Lecture Auditing and assurance services (Second international edition) Chapter 14 Auditing financinginvesting process

Chapter 14 Auditing financinginvesting process Prepaid expenses, intangible assets and goodwill, and property, plant and equipment. In this chapter, the learning objectives are Know the various types of prepaid expenses, deferred charges, and intangible assets; understand the auditors approach to auditing prepaid insurance and intangible assets; develop an understanding of the property management process;...

Auditing the Financing/Investing Process: Prepaid Expenses;

Intangible Assets and Goodwill; and Property, Plant and

Equipment

Chapter Fourteen

Auditing Prepaid Expenses

Other assets that provide economic benefit

for less than a year are classified as current

assets Prepaid expenses are a common

other asset Examples include:

1 Prepaid insurance.

2 Prepaid rent.

3 Prepaid interest.

Insurance Policy

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

Control Risk Assessment –

Prepaid Expenses

Because prepaid expenses are normally

processed through the purchasing process,

control activities in purchasing should ensure that each item is properly authorized and recorded

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

Rights and Obligations

Confirm policy beneficiary with the insurance broker.

Valuation Determine unexpired portion

of policy and insurance expense.

Valuation

Determine unexpired portion

of policy and insurance expense.

Classification Determine propriety of distribution between manufacturing overhead and SG&A

Auditing Intangible Assets and Goodwill

Intangible assets are identifiable assets that provide

economic benefit for longer than a year, but lack physical substance (IFRS), for example:

1 Marketing – trademark, brand name, and Internet domain names 2.Customer – customer lists, order backlogs, and customer

relationships.

3 Artistic – items protected by copyright.

4 Contract – licenses, franchises, and broadcast rights.

5 Technology – patented and unpatented technology.

Goodwill represents the difference between the acquisition price for a company and the fair value of the

identifiable tangible and intangible assets and liabilities

(IFRS).

Inherent Risk Assessment –

Intangible Assets and Goodwill

The inherent risk associated with intangible

assets and goodwill 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 With the judgement and complexity

associated with valuation and estimation of

intangible assets and goodwill, the auditor would likely assess the inherent risk as high

Control Risk Assessment –

Intangible Assets and Goodwill

In assessing control risk, the auditor considers factors such as:

1 The expertise and experience of those determining the fair value of the assets.

2 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.

3 The extent to which the entity engages or employs valuation experts.

4 The significant management assumptions used in determining fair value.

5 The integrity of change controls and security procedures for valuation models and relevant information systems, including approval processes

Substantive Procedures – Intangible Assets and Goodwill

Tests of Details of Intangible Assets and Goodwill

Tests of details associated with valuation and impairment of

intangible assets and goodwill are often necessary because the complexity and degree of judgement 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 and goodwill Four assertions are normally considered for tests of details of intangible assets:

1 Existence and completeness.

2 Valuation.

3 Rights and obligations.

4 Classification.

Auditing the Property Management

Process

Property, 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 havebeen subject to audit

procedures

Recurring Engagement

The auditor is able to focus

on additions and retirements

in the current period because amounts from prior periods havebeen subject to audit

procedures

New Engagement

the auditor has to verify the assets that make up the beginning balance in property, plant and equipment.

New Engagement

the auditor has to verify the assets that make up the beginning balance in property, plant and equipment.

Property Management Process at

Reconcile to general ledger

Physical Plant IT Department

PP&E transaction file

PP&E master file PP&E

program

General ledger master file

General ledger program

General ledger report PP&E

transaction report Monthly

Types of Transactions

Four types of PP&E transactions may occur:

1 Acquisition of capital assets for cash or other non-monetary 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

Four types of PP&E transactions may occur:

1 Acquisition of capital assets for cash or other non-monetary 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

Inherent Risk Assessment –

Property Management Process

There are three inherent risk factors that must

be considered by the auditor

Complexaccountingissues

Complexaccountingissues

Difficult-to-audittransactions

Difficult-to-audittransactions

Misstatementsdetected inprior audits

Misstatementsdetected inprior audits

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

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, non-monetary exchanges, and self-constructed assets are more difficult to audit

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

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

Control Risk Assessment – Property Management Process

Completeness

Control Risk Assessment –

Property Management Process

Key Segregation of Duties and Possible Errors

Substantive Analytical Procedures –

Property, Plant and Equipment

Tests of Details of Transactions and Account

Balances and Disclosures

Completeness and Accuracy

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 The auditor can trace a sample of assets

to the property, plant, and equipment subsidiary

ledger

Tests of Details of Transactions and

Account Balances and Disclosures

Cut-off

Cut-off 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

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

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

Tests of Details of Transactions and

Account Balances and Disclosures

Rights and Obligations

In 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

Tests of Details of Transactions and Account

Balances and Disclosures

Valuation and Allocation

Capital 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.

Capital 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 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 IAS/IFRS requires the comparison of the asset’s fair value (less costs to sell) and its value in use, this process can be quite difficult Auditors may look to other sources of

information to learn about impairments.

The auditor must test for permanent impairment of long-lived assets While IAS/IFRS requires the comparison of the asset’s fair value (less costs to sell) and its value in use, this process can be quite difficult Auditors may look to other sources of

information to learn about impairments.

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 Non-operating assets.

4 Construction or purchase commitments.

5 Liens and mortgages.

6 Acquisition or disposal of major operating facilities.

7 Capitalized and other lease arrangements.

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 Non-operating assets.

4 Construction or purchase commitments.

5 Liens and mortgages.

6 Acquisition or disposal of major operating facilities.

7 Capitalized and other lease arrangements.

Evaluating the Audit Findings

The auditor compares the aggregated identified misstatement

to materiality to determine if the identified misstatement would

affect the audit

The auditor requests the client to correct the identified

misstatements and then compares the uncorrected

misstatements with materiality to conclude whether the

financial statements are fairly stated.

If uncorrected misstatements in property, plant and equipment

accounts, and when considered together with other

uncorrected misstatements, are less than materiality, the auditor may accept that the financial statements are fairly presented Conversely, if the uncorrected misstatement

exceeds the materiality, the auditor should conclude that the

financial statements are not fairly presented.

End of Chapter 14