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.

13-4

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.

13-26

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