1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-1 Chapter Fourteen Auditing Financing Process: Prepaid Expenses and Property, Plant and Equipment Chapter Fourteen Auditing Financing Process: Prepaid Expenses and Property, Plant and Equipment

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-5 Substantive Procedures – Prepaid Insurance Substantive Analytical Procedures 1.Compare current-year balance with prior years balances after considering any changes in operations. 2.Compute the ratio of expense to assets or sales and compare the ratio to prior years ratio.

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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. Existence and Completeness Confirm policy with insurance broker, examine supporting source documents. Rights and Obligations Confirm policy beneficiary with the insurance broker. Rights and Obligations Confirm policy beneficiary with the insurance broker. Valuation Determine unexpired portion of policy and insurance expense. Valuation Classification Determine propriety of distribution between manufacturing overhead and SG&A expense. Classification

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-7 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.

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-8 Property Management Process at EarthWear Clothiers Physical PlantIT Department Specialized PP&E transactions 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 PP&E subledger Reconcile to general ledger Monthly

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-9 Types of Transactions Four types of PP&E transactions may occur: 1.Acquisition of capital assets for cash or other non- monetary 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. Four types of PP&E transactions may occur: 1.Acquisition of capital assets for cash or other non- monetary 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.

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-10 Inherent Risk Assessment – Property Management Process There are three inherent risk factors that must be considered by the auditor. Complex accounting issues. issues. Difficult-to-audit transactions. Misstatements detected in prior audits.

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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, non- monetary exchanges, and self-constructed assets are more difficult to audit.

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-16 Control Risk Assessment – Property Management Process Key Segregation of Duties and Possible Errors

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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. 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.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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. 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.

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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.

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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 vendors invoices and other supporting documents. In some cases the auditor may wish to confirm property deeds or title documentation.

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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 assets 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.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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. 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.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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. 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.

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 14-26 End of Chapter 14