Chapter 13

Audit of Fixed Assets and Related Expense Accounts

Discuss Business Risk and Business Environment

Fixed assets are often the large category of assets

Because there is typically limited activity in fixed assets

Auditors usually focus on testing transactions rather than tests of account balances

Audit period transactions include additions, disposals, write-offs, and depreciation

What is earnings management?

Ways fixed assets can be used to manage earnings:

Change estimated useful lives and residual values

Capitalize costs that should be expensed, such as repairs and maintenance

Account for capital leases as operating leases

Review Risks Associated with Fixed Assets and Related Expenses:

Unrecorded asset disposalsEnvironmental issuesObsolescence or impairment of assetsRestructuring charges related to changes in

the nature of the businessIncorrect recording of assets, hidden by

complex ownership structures designed to keep assets (and related liabilities) off the books

Incorrect valuation of assets acquired as part of a group purchase

Amortization or depreciation which does not reflect the economic use of the asset

Failure to recognize impairments in valueIncorrect computation of gains/losses on

asset disposalImproper recording of capital leases as

operating leasesCapitalization of costs that should be

expensed

Review Risks Associated with Fixed Assets and Related Expenses:

How does the auditor become aware of the risks?

Auditor will normally be aware of these risks through review of:

Industry trends, technological advances, and changes in location of production facilities

Business plan for major acquisitionsMajor contracts regarding capital

investments or joint venturesMinutes of board of director meetingsCompany filings with the SEC describing

actions, risks, strategies

Discuss Analytical Analysis for Possible Misstatements

Analyze industry trends and changes in product lines

Helps identify assets that are not as useful as in previous years

Tour the plant and note idle equipment

Analyze Depreciation for Consistency and Economic Activity

Review gains/losses on equipment disposals

Perform analytical estimate of depreciation

Explain Evaluating Control Risk and Control Effectiveness

Controls issues: Periodic inventories of physical assets reconciled to the

equipment subsidiary ledger Ensure all purchases are authorized and properly valued Classify new equipment according to expected use and useful life Periodic review of estimates Identify obsolete or scrapped equipment and write down to scrap

value Safeguard assets Prevent unauthorized journal entries Periodic review of management strategy to determine continued

usefulness of equipmentThe auditor should assess both the existence and effectiveness of

client controls in determining which direct tests need to be performed

Review Tests of Property Additions and Disposals

If the beginning balance is established, testing can be limited to additions and disposals during the year

Additions: Auditor can usually test existence and valuation by the same

procedures Schedule of property additions is agreed to additions shown in

the ledger to ensure schedule is complete Auditor vouches recorded additions to vendor invoice and

other supporting documentation (existence and valuation) Auditor may trace recorded additions to the physical assets to

establish existence (particularly if client controls are weak) Auditor will vouch fixed asset additions and repair and

maintenance expense transactions to vendor invoices or other supporting documentation to determine if transactions are properly recorded

Auditor will review lease contracts signed during the audit year to determine if they are properly recorded

Review Disposals and Fully Depreciated Equipment

Many organizations do not exercise the same degree of control over asset disposals as they do for acquisitions

Audit procedures are designed to test that ALL disposals have been recorded

Select a sample of (nearly) fully depreciated property from the property ledger and trace to the physical assets to determine existence

Review acquisition documents for trade-ins. Review the property ledger to make sure that the traded-in asset has been removed

Ask client about any assets that have been removed. Trace to the property ledger to make sure asset has been removed

Comment on Asset Impairment

There may be significant declines in the value of fixed assets due to technological obsolescence, or new manufacturing techniques

If there is evidence of asset impairment, valuation must be assessed

The FASB has developed two approaches to valuing impaired assets:

1. Estimate the future economic benefits to be derived from the asset

2. Obtain an independent assessment of the value of the asset

For the first approach, auditors perform a recoverability test to determine if asset is impaired.

If future cash flows exceed asset's carrying value, asset is not impaired

If future cash flows do not exceed carrying value, asset is impaired.

Amount of impairment is difference between net present value of future cash flows and asset's carrying value

For the second approach, the auditor may Obtain appraisal from independent and qualified

appraisal firm Review current transactions to determine if there

has been a decrease in purchase price

Comment on Asset Impairment (Continued)

How are discontinued operations treated?

Company should write net assets down to net realizable value

In assessing fair market value, auditor will normally:

Request estimate of value from an investment broker

Discount estimated future cash flows to develop estimate of value

The nature of the discontinuance decision and the amount of write-down should be fully disclosed in the notes to the financial statements

What’s different about first-time audits?

During first-time audit of a new client, the auditor will need to verify the beginning balances

If the client has been audited before, the predecessor auditor should be contacted

If the predecessor documentation cannot be used, or if this is the client's first audit,

Auditor will sample property in the beginning balance and Vouch back to supporting documents to verify cost Trace back to physical assets to verify existence

Auditor should also recalculate depreciation expense and accumulated depreciation

Discuss Depreciation Expense and Accumulated Deprecation

The procedures used to test deprecation will depend on the controls over depreciation and the risk associated with the engagement and account balance

Low risk - analytical procedures: Current estimate of depreciation is calculated and

modified for additions and disposals during the year Ratios are computed to determine reasonableness of

current deprecationHigh risk - tests of details: Foot the property ledger and agree to the general

ledger Recalculate depreciation for sample of items

Comment on Intangible Assets

May be difficult to determine which costs should be capitalized Especially for internally developed intangibles Auditor will review client accounting to ensure per GAAP

May be difficult to determine appropriate amortization period Expected economic life or legal life, whichever is shorter Auditor should review trade publications for competition

and new product introductions Auditor should make inquiries of client and legal counsel Auditor should review client procedures for determining

when intangibles become impaired

Review Handling Natural Resources

May be difficult to determine which costs should be capitalized

Most companies have procedures for identifying costs

Auditor should test capitalization of new assets by examining documents

May be difficult to estimate the amount of the natural resource

Many companies use geologists to estimate amount of natural resources

Auditor may hire a specialist to review any geological analysis

Depletion should be based on amount extracted during the year

Depletion is based on units of production approach

Auditor may use analytics like current depletion compared to prior years

Auditor may analyze production data and then recompute depletion

May be difficult to estimate reclamation expenses Auditor should examine the reasonableness of

procedures used by management to estimate cost

Review Handling Natural Resources (Continued)

Discuss Leases: Audit Approach

Obtain copies of lease agreements Review agreements to determine if capital or operating leases Review client records to determine if leases properly

accounted for

Review lease expense account Select entries and review to make sure they are for operating

leases

For all capital leases Determine assets and obligations are recorded at net present

value Determine the economic life of the asset Calculate amortization and interest expense Consider bargain purchase agreements to determine economic

life