Auditing the Financing/Investing Process: Prepaid Expenses; Intangible Chapter Fourteen Auditing the Financing/Investing Process: Prepaid Expenses; Intangible Assets and Goodwill; and Property, Plant and Equipment

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: Prepaid insurance. Prepaid rent. Prepaid interest. Insurance Policy

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.

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.

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.

Auditing Intangible Assets and Goodwill Intangible assets are identifiable assets that provide economic benefit for longer than a year, but lack physical substance (IFRS), for example: Marketing – trademark, brand name, and Internet domain names. Customer – customer lists, order backlogs, and customer relationships. Artistic – items protected by copyright. Contract – licenses, franchises, and broadcast rights. Technology – patented and unpatented technology. Goodwill represents the difference between the acquisition price for a company and the fair value of the identifiable tangible and intangible assets and liabilities (IFRS).

Inherent Risk Assessment – Intangible Assets and Goodwill The inherent risk associated with intangible assets and goodwill 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. With the judgement and complexity associated with valuation and estimation of intangible assets and goodwill, the auditor would likely assess the inherent risk as high.

Control Risk Assessment – Intangible Assets and Goodwill In assessing control risk, the auditor considers factors such as: The expertise and experience of those determining the fair value of the assets. 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. The extent to which the entity engages or employs valuation experts. The significant management assumptions used in determining fair value. The integrity of change controls and security procedures for valuation models and relevant information systems, including approval processes

Substantive Procedures – Intangible Assets and Goodwill Tests of Details of Intangible Assets and Goodwill Tests of details associated with valuation and impairment of intangible assets and goodwill are often necessary because the complexity and degree of judgement 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 and goodwill. Four assertions are normally considered for tests of details of intangible assets: Existence and completeness. Valuation. Rights and obligations. Classification. It may be useful here to give some general definitions or examples of these assertions. Goodwill may be a particularly good topic.

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 havebeen subject to audit procedures. New Engagement the auditor has to verify the assets that make up the beginning balance in property, plant and equipment.

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

Types of Transactions Four types of PP&E transactions may occur: Acquisition of capital assets for cash or other non-monetary considerations. Disposition of capital assets through sale, exchange, retirement or abandonment. Depreciation of capital assets over their useful economic life. Leasing of capital assets.

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.

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.

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, non-monetary exchanges, and self-constructed assets are more difficult to audit.

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.

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.

Control Risk Assessment – Property Management Process Completeness The detailed property, plant and equipment subsidiary ledger usually includes the following information for each capital asset: Description, location, and ID number. Date of acquisition and installed cost. Depreciation methods for book and tax purposes, salvage value and estimated useful life.

Control Risk Assessment – Property Management Process Key Segregation of Duties and Possible Errors

Substantive Analytical Procedures – Property, Plant and Equipment The following substantive analytical procedures can be used: Compare prior-year balances in PP&E and depreciation expense with current-year balances. Compute the ratio of depreciation expense to the related PP&E accounts and compare to prior years’ ratios. Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior years’ ratios. Compute the ratio of insurance expense to related PP&E accounts and compare to prior years’ ratio. Review capital budgets and compare the amounts spent with amounts budgeted.

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.

Tests of Details of Transactions and Account Balances and Disclosures Cut-off Cut-off 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.

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.

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.

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.

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/IFRS 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.

Tests of Details of Transactions and Account Balances and Disclosures Disclosure Issues Examples of disclosure items: Classes of capital assets and valuation bases. Depreciation methods and useful lives for financial reporting and tax purposes. Non-operating assets. Construction or purchase commitments. Liens and mortgages. Acquisition or disposal of major operating facilities. Capitalized and other lease arrangements.

Evaluating the Audit Findings The auditor compares the aggregated identified misstatement to materiality to determine if the identified misstatement would affect the audit. The auditor requests the client to correct the identified misstatements and then compares the uncorrected misstatements with materiality to conclude whether the financial statements are fairly stated. If uncorrected misstatements in property, plant and equipment accounts, and when considered together with other uncorrected misstatements, are less than materiality, the auditor may accept that the financial statements are fairly presented. Conversely, if the uncorrected misstatement exceeds the materiality, the auditor should conclude that the financial statements are not fairly presented.

End of Chapter 14