© the mcgraw-hill companies 2010 auditing the financing/investing process: prepaid expenses;...

© The McGraw-Hill Companies 2010

Auditing the Financing/Investing Process: Prepaid Expenses;

IntangibleAssets and

Goodwill; and Property, Plant and

Equipment

Chapter Fourteen


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.

InsurancePolicy


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 andCompletenessConfirm policy

withinsurance broker,

examine supporting

source documents.

Existence andCompletenessConfirm policy

withinsurance broker,

examine supporting

source documents.

Rights andObligations

Confirm policybeneficiary with

the insurance broker.

Rights andObligations

Confirm policybeneficiary with

the insurance broker.

ValuationDetermine

unexpired portionof policy and

insurance expense.

ValuationDetermine

unexpired portionof policy and

insurance expense.

ClassificationDetermine propriety of distribution between

manufacturing overhead and SG&A expense.

ClassificationDetermine propriety of distribution between

manufacturing overhead and SG&A expense.


Auditing Intangible Assets and GoodwillIntangible assets are identifiable assets that provide economic benefit for longer than a year, but lack physical substance (IFRS), for example:

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.

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 GoodwillThe 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:

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 experts.

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


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:

1. Existence and completeness.

2. Valuation.

3. Rights and obligations.

4. Classification.


Auditing the Property Management Process

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

Recurring EngagementThe auditor is able to focus

on additions and retirementsin the current period becauseamounts from prior periods havebeen subject to audit

procedures.

Recurring EngagementThe auditor is able to focus

on additions and retirementsin the current period becauseamounts from prior periods havebeen subject to audit

procedures.

New Engagementthe auditor has to verify the

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

equipment.

New Engagementthe auditor has to verify the

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

equipment.


Property Management Process atEarthWear Clothiers

SpecializedPP&E

transactions

PP&Esubledger

Reconcile togeneral ledger

Physical Plant IT Department

Review forproper

recording

Input

Frompurchasing

process

PP&Etransaction

file

PP&Emaster

file

PP&Eprogram

Generalledger

master file

Generalledger

program

Generalledgerreport

PP&Etransaction

report

Monthly


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.


Inherent Risk Assessment – Property Management Process

There are three inherent risk factors that must be considered by the auditor.

Complexaccounting

issues.

Complexaccounting

issues.Difficult-to-audit

transactions.Difficult-to-audit

transactions.Misstatements

detected inprior audits.

Misstatementsdetected inprior audits.



Complex Accounting Issues

Lease accounting, self-constructed assets and interest capitalization are vivid examples of some

of the complex accounting issues faced by auditors.



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.



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.



Completeness



Key Segregation of Duties and Possible ErrorsSegregation of Duties Possible Errors or Fraud

The initiation function should be segregated from the final approval function.

If one individual is responsible for initiating a capital asset transaction and also has final approval, fictitious or unauthorized purchases of assets can occur. This can result in purchases of unnecessary assets, assets that do not meet the company's quality control standards, or illegal payments to suppliers.

The PP&E records function should be segregated from the general ledger function.

If one individual is responsible for the PP&E records and also for the general ledger functions, that individual can conceal any defalcation that would normally be detected by reconciling subsidiary records with the general ledger control account.

The PP&E records function should be segregated from the custodial function.

If one individual is responsible for the PP&E records and also has custodial responsibility for the related assets, items may be stolen, and the theft can be concealed by adjustment of the accounting records.

If a periodic physical inventory of PP&E is taken, the individual responsible for the inventory should be independent of the custodial and record-keeping functions.

If one individual who is responsible for the periodic physical inventory of PP&E is also responsible for the custodial and record-keeping functions, theft or the entity's capital assets can be concealed.


Substantive Analytical Procedures – Property, Plant and Equipment


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.



Cut-offCut-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.



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.



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.



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.



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.

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 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.

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.



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.


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

© the mcgraw-hill companies 2010 auditing the financing/investing process: prepaid expenses;...

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auditing intangible

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auditing prepaid expenses

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