14-1
Chapter Fourteen
Auditing Financing Process:
Prepaid Expenses
and Property, Plant and Equipment
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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.
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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.
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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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14-5
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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14-6
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 and
Completeness
Confirm policy with
insurance broker,
examine supporting
source documents.
Rights and
Obligations
Confirm policy
beneficiary with
the insurance broker.
Valuation
Determine
unexpired portion
of policy and
insurance expense.
Classification
Determine propriety of distribution between
manufacturing overhead and SG&A expense.
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14-7
Auditing the Property Management
Process
Property, plant and equipment usually represents a
material amount in the financial statements.
Recurring Engagement
New Engagement
The auditor is able to focus
on additions and retirements
in the current period because
amounts from prior periods have
been subject to audit procedures.
the auditor has to verify the
assets that make up the
beginning balance in property,
plant and equipment.
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14-8
Property Management Process at
EarthWear Clothiers
Physical Plant
IT Department
From
purchasing
process
PP&E
transaction
file
Specialized
PP&E
transactions
PP&E
program
Input
General
ledger
program
General
ledger
report
PP&E
transaction
report
Review for
proper
recording
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PP&E
master
file
General
ledger
master file
Reconcile to
general ledger
Monthly
PP&E
subledger
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14-9
Types of Transactions
Four types of PP&E transactions may occur:
1. Acquisition of capital assets for cash or other nonmonetary considerations.
2. Disposition of capital assets through sale,
exchange, retirement, or abandonment.
3. Depreciation of capital assets over their useful
economic life.
4. Leasing of capital assets.
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14-10
Inherent Risk Assessment – Property
Management Process
There are three inherent risk factors that must be
considered by the auditor.
Complex
accounting
issues.
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Difficult-to-audit
transactions.
Misstatements
detected in
prior audits.
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14-11
Inherent Risk Assessment – Property
Management Process
Complex Accounting Issues
Lease accounting, self-constructed assets and
interest capitalization are vivid examples of some of
the complex accounting issues faced by auditors.
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14-12
Inherent Risk Assessment – Property
Management Process
Difficult-to-Audit Transactions
When 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.
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14-13
Inherent Risk Assessment – Property
Management Process
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.
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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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14-15
Control Risk Assessment – Property
Management Process
Completeness
The detailed property, plant and equipment
subsidiary ledger usually includes the following
information for each capital asset:
1. Description, location, and ID number.
2. Date of acquisition and installed cost.
3. Depreciation methods for book and tax purposes,
salvage value and estimated useful life.
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14-16
Control Risk Assessment – Property
Management Process
Key Segregation of Duties and Possible Errors
Segregation of Duties
The initiation function should be
segregated from the final approval
function.
The PP&E records function should be
segregated from the general ledger
function.
The PP&E records function should be
segregated from the custodial function.
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
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functions.
Possible Errors or Fraud
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.
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.
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 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 Copyright
can be
concealed.
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14-17
Substantive Analytical Procedures –
Property, Plant and Equipment
The following substantive analytical procedures
can be used:
1. Compare prior-year balances in PP&E and depreciation
expense with current-year balances.
2. Compute the ratio of depreciation expense to the related
PP&E accounts and compare to prior years’ ratios.
3. Compute the ratio of repairs and maintenance expense to
the related PP&E accounts and compare to prior years’
ratios.
4. Compute the ratio of insurance expense to related PP&E
accounts and compare to prior years’ ratio.
5. Review capital budgets and compare the amounts spent
with amounts budgeted.
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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.
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14-19
Tests of Details of Transactions and
Account Balances and Disclosures
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.
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14-20
Tests of Details of Transactions and
Account Balances and Disclosures
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.
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14-21
Tests of Details of Transactions and
Account Balances and Disclosures
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.
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14-22
Tests of Details of Transactions and
Account Balances and Disclosures
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.
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14-23
Tests of Details of Transactions and
Account Balances and Disclosures
Valuation and Allocation
Capital assets are valued at
acquisition cost plus any costs
necessary to make the asset
operational. The auditor tests
the recorded cost of major new
additions to PP&E.
The auditor may
recompute, either
manually or with the aid
of a computer, the proper
depreciation expense for
the period.
The auditor must test for permanent impairment of long-lived
assets. While IAS requires the comparison of the asset’s fair
value (less costs to sell) and its value in use, this process
can be quite difficult. Auditors may look to other sources of
information to learn about impairments.
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14-24
Tests of Details of Transactions and
Account Balances and Disclosures
Disclosure Issues
Examples of disclosure items:
1. Classes of capital assets and valuation bases.
2. Depreciation methods and useful lives for financial reporting and tax
purposes.
3. Non-operating assets.
4. Construction or purchase commitments.
5. Liens and mortgages.
6. Acquisition or disposal of major operating facilities.
7. Capitalized and other lease arrangements.
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14-25
Evaluating the Audit Findings
The auditor aggregates the misstatements and
compares this amount to the tolerable misstatement.
If the aggregated misstatement is less than the
tolerable misstatement, the evidence indicates that
the PP&E accounts are not materially misstated.
However, if the aggregated misstatement is greater
than the tolerable misstatement, the auditor would
either require adjustment of the accounts or issue a
qualified opinion.
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14-26
End of Chapter 14
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