chapter 14 auditing the financing/investing process: prepaid expenses, intangible assets, and...
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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
Inherent Risk Assessment – Property Management Process
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
Inherent Risk Assessment – Property Management Process
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
Inherent Risk Assessment – Property Management Process
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
Tests of Details of Transactions and Account Balances and Disclosures
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
Tests of Details of Transactions and Account Balances and Disclosures
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
Tests of Details of Transactions and Account Balances and Disclosures
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
Tests of Details of Transactions and Account Balances and Disclosures
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
Tests of Details of Transactions and Account Balances and Disclosures
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
Tests of Details of Transactions and Account Balances and Disclosures
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