1. 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

2. Liabilities and Equity
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

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

4. Auditing Prepaid Expenses
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:
Prepaid insurance.
Prepaid rent.
Prepaid interest.
Insurance
Policy

5. Inherent Risk Assessment – Prepaid Expenses
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.

6. Control Risk Assessment – Prepaid Expenses
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.

7. Substantive Procedures – Prepaid Insurance
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 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.

8. Auditing Intangible Assets
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:
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.

9. Inherent Risk Assessment – Intangible Assets
LO# & 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.

10. Control Risk Assessment – Intangible Assets
LO# & 2
Control Risk Assessment – Intangible Assets
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 specialists.
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 (AU 328).

11. 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

12. 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:
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.

13. Auditing the Property Management Process
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.

14. 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 auditor’s understanding regarding the reasons for the change.
Adequacy of the work performed

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

16. Types of Transactions Four types of PP&E transactions may occur:
LO# 4
Types of Transactions
Four types of PP&E transactions may occur:
Acquisition of capital assets for cash or other nonmonetary considerations.
Disposition of capital assets through sale, exchange, retirement, or abandonment.
Depreciation of capital assets over their useful economic life.
Leasing of capital assets.

17. Inherent Risk Assessment – Property Management Process
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.

18. Inherent Risk Assessment – Property Management Process
LO# 5
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.

19. Inherent Risk Assessment – Property Management Process
LO# 5
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.

20. Inherent Risk Assessment – Property Management Process
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.

21. Control Risk Assessment – Property Management Process
LO# 6
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.

22. Control Risk Assessment – Property Management Process
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:
Description, location, and ID number.
Date of acquisition and installed cost.
Depreciation methods for book and tax purposes, salvage value, and estimated useful life.

23. Control Risk Assessment – Property Management Process
LO# 7
Key Segregation of Duties and Possible Errors

24. Substantive Analytical Procedures – Property, Plant, and Equipment
LO# 8
Substantive Analytical Procedures – Property, Plant, and Equipment
The following substantive analytical procedures can be used in the audit of PP&E:
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.
Students may find additional explanation helpful here. Sometimes just knowing what to do rather than understanding what the formulae are computing is much more helpful than a simple list.

25. 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.

26. 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.
December 28
2007
January 4
2008

27. 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.

28. 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.

29. 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.

30. 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 asset’s carrying amount, this process can be quite difficult. Auditors may look to other sources of information to learn about impairments.

31. 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.
Nonoperating assets.
Construction or purchase commitments.
Liens and mortgages.
Acquisition or disposal of major operating facilities.
Capitalized and other lease arrangements.

32. Evaluating the Audit Findings Property, Plant, and Equipment
LO# 10
Evaluating the Audit Findings Property, Plant, and Equipment
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.

33. Questions

34. End of Chapter 14