1. Copyright © 2007 Pearson Education Canada 1 Chapter 18: Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected Accounts

2. Copyright © 2007 Pearson Education Canada 18-2 Chapter 18 objectives  Identify the process to be followed in the audit of manufacturing asset acquisitions  Discuss the difficulties in auditing intangible assets  Explain the importance of and the audit processes for prepaid expenses  List typical accrued liabilities  Explain how property taxes are audited  Discuss the role of analytical review in the audit of income and expense accounts

3. Copyright © 2007 Pearson Education Canada 18-3 Methodology for designing tests of details for the audit of manufacturing asset acquisitions  Set materiality and assess audit risk and inherent risk for manufacturing asset acquisitions  Assess control risk for manufacturing asset acquisitions  Design and perform tests of controls for manufacturing asset acquisitions  Design and perform analytical procedures for manufacturing asset acquisitions  Design tests of details for manufacturing asset acquisitions (audit procedures, sample size, items to select, timing)

4. Copyright © 2007 Pearson Education Canada 18-4 The nature of manufacturing assets  Manufacturing assets are capital assets that normally have expected lives of more than one year, are used in the business, and are not acquired for resale  The assets are used as a part of the operation of the client’s business  Operational use and normal life of greater than one year distinguishes these assets from inventory, prepaid expenses, or investments

5. Copyright © 2007 Pearson Education Canada 18-5 Tracking manufacturing assets  Large organizations will normally have a capital asset master file, where each asset is described and tracked. This master file is also the source of information for calculating and recording amortization.  Small organizations may have a manual listing of such assets, or may simply track a balance forward from year to year

6. Copyright © 2007 Pearson Education Canada 18-6 Differences between manufacturing assets and current asset accounts  There are usually fewer current period acquisitions  The amount of any given acquisition may be material  The equipment is likely to be kept and maintained in the accounting records for several years

7. Copyright © 2007 Pearson Education Canada 18-7 Audit emphasis for manufacturing asset additions  Emphasis is on auditing current period acquisitions  These are also traced to the capital cost allowance section of the tax working papers  Amortization and accumulated amortization accounts are also verified  Other accounts that are verified in a similar manner include: patents, copyrights, catalogue costs

8. Copyright © 2007 Pearson Education Canada 18-8 Categories of audit tests conducted for manufacturing equipment and related accounts  Analytical procedures  Verification of: – Current-year acquisitions – Current-year disposals – The ending balance in the asset account – Amortization expense – The ending balance in accumulated amortization

9. Copyright © 2007 Pearson Education Canada 18-9 Analytical procedures for manufacturing equipment Analytical procedurePotential misstatement detected Compare amortization expense divided by gross manufacturing equipment cost with previous years Misstatement in amortization expense and accumulated amortization Compare accumulated amortization divided by gross manufacturing equipment cost with previous years Misstatement in accumulated amortization

10. Copyright © 2007 Pearson Education Canada 18-10 Analytical procedures for manufacturing equipment (cont’d) Analytical procedurePotential misstatement detected Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years Expensing amounts that should be capital items Compare gross manufacturing cost divided by some measure of production with previous years Idle equipment or equipment that has been disposed of but not written off

11. Copyright © 2007 Pearson Education Canada 18-11 Verification of current year acquisitions  Important because of the long-term effect that assets have on financial statements  Starting point is normally a continuity schedule prepared by the client (showing additions, disposals and amortization)  An important technique is examination of supporting documentation

12. Copyright © 2007 Pearson Education Canada 18-12 Verification of current year disposals  The most important internal control over disposals is the existence of a formal method to inform management and record the results of sale, trade-in, abandonment or theft  The most important audit procedures are those for searching for unrecorded disposals

13. Copyright © 2007 Pearson Education Canada 18-13 Verification of asset balances  The nature of the internal controls over existing assets determines whether it is necessary to verify manufacturing equipment acquired in prior years  Relevant controls include a periodic count and a formal method of informing the accounting department of disposals

14. Copyright © 2007 Pearson Education Canada 18-14 Verification of amortization expense  Recorded amounts are internal allocations rather than exchange transactions with outside parties  Primary audit objectives involve determining whether the client is: – Following a consistent amortization policy from period to period and whether – Making calculations accurately

15. Copyright © 2007 Pearson Education Canada 18-15 Verification of accumulated amortization  Debits are normally tested as a part of the audit or disposals of assets  Credits are verified as part of the audit of amortization expense

16. Copyright © 2007 Pearson Education Canada 18-16 Practice problem 18-18 (p. 544)  Discuss your responsibilities for auditing opening and closing asset balances  Prepare an audit program for the audit of asset balances

17. Copyright © 2007 Pearson Education Canada 18-17 Auditing intangible assets  Intangible assets include goodwill, copyrights, trademarks, deferred expenses, capitalized charges for brand names, and others  May be extremely difficult to value as they do not have a ready value, and can rapidly drop in value  Audit expertise in the area is required, or the auditor may need to engage an independent expert to value material intangible assets

18. Copyright © 2007 Pearson Education Canada 18-18 Practice problem 18-20 (p. 545)  Evaluate an audit approach for verifying interest and legal expense  Suggest a better approach

19. Copyright © 2007 Pearson Education Canada 18-19 Audit of prepaid expenses  Prepaid expenses arise from the concept of matching expenses with revenues  These types of accounts are found in almost every audit  Prepaid insurance is used as an example because it is a common expense and the auditor is responsible for reviewing the adequacy of insurance coverage

20. Copyright © 2007 Pearson Education Canada 18-20 Audit of prepaid insurance expense  The auditor considers internal controls in the following categories. Controls over: – The acquisition and recording of insurance, – Insurance coverage and – Charge-off of insurance expense  The organization may have an insurance register or spreadsheet, or it may simply have a file of insurance policies in force

21. Copyright © 2007 Pearson Education Canada 18-21 Prepaid insurance expense: audit tests  Analytical procedures  Verification that charges to the insurance expense arose from credits to prepaid insurance (based upon a schedule of insurance charges and prepaid expenses prepared by the client)

22. Copyright © 2007 Pearson Education Canada 18-22 Typical accrued liabilities  Payroll-related accruals (bonuses, commissions, income taxes, interest, payroll, payroll taxes and pension costs)  Professional fees  Rent  Warranty costs

23. Copyright © 2007 Pearson Education Canada 18-23 Auditing accrued property taxes  Payments of property taxes have been partially tested by means of the tests of the acquisition and payment cycle  Emphasis in the tests is normally on the ending property tax liability and payments

24. Copyright © 2007 Pearson Education Canada 18-24 Audit of operations  The purpose of audit of operations is to determine whether the income and expense accounts are fairly presented  The auditor needs to be aware of the importance of the income statement to users  Matching and consistent application of accounting principles are evaulated

25. Copyright © 2007 Pearson Education Canada 18-25 Approach to auditing operations  This part of the audit is closely linked to the audit of all of the other transaction cycles  All tests conducted during the audit need to be considered to evaluate their impact upon the audit of operations  Analytical review is an important audit step for the audit of operations, and is often conducted using audit software or spreadsheet software

26. Copyright © 2007 Pearson Education Canada 18-26 Typical analytical procedures for operations Analytical procedurePossible misstatement Compare individual expenses with previous years Overstatement or understatement of a balance in an expense account Compare individual asset and liability balances with previous years Overstatement or understatement of a balance sheet account that would also affect an income statement account

27. Copyright © 2007 Pearson Education Canada 18-27 Typical analytical procedures for operations (cont’d) Analytical procedurePossible misstatement Compare individual expenses with budgets Misstatement of expenses and related balance sheet accounts Compare gross margin percentage with previous years Misstatement of cost of goods sold and inventory

28. Copyright © 2007 Pearson Education Canada 18-28 Typical analytical procedures for operations (cont’d) Analytical procedurePossible misstatement Compare inventory turnover ratio with previous years Misstatement of cost of goods sold and inventory Compare prepaid insurance and insurance expense with previous years Misstatement of insurance expense and prepaid insurance

29. Copyright © 2007 Pearson Education Canada 18-29 Typical analytical procedures for operations (cont’d) Analytical procedurePossible misstatement Compare commission expense divided by sales with previous years Misstatement of commission expense and accrued commissions Compare individual manufacturing expenses divided by total manufacturing expenses with previous years Misstatement of individual manufacturing expenses and related balance sheet accounts

30. Copyright © 2007 Pearson Education Canada 18-30 Practice problem 18-23 (p. 545)  Review the results of analytical review  Are the explanations reasonable?