Chapter 14

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

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 LO# 1

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.

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 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.

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 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.

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 LO# 2

Substantive Procedures – Prepaid

Insurance
Tests of Details of the Prepaid Insurance Account
Audit testing begins by obtaining a detailed
schedule of the prepaid insurance account.
Existence and Rights and Valuation
Completeness Obligations
Confirm policy with Confirm policy Determine unexpired
insurance broker, beneficiary with portion of policy and
examine supporting the insurance broker. insurance expense.
source documents.
Classification
Determine propriety of distribution between
manufacturing overhead and SG&A expense.

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 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:
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.

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 LO#

Inherent Risk Assessment –

1&2

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 (FASB ASC
Topic 350).
With the judgment and complexity associated with
valuation and estimation of intangible assets, the auditor
would likely assess the inherent risk as high.

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 LO#

Control Risk Assessment –

1&2

Intangible Assets
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 entity to the purchase and those undertaking the valuation.
3. The extent to which the entity engages or employs valuation specialists.
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.

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 Substantive Procedures –
LO# 2

Intangible Assets
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:
1. Existence and completeness.
2. Valuation.
3. Rights and obligations.
4. Classification.
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 LO# 3

Auditing the Property Management

Process
Property, plant, and equipment usually represents a
material amount in the financial statements.
Recurring Engagement New Engagement
The auditor is able to focus The auditor has to verify the
on additions and retirements assets that make up the
in the current period because beginning balance in property,
amounts from prior periods have plant, and equipment.
been subject to audit procedures.

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 LO# 4

Types of Transactions
Four types of PP&E transactions may occur:
1. Acquisition of capital assets for cash or
nonmonetary 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.

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 LO# 4

Property Management Process

at EarthWear Clothiers
Physical Plant IT Department
From
purchasing
process
General
ledger
PP&E PP&E master file
transaction master
file file
Specialized General General
PP&E
PP&E Input ledger ledger
program
transactions program report

Review for PP&E

proper transaction
recording report
Reconcile to Monthly
PP&E
general ledger
subledger 14-12
 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.

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 LO# 5

Inherent Risk Assessment –

Property Management Process
Complex Accounting Issues
Lease accounting, self-constructed assets, and
interest capitalization are examples of some of the
complex accounting issues faced by auditors.

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 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.

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 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.

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 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.
Assets no longer in use.

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 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:
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.

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 Control Risk Assessment –
LO# 7

Property Management Process

Key Segregation of Duties and Possible Errors

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 LO# 8

Substantive Analytical Procedures

– Property, Plant, and Equipment
The following substantive analytical procedures
can be used in the audit of PP&E:
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’ ratios.
5. Review capital budgets and compare the amounts spent
with amounts budgeted.
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 LO# 9

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.

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 LO# 9

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 are recorded in the proper
accounting period.

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 LO# 9

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.

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 LO# 9

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.

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 LO# 9

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.

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 LO# 9

Tests of Details of Transactions and

Account Balances and Disclosures
Valuation and Allocation
Capital assets are valued at The auditor may
acquisition cost plus any costs recompute, either
necessary to make the asset manually or with the aid
operational. The auditor tests of a computer, the proper
the recorded cost of major new depreciation expense for
additions to PP&E. 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.
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 LO# 9

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

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 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 aggregate misstatement is less than
the tolerable misstatement, the evidence indicates
that the PP&E accounts are not materially misstated.

If the aggregate misstatement is greater than the

tolerable misstatement, the auditor would either require
adjustment of the accounts or issue a qualified audit report.

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End of Chapter 14

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