2 Liabilities and Equity Balance SheetAssetsCashInvestmentsReceivablesPrepaidsInventoryPP and EOther assets - intangiblesLiabilities and EquityAccounts payableAccrued liabilitiesDebtCommon stockRetained earnings
3 Other Assets Prepaid expenses – current Intangible assets – long term Property, plant and equipment – long term
4 Auditing Prepaid Expenses LO# 1Auditing Prepaid ExpensesOther assets that provide economic benefit for less than a year are classified as current assets and are called prepaid expenses. Examples include:Prepaid insurance.Prepaid rent.Prepaid interest.InsurancePolicy
5 Inherent Risk Assessment – Prepaid Expenses LO# 1Inherent Risk Assessment – Prepaid ExpensesThe inherent risk associated with prepaid expenses is generally assessed as low because the accounts do not involve any complex or contentious accounting issues.
6 Control Risk Assessment – Prepaid Expenses LO# 1Control Risk Assessment – Prepaid ExpensesBecause prepaid expenses are normally processed through the purchasing process, control procedures in purchasing should ensure that each item is properly authorized and recorded.
7 Substantive Procedures – Prepaid Insurance LO# 2Substantive Procedures – Prepaid InsuranceTests of Details of the Prepaid Insurance AccountAudit testing begins by obtaining a detail schedule of the prepaid insurance account.Existence and CompletenessConfirm policy with insurance broker,examine supporting source documents.Rights and ObligationsConfirm policybeneficiary with the insurance broker.ValuationDetermine unexpired portion of policy and insurance expense.ClassificationDetermine propriety of distribution between manufacturing overhead and SG&A expense.
8 Auditing Intangible Assets LO# 1 & 2Auditing Intangible AssetsIntangible 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:Marketing – trademark, brand name, and Internet domain names.Customer – customer lists, order backlogs, and customer relationships.Artistic – items protected by copyright.Contract – licenses, franchises and broadcast rights.Technology – patented and unpatented technology.
9 Inherent Risk Assessment – Intangible Assets LO# & 2Inherent Risk Assessment – Intangible AssetsThe 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 (FAS 142). With the judgment and complexity association with valuation and estimation of intangible assets, the auditor would likely assess the inherent risk as high.
10 Control Risk Assessment – Intangible Assets LO# & 2Control Risk Assessment – Intangible AssetsIn assessing control risk, the auditor considers factors such as:The expertise and experience of those determining the fair value of the assets.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.The extent to which the entity engages or employs valuation specialists.The significant management assumptions used in determining fair value.The integrity of change controls and security procedures for valuation models and relevant information systems, including approval processes (AU 328).
11 Using the work of a specialist SAS #73 The auditor should consider the following:Professional certification of specialistReputation and standingExperience and expertiseObjectives and scope of the workRelationship to the client ( Independence!)Methods and assumptions usedOther
12 Substantive Procedures – Intangible Assets LO# 2Tests of Details of Intangible AssetsTests 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:Existence and completeness.Valuation.Rights and obligations.Classification.It may be useful here to give some general definitions or examples of these assertions. Goodwill may be a particularly good topic.
13 Auditing the Property Management Process LO# 3Auditing the Property Management ProcessProperty, plant, and equipment usually represents a material amount in the financial statements.Recurring Engagement The auditor is able to focus on additions and retirements in the current period because amounts from prior periods have been subject to audit procedures.New Engagement The auditor has to verify the assets that make up the beginning balance in property, plant, and equipment.
14 Communication between predecessor and successor auditors ( SAS # 84) Successor auditor should consider the following:Information regarding integrity of managementDisagreements with management about accounting principlesCommunications to audit committees about fraud and IC issuesPredecessor auditor’s understanding regarding the reasons for the change.Adequacy of the work performed
15 Property Management Process at EarthWear Clothiers Physical PlantIT DepartmentFrom purchasing processGeneral ledger master filePP&E transaction filePP&E master fileSpecialized PP&E transactionsGeneral ledger programGeneral ledger reportPP&E programInputReview for proper recordingPP&E transaction reportReconcile to general ledgerMonthlyPP&E subledger
16 Types of Transactions Four types of PP&E transactions may occur: LO# 4Types of TransactionsFour types of PP&E transactions may occur:Acquisition of capital assets for cash or other nonmonetary considerations.Disposition of capital assets through sale, exchange, retirement, or abandonment.Depreciation of capital assets over their useful economic life.Leasing of capital assets.
17 Inherent Risk Assessment – Property Management Process LO# 5Inherent Risk Assessment – Property Management ProcessThere are three inherent risk factors that must be considered by the auditor.Complex accountingissues.Difficult-to-audit transactions.Misstatements detected in prior audits.
18 Inherent Risk Assessment – Property Management Process LO# 5Inherent Risk Assessment – Property Management ProcessComplex Accounting IssuesLease accounting, self-constructed assets, and interest capitalization are vivid examples of some of the complex accounting issues faced by auditors.
19 Inherent Risk Assessment – Property Management Process LO# 5Inherent Risk Assessment – Property Management ProcessDifficult-to-Audit TransactionsWhen 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.
20 Inherent Risk Assessment – Property Management Process LO# 5Inherent Risk Assessment – Property Management ProcessMisstatements Detected in Prior AuditsIf 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.
21 Control Risk Assessment – Property Management Process LO# 6Control Risk Assessment – Property Management ProcessOccurrence and AuthorizationControl 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.
22 Control Risk Assessment – Property Management Process LO# 6Control Risk Assessment – Property Management ProcessCompletenessThe detailed property, plant, and equipment subsidiary ledger usually includes the following information for each capital asset:Description, location, and ID number.Date of acquisition and installed cost.Depreciation methods for book and tax purposes, salvage value, and estimated useful life.
23 Control Risk Assessment – Property Management Process LO# 7Key Segregation of Duties and Possible Errors
24 Substantive Analytical Procedures – Property, Plant, and Equipment LO# 8Substantive Analytical Procedures – Property, Plant, and EquipmentThe following substantive analytical procedures can be used in the audit of PP&E:Compare prior-year balances in PP&E and depreciation expense with current-year balances.Compute the ratio of depreciation expense to the related PP&E accounts and compare to prior years’ ratios.Compute the ratio of repairs and maintenance expense to the related PP&E accounts and compare to prior years’ ratios.Compute the ratio of insurance expense to related PP&E accounts and compare to prior years’ ratio.Review capital budgets and compare the amounts spent with amounts budgeted.Students may find additional explanation helpful here. Sometimes just knowing what to do rather than understanding what the formulae are computing is much more helpful than a simple list.
25 Tests of Details of Transactions and Account Balances and Disclosures CompletenessThe 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.
26 Tests of Details of Transactions and Account Balances and Disclosures CutoffCutoff 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.December282007January42008
27 Tests of Details of Transactions and Account Balances and Disclosures ClassificationFirst, 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.
28 Tests of Details of Transactions and Account Balances and Disclosures ExistenceA 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.
29 Tests of Details of Transactions and Account Balances and Disclosures Rights and ObligationsIn 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.
30 Tests of Details of Transactions and Account Balances and Disclosures Valuation and AllocationCapital assets are valued at acquisition cost plus any costs necessary to make the asset operational. The auditor tests the recorded cost of major new additions to PP&E.The auditor may recompute, either manually or with the aid of a computer, the proper depreciation expense for 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.
31 Tests of Details of Transactions and Account Balances and Disclosures Disclosure IssuesExamples of disclosure items:Classes of capital assets and valuation bases.Depreciation methods and useful lives for financial reporting and tax purposes.Nonoperating assets.Construction or purchase commitments.Liens and mortgages.Acquisition or disposal of major operating facilities.Capitalized and other lease arrangements.
32 Evaluating the Audit Findings Property, Plant, and Equipment LO# 10Evaluating the Audit Findings Property, Plant, and EquipmentThe 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.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.