Chapter 14. Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment

Transcription

1 Chapter 14 Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and Property, Plant, and Equipment Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2 LO# 1 Auditing Prepaid Expenses Other assets that provide economic benefit for less than a year are classified as current assets. Prepaid expenses are a common other asset. Examples include: 1. Prepaid insurance. 2. Prepaid rent. 3. Prepaid interest. 14-2

3 Inherent Risk Assessment Prepaid Expenses LO# 1 The inherent risk associated with prepaid expenses is generally assessed as low because the accounts do not involve any complex or contentious accounting issues. 14-3

4 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#

5 Substantive Procedures Prepaid Insurance Tests of Details of the Prepaid Insurance Account Audit testing begins by obtaining a detailed schedule of the prepaid insurance account. LO# 2 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. 14-5

6 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. 14-6

7 Inherent Risk Assessment Intangible Assets LO# 1 & 2 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 (FASB ASC Topic 350). With the judgment and complexity associated with valuation and estimation of intangible assets, the auditor would likely assess the inherent risk as high. 14-7

8 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 entity 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. 14-8

9 Substantive Procedures Intangible Assets 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. LO# 2 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. 14-9

10 Auditing the Property Management Process Property, plant, and equipment usually represents a material amount in the financial statements. LO# 3 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

11 LO# 4 Types of Transactions Four types of PP&E transactions may occur: 1. Acquisition of capital assets for cash or 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

12 Property Management Process Physical Plant Specialized PP&E transactions at EarthWear Clothiers Input IT Department From purchasing process PP&E transaction file PP&E program PP&E master file General ledger master file General ledger program LO# 4 General ledger report Review for proper recording PP&E transaction report Reconcile to general ledger Monthly PP&E subledger 14-12

13 Inherent Risk Assessment Property Management Process LO# 5 There are three inherent risk factors that must be considered by the auditor. Complex accounting issues. Difficult-toaudit transactions. Misstatements detected in prior audits

14 Inherent Risk Assessment Property Management Process LO# 5 Complex Accounting Issues Lease accounting, self-constructed assets, and interest capitalization are examples of some of the complex accounting issues faced by auditors

15 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

16 Inherent Risk Assessment Property Management Process LO# 5 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

17 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. Assets no longer in use

18 Control Risk Assessment Property Management Process LO# 6 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

19 Control Risk Assessment Property Management Process Key Segregation of Duties and Possible Errors LO#

20 Substantive Analytical Procedures Property, Plant, and Equipment 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 ratios. 5. Review capital budgets and compare the amounts spent with amounts budgeted LO# 8

21 Tests of Details of Transactions and Account Balances and Disclosures Completeness and Accuracy 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. The auditor can trace a sample of assets to the property, plant, and equipment subsidiary ledger. LO#

22 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 are recorded in the proper accounting period. LO#

23 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. LO#

24 Tests of Details of Transactions and Account Balances and Disclosures LO# 9 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

25 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. LO#

26 Tests of Details of Transactions and Account Balances and Disclosures 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. Valuation and Allocation 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 asset s carrying amount, this process can be quite difficult. Auditors may look to other sources of information to learn about impairments LO# 9

27 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. Nonoperating assets. 4. Construction or purchase commitments. 5. Liens and mortgages. 6. Acquisition or disposal of major operating facilities. 7. Capitalized and other lease arrangements. LO#

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

29 End of Chapter