Fixed Assets often represent the largest single category of assets of many

organizations. Lon-lived assets are those with a useful life extending greater
than one year.

Significan accounts and relevant assertions in the long-lives asset cycle.

The asset account (equipment, buildings, or similarly titled asstes) represents

the culmination of major capital additions and disposals. Unlessthid is s first
year, the beginning balance is established via resultsof the previous-year
audit.

As indicated in Exhibits 13.1 the significant and relevant accounts typically

include the long-lived asset, the related expense, any related gains due to
disposals, and any related losses due to disposals or impairments. The
auditor will likely obtain for these accounts ecidence related to each of the
five financial statement assertions discussed in Chapter 7. However for
specific accounts and specific clients, some assertions are more relevant, and
thus require more evidence, that other assertions. At many clients, the
existence and valuation assertions related to the long-lived asset account
may be judged the more relevant assetions. Those assertions determined to
be more relevant are those for which the risk of misstatement is higuer and
for which more audit evidence is needed.

Performing the integrated Audit of Long-lived assets and related

expenses

The audit stars with an analysis of risks to reliable financial reporting and
including an analysis of controls to address those risks. The substantive
testing of the account balances focuses on material transactions affecting the
account balance during the year: additions, disposals, and write-offs of
existing assets ans the recognition of periodic depreciation of the assets.

The relative strenghts of the client'sinternal controls have a significant

impact on the audit of fixes assets and related expenses. Weak control
environments at Worldcom and Waste Managements resultedin material
misstatements in fixed assets and related expenses. The weaknesses in the
control environments led to management override of existing controls and
ultimately to the ability to commit large frauds.

How does an integrated audit of fixed assets differ from a more traditional
audit?

A traditional audit will focus on changes in the accounts during the year,
including a significant effort directes at recalculating decpreciation expense.
In contrast, an integrated audit will focus on assessing the controls related to
cycle-specific accounts. If the controls are effective, minimal direct testing of
changes in account balances is needed.

We have tailored this approach to the audit of fixed asstes as follows:

Phases I and II of the Audit Opinion Formulation Process

1. Continually updated information on business risk, including the

identification of any fraud risk factors noted during preliminary audit
planning. Update audit planning for new risk information.

2. Analyze the potential motivations to misstate long-lived asset and related

expense accounts, as well as the existence if other fraud indicators, and
determine the most likely methos by which those accounts might be
misstated.

3. Perform preliminary analytical procedures to determine if unexpected

relationships exist in the accounts and documents how the audit testing
should be modified because of the unusual relationships.

4. Develop and understanding of the internal controls over long-lived assets

and related expense accounts that are designed to address the risks
identified in the three previous steps, including the applicability of entity-
level controls to these accounts. The understandins will include a review of
the client's documentation of internal controls.

Phases III and IV the Audit Opinion FOrmulation process

5. determine the important controls that need to be testes for the purposes of
formulating an opinion in the entity's internal controls and reducing
substantive testing for the financial statement audit.

6. Develop a plan for testing internal controls and perform the tests of key
controls in long-lived assets and related expense accounts. (For ninpublic
companies, the auditor can choose to not test controls. but must determine
where material misstatements could occur if controls are not present.)

7. Analyze the results of the test of controls.

If deficiencies are identified, assess those deficiencies to determine whether

they are significant deficiencies or material weaknesses. Determine whether
the preliminary control risk assessment should be modified (should control
risk be assessed at a higuer level) and documents the implication for
substantive testing. Determine the impact of these deficiencies, and any
revision in the control risk assessment, on planned substantive audit
procedures by determining the types os misstatements that are most likely to
occur.
In no control deficiencies are identified, assess whether the preliminary
control risk assessment is still appropriate, determine the extent tha controls
can provide evidence on the correctness of account balances, and then
determine planned substantive audit procedures. The level of substantive
testing in this situation will be less than what is likely required in
circumstances where deficiencies in internal control were identified.

8. Perform planned substantive procedures (substantive analytical

procedures and direct test of accounts balances) based on the potential for
misstatement and the information gathered about the effectuveness of
internal controls. The substantive procedures will include procedures to
address fraud risks.

Consider the risks related to fixed asses

Management can manage earnings in a variety of ways related to fixed asset

accounts, including:

•Changing estimated useful lives and residual values

•Capitalizing costs that should be expensed, such as repairs and

maintenance costs

•Improperly accounting for assets restructuring or acquisition

•Failing to properly perform asset impairment adjustments

•Accounting for capital leases as operating leases

Unusual entries, particularly credits to depreciation expense or nonstandard

adjusting entries, reflect risk and should attract special attention during the
audit. It is external auditor's responsability to actively search for such entries.

Other risks associated with fixed assets and related expenses include the
followings:

•Incomplete recording of assets disposals

•Environmental liabilities or claims related to violations of safety and

protection regulations, or violation of environmental regulations

•Obsolescence of assets

•Restructuring charges related ti changes in the nature of the business

•Incorrect recording of assets, hidden by complex ownership structures

 designed to keep assets (and related liabilities) off the books.

•Incorrect caluation of assets acquired as part od a group purchase,

including assets acquired as part of an acquisition of another business.

•Amortization schedules or depreciation schedules that do not reflect

economic impairment or use of the asset

•Failure to properly recogniza impairment in value

The auditor will normally become aware of these risks through review of:

•Industry trends, technological advances, and changes in the location of

production facilities.

•The business plan for major acquisition or changes in the way the
company conducts its business.

•Major contracts regarding capital investments or joint ventures with other

companies.

•The minutes of board of directors meetings

•Company filings with SEC describing company actions, risks, and

strategies.

Many new auditors just returning from an internshio believe that the audit of
fixes assets is primarily mechanical, for example, recalculating depreciation,
tracing amounts to accumulated depreciation, and vouching fixed assets
additions. In some organizations, that may be the case. However, as with all
other aspects of the audit, the auditor must understand the client's business
strategy, current economic conditions, abs potencial changes in the economic
value of the assets. Auditors can make serious mistakes if they act as if fixed
assets are always a low-risk audit area. ( page 659)

Perform Preliminary analytical procedures for possible

misstatements (Step 3)

Analyze Industry Trends and Changes in Product lines

It is often very dificult to determine if the value of fixed assets has been
impaired. However, knowledge of industry product trends and changes in the
cleint's product lines may indicate that those assets are not as useful as they
have been in previous year. Specifically, thiose assets may not generate as
much cash flow in the future yeas as they have in the past. A tour of the plant
may provide hints that some assets are not fully utilized or are not utilized
efficiently . Such ibservations might indicate a potencial impairmnent in
value. Other times, impairments are more apparent. For example, Ford Motor
Company announced plans in 2007 to reduce vehicle production by 20% over
the next few years. That reduction requires the company and its auditors to
carefully identify which assets will be discountinued and should received a
write-down to their impaired value.

Analyze Depreciation for consistency and economic activity

We have repeatedly made the point that the auditor must know the business
and the economics of the business of picking upand hauling garbage.
Shouldn't the auditors have a fairly good idea of approximately how long the
trucks will last? The knowthe mileage; they know the beating trucks take
every day; they know something about the company's policy for cleaning
and repairing the trucks. What if management comes in and makes a
decision to extend the depreciable life from 5 to 12 years when the rest of
the industry is at about 6 years? Does this make sense? See the Focus
discussion of Waste Management, which illustrates the type of the fraud than
can be committed when auditors are nor prepared to review the economics of
such desicions. Although the auditor cannot always make a decision as to
whether 5 years is better than 6, the auditor needs to be in a position to
understand that 5 years is much closer to economic reality than 12 years.

There are at least four relatively simple analytical techniques that auditors
can use to supplement their overall business understanding of the client:

•Review gains/losses on disposals of equipment (gains indicate

depeciation lives are too short, losses indicate the opposite).

•Tour the plan and note the amount of idle equipmnet.

•Perform an estimate of depreciation.

•Compare depreciable lives for various asset categories between the

existing client and industry norms; large differences may indicate
earnings management.

The auditor can utilize spreadsheets to develop estimates of depreciation

based on costs of assets, estimates lives, and salvage value. Assuming
the auditor agrees with the client's estimate of useful life and salvage
value, the depreciation estimate can be compared with recorded
depreciation as a starting point to determine if additional work is needed.
Linking Intenal Controls and Financial Statement Assertions for
Long-lived Assets and Related Expenses.

The auditor will gain an understanding of the controls that the client has
implemented to address the risks associated with misstatements in the
long-lives assets, and related accounts. As part of this understanding, the
auditors will focus on the assertions for each account and identify the
controls that relate to risks for each assertion. In a integrated audit, or in
a nonintegrated audit where the auditor wants to reduce substantive
testing, this understanding will be used to identify important controls that
need to be tested.

Controls for intangible assets

To help assure that existence and valuation asssertions for fixed assets are
materially correct, controls should be in place to:

•Identify existing assets, inventory them, and reconcile the physical asset
inventory with the property ledger. (existence)

•Assure that all purchases, including acquisitions of other companies, are

authorized and properly valued ( valuation)

•Appropriately classify new equipment according to its expected use and

estimates of useful life (valuation)

•Periodically reassess the appropriateness of depreciation categories

(valuation)

•Identify obsolete or scrapped equipment and write the equipment down

to scrap value (valuation)

•Periodically review management strategy and systematically assess the

impairment of assets (valuation)

As additional examples, clients should have controls in place to safeguard

the assets and to prevent unauthorized journal entries to the account
balances.

If the client's controls related to long-lived assets are effective, the

the auditor can rely more extensively on substantive analytical
procedures to obtain evidence on account balances. For example,
substantive analytical procedures can be used to estimate depreciation
expense and accumulated depreciation. The auditor can use a property
ledger, which shouls uniquely identify each asset and provide details on
cost of the property, acquisition date, depreciation method used for both
book and tax, estimated life, estimated scrap value (if any), and
accumulated depreciation to date, to develop these estimates.

Controls for Intangible Assets

For intangible assets, controls should be designed to:

•Assure that decisions are appropriately made as to when to capitalize

or expense research and development expenditures (presentation
and disclosure).

•Develop amortization schedules that reflect the remaining useful life

of patents or copyrights associated with the asset (valuation).

•Identify and account for intangible-assets impairments (valuation)

Management should have a monitoring process in place to review

valuation of intangible assets. For example, a pharmaceutical company
should have sophisticated models to predict the sucess of nwely
developed drugs and monitor actual performance against expected
revenue and profit goals. Similarly, a msoftware company should have
controls in place to determine whether capitalized software
development costs will be realized. The auditor should assess both the
existence and effectiveness of these controls in determining which
substantive test of account balances need to be performed.

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