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Chapter 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
Assets
Cash
Investments
Receivables
Prepaids
Inventory
PP and E
Other assets intangibles

Liabilities and Equity


Accounts payable
Accrued liabilities
Debt
Common stock
Retained earnings

Other Assets
Prepaid expenses current
Intangible assets long term
Property, plant and equipment long term

LO# 1

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.
Insurance
Policy

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LO# 1

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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LO# 1

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.

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LO# 2

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
Existence and
and
Completeness
Completeness
Confirm
Confirm policy
policy with
insurance
insurance broker,
examine
examine supporting
supporting
source
source documents.
documents.

Rights
Valuation
Rights and
and
Valuation
Obligations
Obligations
Confirm
Determine
Confirm policy
policy
Determine unexpired
unexpired portion
portion
beneficiary
of policy and
beneficiary with
the
insurance
the insurance
insurance broker.
insurance expense.
expense.
Classification
Determine
Determine propriety
propriety of
of distribution
distribution between
between
manufacturing
manufacturing overhead
overhead and
and SG&A
SG&A expense.
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LO#

1&2

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.
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LO#
1&2

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.

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Control Risk Assessment


Intangible Assets

LO#
1&2

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).
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Using the work of a specialist


SAS #73
The auditor should consider the following:
Professional certification of specialist
Reputation and standing
Experience and expertise
Objectives and scope of the work
Relationship to the client ( Independence!)
Methods and assumptions used
Other
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Substantive Procedures
Intangible Assets

LO# 2

Tests of Details of Intangible Assets


Tests 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.

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LO# 3

Auditing the Property Management


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

New Engagement

The auditor has to verify the


assets that make up the
beginning balance in property,
plant, and equipment.

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Communication between predecessor and


successor auditors ( SAS # 84)
Successor auditor should consider the following:
Information regarding integrity of management
Disagreements with management about
accounting principles
Communications to audit committees about
fraud and IC issues
Predecessor auditors understanding regarding
the reasons for the change.
Adequacy of the work performed
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Property Management Process


at EarthWear Clothiers
Physical Plant

IT Department
From
purchasing
process
PP&E
transaction
file

Specialized
PP&E
transactions

LO# 3

PP&E
master
file

PP&E
program

Input

General
ledger
master file

General
ledger
program

General
ledger
report

PP&E
transaction
report

Review for
proper
recording
Reconcile to
general ledger

Monthly

PP&E
subledger

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LO# 4

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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LO# 5

Inherent Risk Assessment


Property Management Process
There are three inherent risk factors that must be
considered by the auditor.
Complex
accounting
issues.

Difficult-to-audit
transactions.

Misstatements
detected in
prior audits.
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Inherent Risk Assessment


Property Management Process

LO# 5

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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Inherent Risk Assessment


Property Management Process

LO# 5

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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LO# 5

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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Control Risk Assessment


Property Management Process

LO# 6

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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LO# 6

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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Control Risk Assessment


Property Management Process

LO# 7

Key Segregation of Duties and Possible Errors

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Substantive Analytical Procedures


Property, Plant, and Equipment

LO# 8

The following substantive analytical procedures


can be used in the audit of PP&E:
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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LO# 9

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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LO# 9

Tests of Details of Transactions and


Account Balances and Disclosures
Cutoff
Cutoff is normally part of the accounts payable and
accrued expenses work. Vendors invoices from a
few days before and after year-end are examined to
determine if the assets is recorded in the proper
accounting period.
December
28
2007

January
4
2008

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LO# 9

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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LO# 9

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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LO# 9

Tests of Details of Transactions and


Account Balances and Disclosures
Rights and Obligations
In most cases, rights or ownership can be
determined by examining vendors invoices and
other supporting documents. In some cases, the
auditor may wish to confirm property deeds or title
documentation.

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LO# 9

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 GAAP requires the comparison of future cash
inflows to the assets carrying amount, this process can be
quite difficult. Auditors may look to other sources of
information to learn about impairments.
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LO# 9

Tests of Details of Transactions and


Account Balances and Disclosures
Disclosure Issues
Examples of disclosure items:
1.
1.
2.
2.
3.
3.
4.
4.
5.
5.
6.
6.
7.
7.

Classes
Classes of
of capital
capital assets
assets and
and valuation
valuation bases.
Depreciation
Depreciation methods and useful lives for financial reporting
reporting and
and tax
tax
purposes.
purposes.
Nonoperating
Nonoperating assets.
Construction
Construction or
or purchase
purchase commitments.
commitments.
Liens
Liens and
and mortgages.
mortgages.
Acquisition
Acquisition or
or disposal
disposal of
of major operating facilities.
facilities.
Capitalized
Capitalized and other
other lease
lease arrangements.
arrangements.

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Evaluating the Audit Findings


Property, Plant, and Equipment

LO# 10

The auditor aggregates the likely misstatements and


compares this amount to the tolerable misstatement.
If the likely misstatement is less than
the tolerable misstatement, the evidence indicates
that the PP&E accounts are not materially misstated.
If the likely misstatement is greater than the
tolerable misstatement, the auditor would either require
adjustment of the accounts or issue a qualified audit report.

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Questions

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End of Chapter 14

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