Property, Plant, and
Equipment:
Depreciation and
Depletion
Chapter 13
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
13-2
Property, plant and equipment
Tangible assets with a service life of more
than one year that are used in the
operation of the business and are not
acquired for the purpose of resale
Three major subgroups:
Land
Buildings, machinery, equipment and land
improvements
Natural resources
13-3
Objectives for the Audit of
Property, Plant and Equipment
1. Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to property, plant, and equipment.
2. Obtain an understanding of internal control over property, plant, and equipment.
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Objectives cont.
1. Assess the risks of material misstatement and design tests of controls and substantive procedures that:
a. Substantiate the existence of property, plant, and equipment
b. Establish the completeness of recorded property, plant, and equipment
c. Verify the cutoff of transactions affecting property, plant, and equipment
d. Determine that the client has rights to recorded property, plant, and equipment
e. Establish the proper valuation or allocation of property, plant, and equipment and the accuracy of transactions affecting property, plant, and equipment
f. Determine that the presentation and disclosure of property, plant, and equipment are appropriate
13-5
Audit Approach—Current Accounts Versus Noncurrent Account
Cash
Securities
Accounts Receivable
Inventories
Accrued Liabilities
Accounts Payable
Short-Term Notes
Property, Plant
& Equipment
Intangible Assets
Long-Term Liabilities
Owner’s Equity
Accounts
High turnover
accounts
Audit approach—
audit the balance
Low turnover
accounts
Audit approach—
audit the changes
in the accounts
13-6
Controls Over Plant
and Equipment
Use of a plant and equipment capital budget
Maintenance of a subsidiary ledger
A system of authorizations
Analysis of variances from budgeted expenditures
A statement of policy distinguishing between capital and
revenue expenditures
A requirement that purchases of plant and equipment are
subjected to normal purchasing procedures
Periodic physical inventories
A system of retirement authorization and documentation
13-7
Audit Documentation
Working papers
Summary analysis that emphasizes changes
during the year under audit
Analyses of additions and retirements for the
current year
Analyses of repairs and maintenance
expense accounts
Tests of depreciation
13-8
Initial Audits
Beginning balances
Substantiated by review of predecessor firm’s
working papers
If not previously audited, a complete historical
analysis of property accounts is needed
• Thorough review of all major charges and credits
to property accounts
13-9
PPE Audit Steps (1 of 3)
A. Use the understanding of the client and its
environment to consider inherent risks, including fraud
risks, related to property, plant, and equipment.
B. Obtain an understanding of internal control over
property, plant, and equipment.
C. Assess the risks of material misstatement and design
further audit procedures.
D. Perform further audit procedures—tests of controls. 1. Nature of tests of controls.
2. If necessary, revise the risks of material misstatement based on the
results of tests of controls.
13-9
13-10
PPE Audit Steps (2 of 3)
E. Perform further audit procedures—substantive procedures for
property, plant, and equipment.
1. Obtain a summary analysis of changes in property owned and
reconcile to ledgers.
2. Vouch additions to property, plant, and equipment during the
year.
3. Make a physical inspection of major acquisitions of plant and
equipment.
4. Analyze repair and maintenance expense accounts.
5. Investigate the status of property, plant, and equipment not in
current use.
6. Test the client’s provision for depreciation.
7. Investigate potential impairments of property, plant, and
equipment.
8. Investigate retirements of property, plant, and equipment during
the year.
13-11
PPE Audit Steps (3 of 3)
E. Perform further audit procedures (cont.)
9. Examine evidence of legal ownership of property, plant, and
equipment.
10. Review rental revenue from land, buildings, and equipment
owned by the client but leased to others.
11. Examine lease agreements on property, plant, and equipment
leased to and from others.
12. Perform analytical procedures for property, plant, and
equipment.
13. Evaluate financial statement presentation and disclosure for
plant assets and for related revenue and expenses.
13-12
13-13
Summary of Substantive Tests of Property,
Plant, and Equipment
13-14
Vouch Additions (1 of 2)
Specific steps: a. Review changes during the year in construction in progress and
examine supporting work orders, both incomplete and closed.
b. Trace transfers from the Construction in Progress account to the
property accounts, observing propriety of classification. Determine
that all completed items have been transferred out of the account.
c. On a test basis, vouch purchases of property, plant, and equipment
to invoices, deeds, contracts, or other supporting documents.
Recompute extensions, footings, and treatment of discounts. Make
certain repairs and maintenance expenses were not improperly
capitalized.
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Vouch Additions (2 of 2)
Specific steps (cont.)
d. Investigate all instances in which the actual cost of
acquisitions substantially exceeded authorized amounts.
Determine whether such excess expenditures were
analyzed and approved by appropriate officials.
e Investigate fully any debits to property, plant, and
equipment accounts not arising from acquisition of
physical assets.
f. Determine that the total cost of any plant and equipment
assets purchased on the installment plan is reflected in
the asset accounts and that the unpaid installments are
set up as liabilities.
13-16
Analyze Expense Accounts
Analyze repairs and maintenance expense
accounts to:
Discover items that should have been
capitalized
Use company policy to determine consistency
in application
Analyze monthly amounts for significant
variations from:
• Month to month
• Between corresponding months of two years
13-17
Impairment of Long-Lived Assets
Long-lived assets must be reviewed for
impairment whenever events or changes
in circumstances indicate that carrying
value may not be recoverable
Test involves projecting future cash flows
If impairment is indicated by cash flows
asset must be written down to fair value
May require the use of a valuation
specialist
13-18
Investigate Retirements
Determine if property sold, dismantled, or abandoned
without being reflected in accounting records
Steps to discover unrecorded retirements:
1. For new additions, determine status of old equipment
2. Analyze miscellaneous revenue account for cash proceeds
3. If company’s products discontinued, investigate disposition of
plant facilities
4. Inquire of executives and supervisors of plant asset retirements
5. Examine retirement work orders for proper authorization
6. Investigate any reduction in insurance coverage
13-19
Analytical Procedures
Ratios and trends for overall reasonableness of
recorded amounts
a. Total cost of plant assets divided by annual output in
dollars, pounds, or other units.
b. Total cost of plant assets divided by cost of goods
sold.
c. Comparison of repairs and maintenance expense on
a monthly basis and from year to year.
d. Comparison of acquisitions for the current year with
prior years.
e. Comparison of retirements for the current year with
prior years.
13-20
Presentation and Disclosure
Disclose major classes of depreciable assets
Accumulated depreciation
Principles: a. The basis of valuation should be explicitly stated. At present, cost is the
generally accepted basis of valuation for plant and equipment; property
not in use should be valued at the lower of cost or estimated realizable
value.
b. Property pledged to secure loans should be clearly identified.
c. Property not in current use should be segregated in the balance sheet.
13-21
13-22
Auditors’ Approach for Depreciation
Important because depreciation is an estimate.
Client makes
Estimate of useful economic life
Choice of several depreciation methods
Audit approach for estimate
Review and test management’s process of
developing the estimate
Review subsequent events or transactions bearing on
the estimate
Independently develop an estimate of the amount to
compare to management’s estimate
13-23
Audit Program – Depreciation
(1 of 5)
1. Review the depreciation policies set forth in company
manuals or other management directives. Determine
whether the methods in use are designed to allocate
costs of plant and equipment assets systematically
over their service lives.
a. Inquire whether any extra working shifts or other conditions
of accelerated production are present that might warrant
adjustment of normal depreciation rates.
b. Discuss with executives the possible need for recognition of
obsolescence resulting from technological or economic
developments.
13-24
Audit Program – Depreciation
(2 of 5)
2. Obtain or prepare a summary analysis (see Figure 13.1)
of accumulated depreciation for the major property
classifications as shown by the general ledger control
accounts, listing beginning balances, provisions for
depreciation during the year, retirements, and ending
balances.
a. Compare beginning balances with the audited amounts in
last year’s working papers.
b. Determine that the totals of accumulated depreciation
recorded in the plant and equipment subsidiary records
agree with the applicable general ledger controlling accounts.
13-25
Audit Program – Depreciation
(3 of 5)
3. Test the provisions for depreciation.
a. Compare rates used in the current year with those employed in
prior years and investigate any variances.
b. Test computations of depreciation provisions for a representative
number of units and trace to individual records in the property
ledger. Be alert for excessive depreciation on fully depreciated
assets. Generalized audit software can be used to test the
depreciation calculations in the client’s records if the client
maintains computer based records.
c. Compare credits to accumulated depreciation accounts for the
year’s depreciation provisions with debit entries in related
depreciation expense accounts.
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Audit Program – Depreciation
(4 of 5)
4. Test deductions from accumulated depreciation for
assets retired.
a. Trace deductions to the working paper analyzing retirements of
assets during the year.
b. Test the accuracy of accumulated depreciation to date of
retirement.
5. Perform analytical procedures for depreciation.
a. Compute the ratio of depreciation expense to total cost of plant
and compare with prior years.
b. Compare the percentage relationships between accumulated
depreciation and related property accounts with those prevailing
in prior years. Discuss significant variations from the normal
depreciation program with appropriate members of
management.
13-27
Audit Program – Depreciation
(5 of 5) Overall test 1. List the balances in the various asset accounts at the
beginning of the year.
2. Deduct any fully depreciated assets, since these items
should no longer be subject to depreciation.
3. Add one-half of the asset additions for the year.
4. Deduct one-half of the asset retirements for the year
(exclusive of any fully depreciated assets).
13-28
Natural Resources
Properties subject to depletion
Similar to depreciation
Recorded consistently and in accordance with
GAAP
Test mathematical accuracy
Often rely on specialists for valuation
Establish ownership
13-29
Audit of Intangibles
Assets with definite useful lives are
audited similar to property, plant and
equipment
Assets with indefinite useful lives (e.g.,
goodwill) must be tested for impairment
Auditors generally rely on business
valuation specialists to value goodwill for
tests of impairment
13-30
Audit of PPE—Advance Work
Most work can be done in advance
Consideration of internal control can be
carried out at any convenient time
Many firms audit during interim work in
October and November
After balance sheet date, only need to
exam transaction for final two or three
months