepaid insurance.2.Prepaid rent.3.Prepaid interest.

LO# 1

InsurancePolicy

14-5

Inherent Risk Assessment – Prepaid Expenses

The inherent risk associated with prepaid expenses is generally assessed as low because the accounts

do not involve any complex or contentious accounting issues.

LO# 1

14-6

Control Risk Assessment – Prepaid Expenses

Because prepaid expenses are normally processed through the purchasing process, control procedures

in purchasing should ensure that each item is properly authorized and recorded.

LO# 1

14-7

Substantive Procedures – Prepaid Insurance

Tests of Details of the Prepaid Insurance AccountAudit testing begins by obtaining a detail

schedule of the prepaid insurance account.

Existence andExistence andCompletenessCompleteness

Confirm policy withConfirm policy withinsurance broker,insurance broker,

examine supportingexamine supportingsource documents.source documents.

Existence andExistence andCompletenessCompleteness

Confirm policy withConfirm policy withinsurance broker,insurance broker,

examine supportingexamine supportingsource documents.source documents.

Rights andRights andObligationsObligations

Confirm policyConfirm policybeneficiary withbeneficiary with

the insurance broker.the insurance broker.

Rights andRights andObligationsObligations

Confirm policyConfirm policybeneficiary withbeneficiary with

the insurance broker.the insurance broker.

ValuationValuation

DetermineDetermine unexpired portionunexpired portionof policy andof policy and

insurance expense.insurance expense.

ValuationValuation

DetermineDetermine unexpired portionunexpired portionof policy andof policy and

insurance expense.insurance expense.

ClassificationClassificationDetermine propriety of distribution betweenDetermine propriety of distribution between

manufacturing overhead and SG&A expense.manufacturing overhead and SG&A expense.

ClassificationClassificationDetermine propriety of distribution betweenDetermine propriety of distribution between

manufacturing overhead and SG&A expense.manufacturing overhead and SG&A expense.

LO# 2

14-8

Auditing Intangible Assets

Intangible assets are assets that provide economic benefit for longer than a year, but lack physical substance. The following list includes examples of five general categories of intangible assets:

1. Marketing – trademark, brand name, and Internet domain names.

2. Customer – customer lists, order backlogs, and customer relationships.

3. Artistic – items protected by copyright.4. Contract – licenses, franchises and broadcast rights.5. Technology – patented and unpatented technology.

LO# 1 & 2

14-9

Inherent Risk Assessment – Intangible Assets

The inherent risk associated with intangible assets raises serious risk considerations. The accounting rules are complex and the transactions are difficult

to audit. Accounting standards require different asset impairment tests for different classes of

intangible assets (FAS 142). With the judgment and complexity association with valuation and

estimation of intangible assets, the auditor would likely assess the inherent risk as high.

LO# 1 & 2

14-10

Control Risk Assessment – Intangible Assets

In assessing control risk, the auditor considers factors such as:

1. The expertise and experience of those determining the fair value of the assets.

2. Controls over the process used to determine fair value measurements, including controls over data and segregation of duties between those committing the client to the purchase and those undertaking the valuation.

3. The extent to which the entity engages or employs valuation specialists.

4. The significant management assumptions used in determining fair value.

5. The integrity of change controls and security procedures for valuation models and relevant information systems, including approval processes (AU 328).

LO# 1 & 2

14-11

Using the work of a specialist SAS #73

The auditor should consider the following:Professional certification of specialistReputation and standing Experience and expertiseObjectives and scope of the workRelationship to the client ( Independence!)Methods and assumptions usedOther

14-12

Substantive Procedures – Intangible Assets

Tests of Details of Intangible AssetsTests of details associated with valuation and impairment of

intangible assets are often necessary because the complexity and degree of judgment increase the risk of material misstatement. Some substantive evidence is required for all significant accounts, and, as noted above, substantive analytical procedures are not likely to provide sufficient, appropriate evidence for significant transactions involving intangible assets. Four assertions are normally considered for tests of details of intangible assets:

1. Existence and completeness.

2. Valuation.

3. Rights and obligations.

4. Classification.

LO# 2

14-13

Auditing the Property Management Process

Property, plant, and equipment usually represents a material amount in the financial statements.

Recurring EngagementThe auditor is able to focusThe auditor is able to focus

on additions and retirementson additions and retirementsin the current period becausein the current period because

amounts from prior periods haveamounts from prior periods havebeen subject to audit procedures.been subject to audit procedures.

Recurring EngagementThe auditor is able to focusThe auditor is able to focus

on additions and retirementson additions and retirementsin the current period becausein the current period because

amounts from prior periods haveamounts from prior periods havebeen subject to audit procedures.been subject to audit procedures.

New EngagementThe auditor has to verify the

assets that make up the beginning balance in property,

plant, and equipment.

New EngagementThe auditor has to verify the

assets that make up the beginning balance in property,

plant, and equipment.

LO# 3

14-14

Communication between predecessor and successor auditors ( SAS # 84)

Successor auditor should consider the following:

Information regarding integrity of managementDisagreements with management about

accounting principlesCommunications to audit committees about

fraud and IC issuesPredecessor auditor’s understanding regarding

the reasons for the change.Adequacy of the work performed

14-15

Property Management Process at EarthWear Clothiers

Physical Plant IT Department

SpecializedPP&E

transactions

Review forproper

recording

Input

Frompurchasing

process

PP&Etransaction

file

PP&Emaster

file

PP&Eprogram

Generalledger

master file

Generalledger

program

Generalledgerreport

PP&Etransaction

report

PP&Esubledger

Reconcile togeneral ledger

Monthly

LO# 3

14-16

Types of Transactions

Four types of PP&E transactions may occur:Four types of PP&E transactions may occur:

1.1. AcquisitionAcquisition of capital assets for cash or other of capital assets for cash or other nonmonetary considerations.nonmonetary considerations.

2.2. DispositionDisposition of capital assets through sale, of capital assets through sale, exchange, retirement, or abandonment.exchange, retirement, or abandonment.

3.3. DepreciationDepreciation of capital assets over their useful of capital assets over their useful economic life.economic life.

4.4. LeasingLeasing of capital assets. of capital assets.

Four types of PP&E transactions may occur:Four types of PP&E transactions may occur:

1.1. AcquisitionAcquisition of capital assets for cash or other of capital assets for cash or other nonmonetary considerations.nonmonetary considerations.

2.2. DispositionDisposition of capital assets through sale, of capital assets through sale, exchange, retirement, or abandonment.exchange, retirement, or abandonment.

3.3. DepreciationDepreciation of capital assets over their useful of capital assets over their useful economic life.economic life.

4.4. LeasingLeasing of capital assets. of capital assets.

LO# 4

14-17

Inherent Risk Assessment – Property Management Process

There are three inherent risk factors that must be considered by the auditor.

ComplexComplexaccountingaccounting

issues.issues.

ComplexComplexaccountingaccounting

issues.issues.Difficult-to-auditDifficult-to-audit

transactions.transactions.Difficult-to-auditDifficult-to-audit

transactions.transactions.MisstatementsMisstatements

detected indetected inprior audits.prior audits.

MisstatementsMisstatementsdetected indetected inprior audits.prior audits.

LO# 5

14-18


Complex Accounting IssuesLease accounting, self-constructed assets, and

interest capitalization are vivid examples of some of the complex accounting issues faced by auditors.

LO# 5

14-19


Difficult-to-Audit TransactionsWhen assets are purchased directly from a vendor, the transaction is relatively easy to audit. However,

transactions involving donated assets, nonmonetary exchanges, and self-constructed

assets are more difficult to audit.

LO# 5

14-20


Misstatements Detected in Prior AuditsIf misstatements in prior audits have been

detected, the auditor should set inherent risk higher than if few or no misstatements

have been found in the past.

LO# 5

14-21

Control Risk Assessment – Property Management Process

Occurrence and AuthorizationControl procedures for the occurrence and

authorization of property, plant, and equipment are normally part of the purchasing process. However, large capital asset transactions may be subject to

additional controls. Companies should have an authorization table for approving capital asset

transactions.

LO# 6

14-22

Control Risk Assessment – Property Management Process

Completeness

The detailed property, plant, and equipment The detailed property, plant, and equipment subsidiary ledger usually includes the following subsidiary ledger usually includes the following

information for each capital asset:information for each capital asset:1.1. Description, location, and ID number.Description, location, and ID number.

2.2. Date of acquisition and installed cost.Date of acquisition and installed cost.

3.3. Depreciation methods for book and tax purposes, Depreciation methods for book and tax purposes, salvage value, and estimated useful life.salvage value, and estimated useful life.

LO# 6

14-23

Control Risk Assessment – Property Management ProcessKey Segregation of Duties and Possible Errors

Segregation of Duties Possible Errors or Fraud

The initiation function should be segregated from the final approval function.

If one individual is responsible for initiating a capital asset transaction and also has final approval, fictitious or unauthorized purchases of assets can occur. This can result it purchases of unnecessary assets, assets that do not meet the company's quality control standards, or illegal payments to suppliers.

The PP&E records function should be segregated from the general ledger function.

If one individual is responsible for the PP&E records and also for the general ledger functions, that individual can conceal any defalcation that would normally be detected by reconciling subsidiary records with the general ledger control account.

The PP&E records function should be segregated from the custodial function.

If one individual is responsible for the PP&E records and also has custodial responsibility for the related assets, items may be stolen, and the theft can be concealed by adjustment of the accounting records.

If a periodic physical inventory of PP&E is taken, the individual responsible for the inventory should be independent of the custodial and record-keeping functions.

If one individual who is responsible for the periodic physical inventory of PP&E is also responsible for the custodial and record-keeping functions, theft or the entity's capital assets can be concealed.

LO# 7

14-24

Substantive Analytical Procedures – Property, Plant, and EquipmentThe following substantive The following substantive analytical proceduresanalytical procedures can be used in the audit of PP&E:can be used in the audit of PP&E:The following substantive The following substantive analytical proceduresanalytical procedures can be used in the audit of PP&E:can be used in the audit of PP&E:1.1. Compare prior-year balances in PP&E and depreciation Compare prior-year balances in PP&E and depreciation

expense with current-year balances.expense with current-year balances.

2.2. Compute the ratio of depreciation expense to the related Compute the ratio of depreciation expense to the related PP&E accounts and compare to prior years’ ratios.PP&E accounts and compare to prior years’ ratios.

3.3. Compute the ratio of repairs and maintenance expense Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior to the related PP&E accounts and compare to prior years’ ratios.years’ ratios.

4.4. Compute the ratio of insurance expense to related PP&E Compute the ratio of insurance expense to related PP&E accounts and compare to prior years’ ratio.accounts and compare to prior years’ ratio.

5.5. Review capital budgets and compare the amounts spent Review capital budgets and compare the amounts spent with amounts budgeted.with amounts budgeted.

1.1. Compare prior-year balances in PP&E and depreciation Compare prior-year balances in PP&E and depreciation expense with current-year balances.expense with current-year balances.

2.2. Compute the ratio of depreciation expense to the related Compute the ratio of depreciation expense to the related PP&E accounts and compare to prior years’ ratios.PP&E accounts and compare to prior years’ ratios.

3.3. Compute the ratio of repairs and maintenance expense Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior to the related PP&E accounts and compare to prior years’ ratios.years’ ratios.

4.4. Compute the ratio of insurance expense to related PP&E Compute the ratio of insurance expense to related PP&E accounts and compare to prior years’ ratio.accounts and compare to prior years’ ratio.

5.5. Review capital budgets and compare the amounts spent Review capital budgets and compare the amounts spent with amounts budgeted.with amounts budgeted.

LO# 8

14-25

Tests of Details of Transactions and Account Balances and Disclosures

CompletenessThe auditor begins the process by obtaining a lead schedule and detailed schedules of additions and

dispositions of assets. These schedules are footed and agreed to the general ledger.

LO# 9

14-26

CutoffCutoff is normally part of the accounts payable and accrued expenses work. Vendor’s invoices from a

few days before and after year-end are examined to determine if the assets is recorded in the proper

accounting period.

LO# 9


December 28

2007

January 4

2008

14-27

ClassificationFirst, the auditor must determine that the capital

asset is recorded in the proper account. Second, the repairs and maintenance account should be

reviewed to determine if any capital assets have been incorrectly recorded in these accounts. Finally, each material lease agreement should be reviewed

for proper classification as operating or capital lease.

LO# 9


14-28

ExistenceA list of all major additions should be obtained and

each addition should be vouched to supporting documentation. For major acquisitions, the auditor may physically examine the capital asset. This is

often done during the inventory observation. Major dispositions should be vouched to supporting

documentation and examined for proper authorization.

LO# 9


14-29

Rights and ObligationsIn most cases, rights or ownership can be

determined by examining vendor’s invoices and other supporting documents. In some cases, the

auditor may wish to confirm property deeds or title documentation.

LO# 9


14-30

Valuation and AllocationCapital assets are valued at Capital assets are valued at

acquisition cost plus any costs acquisition cost plus any costs necessary to make the asset necessary to make the asset operational. The auditor tests operational. The auditor tests

the recorded cost of major new the recorded cost of major new additions to PP&E.additions to PP&E.

Capital assets are valued at Capital assets are valued at acquisition cost plus any costs acquisition cost plus any costs necessary to make the asset necessary to make the asset operational. The auditor tests operational. The auditor tests

the recorded cost of major new the recorded cost of major new additions to PP&E.additions to PP&E.

The auditor may The auditor may recompute, either recompute, either

manually or with the aid of manually or with the aid of a computer, the proper a computer, the proper

depreciation expense for depreciation expense for the period.the period.

The auditor may The auditor may recompute, either recompute, either

manually or with the aid of manually or with the aid of a computer, the proper a computer, the proper

depreciation expense for depreciation expense for the period.the period.

The auditor must test for permanent impairment of long-lived The auditor must test for permanent impairment of long-lived assets. While GAAP requires the comparison of future cash assets. While GAAP requires the comparison of future cash inflows to the asset’s carrying amount, this process can be inflows to the asset’s carrying amount, this process can be

quite difficult. Auditors may look to other sources of quite difficult. Auditors may look to other sources of information to learn about impairments.information to learn about impairments.

The auditor must test for permanent impairment of long-lived The auditor must test for permanent impairment of long-lived assets. While GAAP requires the comparison of future cash assets. While GAAP requires the comparison of future cash inflows to the asset’s carrying amount, this process can be inflows to the asset’s carrying amount, this process can be

quite difficult. Auditors may look to other sources of quite difficult. Auditors may look to other sources of information to learn about impairments.information to learn about impairments.

LO# 9


14-31

Disclosure Issues

Examples of disclosure items:Examples of disclosure items:1.1. Classes of capital assets and valuation bases.Classes of capital assets and valuation bases.2.2. Depreciation methods and useful lives for financial reporting and tax Depreciation methods and useful lives for financial reporting and tax

purposes.purposes.3.3. Nonoperating assets.Nonoperating assets.4.4. Construction or purchase commitments.Construction or purchase commitments.5.5. Liens and mortgages.Liens and mortgages.6.6. Acquisition or disposal of major operating facilities.Acquisition or disposal of major operating facilities.7.7. Capitalized and other lease arrangements.Capitalized and other lease arrangements.

Examples of disclosure items:Examples of disclosure items:1.1. Classes of capital assets and valuation bases.Classes of capital assets and valuation bases.2.2. Depreciation methods and useful lives for financial reporting and tax Depreciation methods and useful lives for financial reporting and tax

purposes.purposes.3.3. Nonoperating assets.Nonoperating assets.4.4. Construction or purchase commitments.Construction or purchase commitments.5.5. Liens and mortgages.Liens and mortgages.6.6. Acquisition or disposal of major operating facilities.Acquisition or disposal of major operating facilities.7.7. Capitalized and other lease arrangements.Capitalized and other lease arrangements.

LO# 9


14-32

Evaluating the Audit Findings Property, Plant, and Equipment

The auditor aggregates the likely misstatements and The auditor aggregates the likely misstatements and compares this amount to the tolerable misstatement.compares this amount to the tolerable misstatement.

If the likely misstatement is less than If the likely misstatement is less than the tolerable misstatement, the evidence indicates the tolerable misstatement, the evidence indicates that the PP&E accounts are that the PP&E accounts are notnot materially misstated. materially misstated.

If the likely misstatement is greater than the If the likely misstatement is greater than the tolerable misstatement, the auditor would either require tolerable misstatement, the auditor would either require

adjustment of the accounts or issue a qualified audit report.adjustment of the accounts or issue a qualified audit report.

The auditor aggregates the likely misstatements and The auditor aggregates the likely misstatements and compares this amount to the tolerable misstatement.compares this amount to the tolerable misstatement.

If the likely misstatement is less than If the likely misstatement is less than the tolerable misstatement, the evidence indicates the tolerable misstatement, the evidence indicates that the PP&E accounts are that the PP&E accounts are notnot materially misstated. materially misstated.

If the likely misstatement is greater than the If the likely misstatement is greater than the tolerable misstatement, the auditor would either require tolerable misstatement, the auditor would either require

adjustment of the accounts or issue a qualified audit report.adjustment of the accounts or issue a qualified audit report.

LO# 10

14-33

Questions

14-34

End of Chapter 14

Documents

Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment McGraw-Hill/Irwin ©2008 The