14-1

Chapter Fourteen
Auditing Financing Process:
Prepaid Expenses
and Property, Plant, and Equipment

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 14-2

Auditing Prepaid Expenses

Other assets that provide economic benefit
for less than a year:
1.Prepaid insurance.
2.Prepaid rent.
3.Prepaid interest.

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 14-3

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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 14-4

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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 14-5

Substantive Procedures Prepaid

Insurance
Substantive Analytical Procedures

1. Compare current-year balance with prior years

balances after considering any changes in
operations.
2. Compute the ratio of expense to assets or sales
and compare the ratio to prior years ratio.

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 14-6

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 with Confirm policy unexpired portion
insurance broker, beneficiary with 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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 14-7

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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 14-8

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

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general ledger subledger Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 14-9

Types of Transactions

Four types of PP&E transactions may occur:

1. Acquisition of capital assets for cash or other
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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 14-10

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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 14-11

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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 14-12

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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 14-13

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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 14-14

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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 14-15

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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 14-16

Control Risk Assessment Property

Management Process
Key Segregation of Duties and Possible Errors
Segregation of Duties Possible Errors or Fraud
If one individual is responsible for initiating a capital
The initiation function should be asset transaction and also has final approval, fictitious
segregated from the final approval or unauthorized purchases of assets can occur. This
function. can result it 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
The PP&E records function should be and also for the general ledger functions, that
segregated from the general ledger individual can conceal any defalcation that would
function. normally be detected by reconciling subsidiary records
with the general ledger control account.
If one individual is responsible for the PP&E records
The PP&E records function should be and also has custodial responsibility for the related
segregated from the custodial function. 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
If one individual who is responsible for the periodic
is taken, the individual responsible for
physical inventory of PP&E is also responsible for the
the inventory should be independent of
custodial and record-keeping functions, theft or the
the custodial and record-keeping
entity's capital assets Copyright
can be concealed.
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 14-17

Substantive Analytical Procedures

Property, Plant, and Equipment
The following substantive analytical procedures
can be used:
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 ratio.
5. Review capital budgets and compare the amounts spent
with amounts budgeted.
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 14-18

Tests of Details of Transactions and

Account Balances and Disclosures
Completeness

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.

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 14-19

Tests of Details of Transactions and

Account Balances and Disclosures
Cutoff

Cutoff is normally part of the accounts payable and

accrued expenses work. Vendors 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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 14-20

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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 14-21

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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 14-22

Tests of Details of Transactions and

Account Balances and Disclosures
Rights and Obligations

In most cases, rights or ownership can be

determined by examining vendors invoices and
other supporting documents. In some cases the
auditor may wish to confirm property deeds or title
documentation.

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 14-23

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 assets carrying amount, this process can be
quite difficult. Auditors may look to other sources of
information to learn about impairments.
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 14-24

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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 14-25

Evaluating the Audit Findings

The auditor aggregates the likely misstatements and

compares this amount to the tolerable misstatement.
If the likely misstatement is less than the tolerable
misstatement, the evidence indicates that the PP&E
accounts are not materially misstated.
However, if the likely 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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 14-26

End of Chapter 14

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