Chapter Fourteen

Auditing the
Financing/Investing
Process:
Prepaid Expenses;
Intangible
Assets and
Goodwill; and
Property, Plant and
Equipment
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 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. Insurance
Policy

2. Prepaid rent.
3. Prepaid interest.

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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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 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.

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 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 Rights and Valuation
Completeness Obligations Determine
Confirm policy Confirm policy unexpired portion
with beneficiary with of policy and
insurance broker, the insurance broker. insurance expense.
examine
supporting Classification
source Determine propriety of distribution between
documents. manufacturing overhead and SG&A
expense.
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Auditing Intangible Assets and Goodwill
Intangible 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).
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 Inherent Risk Assessment –
Intangible Assets and Goodwill
The 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.
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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
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 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.
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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
on additions and retirements
in the current period because
amounts from prior periods
havebeen subject to audit
procedures.
the auditor has to verify the
assets that make up the
beginning balance in
property, plant and
equipment.

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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 Input PP&E
ledger ledger
transactions program
program report
Review for PP&E
proper transaction
recording report

Reconcile to Monthly PP&E

general ledger subledger

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 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.

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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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 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.

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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.

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 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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 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.

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 Control Risk Assessment –
Property Management Process
Completeness

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 Control Risk Assessment –
Property Management Process
Key Segregation of Duties and Possible Errors
Segregation of Duties
The initiation function should be
segregated from the final approval
function.
The PP&E records function should be
segregated from the general ledger
function.
The PP&E records function should be
segregated from the custodial function.
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.
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Possible Errors or Fraud
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.
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.
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 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

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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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Tests of Details of Transactions and
Account Balances and Disclosures
Cut-off
Cut-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.

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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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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.

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

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.

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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.

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 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.

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 End of Chapter 14

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