1. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-1

2. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-2 Part Five AUDITING BUSINESS PROCESSES

3. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-3 Chapter 14 CHAPTER 14 AUDITING SELECTED ASSET ACCOUNTS: PREPAID EXPENSES AND PROPERTY, PLANT, AND EQUIPMENT

4. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-4 AUDITING PREPAID EXPENSES Prepaid expenses are assets that provide economic benefit for less than a year. Deferred charges or intangible assets are assets that provide economic benefit for longer than a year.

5. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-5 EXAMPLES OF PREPAID EXPENSES AND OTHER ASSETS Prepaid insurance Prepaid rent Prepaid interest

6. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-6 EXAMPLES OF DEFERRED CHARGES AND INTANGIBLE ASSETS Organization costs Patents Copyrights Trademarks Trade names Licenses Franchises Goodwill Debt issuance costs Computer software development costs

7. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-7 INHERENT RISK ASSESSMENT Inherent risk for prepaid expenses such as prepaid insurance would generally be assessed as being low, since these accounts do not involve any complex or contentious accounting issues. Deferred charges and intangible assets may present serious inherent risk considerations because the valuation and estimated lives for patents, franchises, and goodwill involve considerable judgment and may lead to potential disagreements between the auditor and client.

8. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-8 CONTROL RISK ASSESSMENT - PREPAID INSURANCE The auditor's assessment of control risk for prepaid expenses, such as prepaid insurance, is based on the effectiveness of control procedures in the purchasing process. Additional control procedures for prepaid insurance may include the use of an insurance register which contains a separate record of all insurance policies in force. The entity should also maintain controls that provide for the systematic allocation of prepaid insurance to insurance expense.

9. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-9 The auditor is generally able to gather sufficient, competent evidence on prepaid insurance by performing analytical procedures. Substantive tests of transactions, if performed at all, are conducted as part of testing the purchasing process. Substantive tests of the prepaid insurance balance are generally necessary only when misstatements are expected. SUBSTANTIVE TESTING - PREPAID INSURANCE

10. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-10 ANALYTICAL PROCEDURES - PREPAID INSURANCE Comparing the current year balance in prepaid insurance and insurance expense with the prior year's balances after considering any changes in operations. Computing the ratio of insurance expense to assets or sales and comparing it with the prior year's ratio.

11. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-11 SUBSTANTIVE TESTING - PREPAID INSURANCE Substantive tests of balances for prepaid insurance and insurance expense may be necessary when the auditor suspects misstatements based on prior years' audits or when analytical procedures indicate that the account balance may be misstated. The auditor begins testing of the prepaid insurance account balance by obtaining a schedule from the client that contains a detailed analysis of the policies included in the prepaid insurance account (see Exhibit 14-1). The auditor's work then focuses on testing the validity, completeness, ownership, valuation, and classification audit objectives.

12. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-12 AUDITING PROPERTY MANAGEMENT PROCESS For most entities, property, plant, and equipment represents a material amount in the financial statements. When the audit is an ongoing engagement, the auditor is able to focus on the current year activity since the assets acquired in earlier years were subjected to audit tests at the time of acquisition. The size of the entity may also affect the auditor's approach.

13. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-13 TYPES OF TRANSACTIONS 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.

14. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-14 OVERVIEW OF THE PROPERTY MANAGEMENT PROCESS Figure 14-1 presents a flowchart of an accounting system for a property management process.

15. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-15 INHERENT RISK ASSESSMENT - PROPERTY MANAGEMENT PROCESS Complex accounting issues. Difficult-to-audit transactions. Misstatements detected in prior audits.

16. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-16 CONTROL RISK ASSESSMENT - PROPERTY MANAGEMENT PROCESS Although the auditor generally follows a substantive strategy when auditing property, plant, and equipment, a sufficient understanding of internal control is still required. Many of the internal control objectives for property, plant, and equipment are included as part of the purchasingprocess. The auditor is mainly concerned with the validity, authorization, and completeness internal control objectives.

17. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-17 SEGREGATION OF DUTIES The initiation function should be segregated from the final approval function. The property, plant, and equipment records function should be segregated from the general ledger function. The property, plant, and equipment records function should be segregated from the custodial function. If a periodic physical inventory of property, plant, and equipment is taken, the individual responsible for the inventory should be independent of the custodial and record keeping functions.

18. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-18 SUBSTANTIVE TESTING - PROPERTY, PLANT, AND EQUIPMENT Because of the limited number of transactions or efficiency considerations, auditors often follow a substantive strategy when auditing property, plant, and equipment. Auditors typically rely on analytical procedures and substantive tests of account balances as sources of evidence.

19. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-19 ANALYTICAL PROCEDURES - PROPERTY, PLANT AND EQUIPMENT Compare prior-year balances in property, plant, and equipment and depreciation expense with current- year balances after consideration of any changes in conditions or asset composition. Compute the ratio of depreciation expense to the related property, plant, and equipment accounts and comparison to prior years' ratios. Compute the ratio of repairs and maintenance expense to the related property, plant, and equipment accounts and comparison to prior years' ratios.

20. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-20 ANALYTICAL PROCEDURES - PROPERTY, PLANT AND EQUIPMENT Compute the ratio of insurance expense to the related property, plant, and equipment account and comparison to prior years' ratios. Review capital budgets and compare amounts spent with amounts budgeted.

21. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-21 TESTS OF ACCOUNT BALANCES - PROPERTY, PLANY, AND EQUIPMENT Table 14-2 summarizes the substantive tests of balances for property, plant, and equipment account by each audit objective. Exhibit 14-2 presents an example of a lead schedule for EarthWear Clothiers’ property, plant, and equipment.

22. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 14-22 Chapter 14 CHAPTER 14 AUDITING SELECTED ASSET ACCOUNTS: PREPAID EXPENSES AND PROPERTY, PLANT, AND EQUIPMENT