Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-1...

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

14-1

Chapter Fourteen Auditing Financing Process:

Prepaid Expenses and Property, Plant and Equipment

Chapter Fourteen Auditing Financing Process:

Prepaid Expenses and Property, Plant and Equipment


14-2

Auditing Prepaid Expenses

Other assets that provide economic benefit for less than a year:

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


14-3

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.


14-4

Control Risk Assessment – Prepaid Expenses

Because prepaid expenses are normally processed through the purchasing process, control activities in purchasing should ensure that each item is properly

authorized and recorded.


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Substantive Procedures – Prepaid Insurance

Substantive Analytical Procedures

1. Compare current-year balance with prior year’s balances after considering any changes in operations.

2. Compute the ratio of expense to assets or sales and compare the ratio to prior year’s ratio.


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Substantive Procedures – Prepaid Insurance

Tests of Details of the Prepaid Insurance Account

Audit 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.

ValuationValuationDetermineDetermine

unexpired portionunexpired portionof policy andof policy and

insurance expense.insurance expense.

ValuationValuationDetermineDetermine

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.


14-7

Auditing the Property Management Process

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

Recurring EngagementRecurring 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 EngagementRecurring 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.


14-8

Property Management Process atEarthWear 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


14-9

Types of Transactions

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

1.1. Acquisition of capital assets for cash or other non-Acquisition of capital assets for cash or other non-monetary considerations.monetary considerations.

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

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

4.4. Leasing of capital assets.Leasing of capital assets.

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

1.1. Acquisition of capital assets for cash or other non-Acquisition of capital assets for cash or other non-monetary considerations.monetary considerations.

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

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

4.4. Leasing of capital assets.Leasing of capital assets.


14-10

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.


14-11


Complex Accounting Issues

Lease accounting, self-constructed assets and interest capitalization are vivid examples of some of the complex accounting issues faced by auditors.


14-12


Difficult-to-Audit Transactions

When assets are purchased directly from a vendor, the transaction is relatively easy to audit. However,

transactions involving donated assets, non-monetary exchanges, and self-constructed assets

are more difficult to audit.


14-13


Misstatements Detected in Prior Audits

If 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.


14-14

Control Risk Assessment – Property Management Process

Occurrence and Authorization

Control 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.


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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.


14-16


Key Segregation of Duties and Possible ErrorsSegregation 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.


14-17

Substantive Analytical Procedures – Property, Plant and Equipment

The following substantive The following substantive analytical analytical procedures procedures can be used:can be used:The following substantive The following substantive analytical analytical procedures procedures can be used:can be used: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 to Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior years’ the related PP&E accounts and compare to prior years’ ratios.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 to Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior years’ the related PP&E accounts and compare to prior years’ ratios.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.


14-18

Tests of Details of Transactions and Account Balances and Disclosures

Completeness

The 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.


14-19


Cutoff

Cutoff 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.


14-20


Classification

First, 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.


14-21


Existence

A 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.


14-22


Rights and Obligations

In 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.


14-23


Valuation and Allocation

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.

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 IAS requires the comparison of the asset’s fair assets. While IAS requires the comparison of the asset’s fair

value (less costs to sell) and its value in use, this process value (less costs to sell) and its value in use, this process can be quite difficult. Auditors may look to other sources of can be 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 IAS requires the comparison of the asset’s fair assets. While IAS requires the comparison of the asset’s fair

value (less costs to sell) and its value in use, this process value (less costs to sell) and its value in use, this process can be quite difficult. Auditors may look to other sources of can be quite difficult. Auditors may look to other sources of

information to learn about impairments.information to learn about impairments.


14-24


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. Non-operating assets.Non-operating 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. Non-operating assets.Non-operating 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.


14-25

Evaluating the Audit Findings

The auditor aggregates the misstatements and The auditor aggregates the misstatements and compares this amount to the tolerable compares this amount to the tolerable misstatement. If the aggregated misstatement is misstatement. If the aggregated misstatement is less than the tolerable misstatement, the evidence less than the tolerable misstatement, the evidence indicates that the PP&E accounts are not materially indicates that the PP&E accounts are not materially misstated.misstated.

However, if the aggregated misstatement is greater However, if the aggregated misstatement is greater than the tolerable misstatement, the auditor would than the tolerable misstatement, the auditor would either require adjustment of the accounts or issue a either require adjustment of the accounts or issue a qualified opinion.qualified opinion.

The auditor aggregates the misstatements and The auditor aggregates the misstatements and compares this amount to the tolerable compares this amount to the tolerable misstatement. If the aggregated misstatement is misstatement. If the aggregated misstatement is less than the tolerable misstatement, the evidence less than the tolerable misstatement, the evidence indicates that the PP&E accounts are not materially indicates that the PP&E accounts are not materially misstated.misstated.

However, if the aggregated misstatement is greater However, if the aggregated misstatement is greater than the tolerable misstatement, the auditor would than the tolerable misstatement, the auditor would either require adjustment of the accounts or issue a either require adjustment of the accounts or issue a qualified opinion.qualified opinion.


14-26

End of Chapter 14

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-1...

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Transcript of Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-1...