Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 1
Audit of Long-Lived Assets and Related Expense
I. BUSINESS RISK AND BUSINESS ENVIRONMENT
a. Fixed assets often represent the largest single category of assets of
manufacturing organizations. The asset account (equipment, buildings, or
similarly titled asset) represents the culmination of major capital additions and
disposals. Unless this is a first-year audit, the beginning balance is established
in previous-year audits. The audit focuses on material transactions affecting
the account balance during the year: additions, disposals, and write-offs of
existing assets and the recognition of periodic depreciation of the assets.
Transparency 14-1 lists ways that management can use fixed asset accounts to
“manage earnings” and other risks associated with fixed assets and relate
b. Unusual entries, particularly credits to depreciation expense or non-standard
adjusting entries will require special attention. The auditor must be aware of
the business plan, current economic conditions, and potential changes in the
economic value of the assets.
II. ANALYTICAL ANALYSIS FOR POSSIBLE MISSTATEMENTS
a. Analyze Industry Trends and Changes in Product Lines
i. Knowledge of industry product trends and changes in the client’s
product lines may indicate that those assets are not as useful as they
have been in previous years; they may not help generate as much cash
flow in future years as they have in the past indicating an impairment
b. Analyze Depreciation for Consistency and Economic Activity
i. To determine the appropriateness of depreciation, the auditor must
know the business and the economics of the business. There are three
relatively simple analytical techniques that auditors can use to
supplement their business understanding:
1. Review gains/losses on disposals of equipment; (gains indicate
depreciation lives are too short, losses indicate the opposite);
2. Tour the plant and note the amount of idle equipment,
3. Perform an analytical estimate of depreciation.
III. INTEGRATED AUDIT OF FIXED ASSETS AND RELATED EXPENSES
a. A comprehensive audit program for the audit of equipment is shown in
Transparency 14-2. In addition to providing evidence concerning the fairness
of the account balance, the audit program is designed to gather information
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that will assist in auditing tax depreciation and the deferred tax liability. The
scope and extent of testing on each program will vary with the complexity of
assets utilized, the difficulty in estimating useful life, and the risk associated
with the client.
b. Evaluating Control Risk and Control Effectiveness
i. Transparency 14-3 lists internal control objectives and procedures for
PP&E. If the client's control procedures are effective, analytical
procedures can be used to estimate depreciation expense and
accumulated depreciation. Property ledgers serve as important
controls. Management should have fairly sophisticated monitoring
controls for intangible assets. The auditor should determine if such a
process is in place.
c. Controls for Intangible Assets
i. Controls should be designed to:
1. Ensure that decisions are appropriately made as to when to
capitalize or expense research and development expenditures
2. Develop amortization schedules that reflect the remaining
useful life of patents or copyrights associated with the test
3. Identify and account for intangible asset impairments
d. Basic Audit Procedures and Impact of Auditor’s Assessment of Internal
i. A comprehensive audit program for the audit of equipment is shown in
Exhibit 14.2. In addition to providing evidence concerning the fairness
of the account balance, the audit program is designed to gather
information that will assist in auditing tax depreciation and the
deferred tax liability because much of the tax difference is due to
timing differences associated with depreciation methods. The
remainder of the audit examines the approach that underlies the audit
program, starting with the evaluation of internal controls over assets.
ii. The scope and extent of testing on each program will vary with the
complexity of assets utilized, the difficulty in estimating useful life,
and the risk associated with the client. The auditor must challenge the
client’s entries and computations with a reality check—do the
accounting numbers reflect the economic use of the assets and the
business plan being executed by the company.
e. Tests of Property Additions and Disposals
i. Audit procedures should determine that all additions have been
properly authorized, properly classified, and properly valued.
Transparency 14-4 illustrates typical fixed asset audit documentation.
Management may overstate earnings by capitalizing costs that should
be expensed. The auditor must examine all unusual entries to fixed
asset additions since these additions often come in the form of general
journal entries rather than individual contracts. Such procedures will
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 3
typically be supplemented by a tour of the factory to observe the
general layout and condition of the equipment, and the existence of
idle equipment. The auditor’s knowledge of the client’s strategic plans
and industry changes is used to determine whether additional work
should be performed.
1. The auditor can usually test existence, rights, and valuation by
the same procedures. The following procedures are designed to
determine that all fixed-asset additions have been properly:
a. Authorized by examining purchase agreements, board
of directors minutes for major acquisitions, and
approval by a capital budgeting committee
b. Classified based on their function, expected useful life,
and established depreciation schedule
c. Valued by examining purchase documents such as
invoices or construction billings
2. This work can easily be performed in conjunction with the
internal control work as part of the integrated audit. One way to
be efficient is to concentrate on the entries made during the
year including a schedule of additions usually prepared by the
client. After the schedule is agreed to the general ledger, the
auditor should select a few items to test the controls, and vouch
the items to vendor invoices and other supporting
3. Thus, while the account balance may be large, the audit work
can be done efficiently by concentrating on the additions, and
then adjusting the estimates of depreciation expense and
accumulated depreciation for changes made during the year.
iii. Visually Inspecting Existence
1. Normally, the auditor will not visually inspect every addition.
However, when there are large additions, e.g., the construction
of a new plant, the acquisition of new facilities, or weaknesses
in the control environment or deficiencies in the control
activities over fixed-asset purchases and disposals, the auditor
will want to physically verify that the asset exists. The risk is
usually higher in remote locations where the auditor does not
normally visit. If those sites show large additions of fixed
assets and there are deficiencies in controls, the auditor should
adjust the audit program to ensure that such sites are visited. If
there are other situations that indicate high risk, e.g., assets that
are difficult to visually observe, the auditor may want to verify
the existence of contracts with bona fide contractors and, on a
selected basis, accompany personnel to sites to observe the
processes they have in place to monitor the installation of the
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 4
2. For many manufacturing companies, these tests are
supplemented by a tour of the factory to observe the general
layout and condition of equipment, as well as the existence of
idle equipment. The auditor’s knowledge of the client’s
strategic plans and industry changes is used to determine
whether additional work should be performed in evaluating
whether some assets should be written down to their net
iv. Misclassifying Expenses as Assets
1. The auditor needs to summarize all journal entries to fixed-
asset additions from any source other than a purchase of an
asset and then gather independent evidence to verify the
validity of the entries.
2. For many companies there are often judgments made as to
whether a particular expenditure should be capitalized or
expensed as a repair. Understand that a company can have
different motivations. While we think about large companies
wanting to maximize earnings and therefore capitalize most
items, there are a number of smaller companies that want to
minimize reported earnings to minimize their tax bills. The
auditor should be alert to the possibility that management may
be manipulating earnings by inappropriately expensing capital
items or inappropriately capitalizing expense items. If the
auditor believes such a risk is high and there are deficiencies in
controls, the auditor will ask the client to prepare a schedule of
both fixed-asset additions and repair and maintenance expense
transactions. Selected transactions from both schedules can be
vouched to vendor invoices, work orders, or other supporting
evidence to determine their proper classification.
v. Disposals and Fully Depreciated Equipment
1. Many organizations do not have the same level of controls over
asset disposal or idle assets as they have for the acquisition of
assets. Therefore special procedures are often used to
determine whether disposals of fully depreciated property have
been properly recorded.
The ACL software can be used to extract a list of fully depreciated, or near fully
depreciated, assets for further analysis.
vi. Decommissioning Costs
1. Some assets must be decommissioned upon completion of their
life. The company should be accruing a liability for the
decommissioning cost as the asset is being used, so that upon
its retirement the liability represents the present value
associated with the decommissioning process.
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f. Asset Impairment
i. The issue of asset impairment presents three difficult, and often
conflicting, audit problems:
1. Normally, management is not interested in identifying and
writing down such assets.
2. Sometimes, management wants to write every potentially
impaired asset down to a minimum realizable value to enhance
the balance sheet for future earnings.
3. Determining asset impairment, especially for intangible assets
such as goodwill, requires a good information system and a
great deal of judgment.
ii. The auditor must periodically assess management’s approach to
identifying impaired assets and writing them down to their current
economic value. Thus the auditor needs an up-to-date knowledge of
changes taking place in the client’s industry as well as a thorough
understanding of management’s strategies and plans in order to make
estimates of impaired assets. The auditor should look for management
controls in the area including:
1. A systematic process to identify assets that are not currently in
2. Projections of future cash flows, by reporting unit, that is based
on management’s strategic plans and economic conditions
3. Current market values of similar assets
4. Current market value of the company’s stock (often used as
part of a goodwill impairment test)
iii. Unfortunately, many companies that have excellent controls over
transaction processing do not have the same level of controls over
periodic assessments of impairment. Thus, a major audit task is to
develop a systematic approach to continuously review the overall
composition of an entity’s asset base in light of current and planned
production and technological and competitive developments in the
client’s industry. The financial reporting objective is to value assets at
their economic benefit to the organization, and when that value has
been impaired, to write down the assets when there is a permanent
decline in economic value of the asset.
iv. If there is evidence that an asset has been impaired, the auditor next
needs to address the valuation issue. The general concept of valuing
impaired assets has been developed by the FASB and consists of two
1. Estimating the future economic benefits to be derived from the
a. This is most often used with assets such as goodwill,
but could be used for fixed assets such as electric power
plants or other assets where the company had developed
a capital budget plan to justify the purchase or
development of the asset.
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b. The first step is a recoverability test to determine if the
net future cash flows from the asset exceed the carrying
value of the asset.
i. If they do, the FASB has determined there is no
impairment for accounting purposes.
c. On the other hand, if the undiscounted future cash flows
do not exceed the carrying value, the company has an
impairment. The expected cash inflows may be less
than the carrying value because of competitor actions or
a change in the regulatory environment.
i. If there is a change in the estimate of cash
flows, the new cash flows should be discounted
back to the net present value using the current
risk free interest rate to determine the asset
d. The value would be compared to the carrying cost of
the asset to determine the amount of the impairment to
2. Obtaining an independent assessment of the value of the asset
a. This is often used for equipment, is to look at
replacement cost as a measure of asset impairment. The
two approaches the auditor will use are the following:
i. Obtain current market values, where applicable,
or if not applicable, obtain an independent
appraisal from a reputable, independent, and
qualified appraisal firm.
ii. Review current transactions to determine if
there has been a decrease in purchase price.
b. If the auditor uses market value for the estimate, it is
important to determine that the information comes from
a market that is orderly and is liquid.
Stress that knowledge of business conditions is crucial to identifying the potential
impairment of assets.
g. Discontinued Operations
i. When a decision is made to discontinue, the company should write
down the net assets to a best estimate of net realizable value, but only
if the company expects a loss on the disposal.
h. Depreciation Expense and Accumulated Depreciation
i. The specific procedures used by the auditor to test depreciation will
depend on the controls over depreciation and the risk associated with
the engagement and the account balance.
1. Low Risk: Analytical Procedures
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a. In most situations, the calculation of depreciation
expense is fairly straightforward and analytical
procedures are effective in estimating the
reasonableness of depreciation expense and
accumulated depreciation. Auditors often develop a
computer spreadsheet to estimate changes in
depreciation expense. The current estimate of
depreciation on assets continuing in the business is
calculated and then modified for assets added or
disposed of during the year. The worksheet should
incorporate a number of ratios and an overall test of
2. High Risk: Test the Details
a. The client calculates depreciation on each asset and
sums the total to come up with the depreciation expense
for the year. If the company is considered high risk, or
the analytical procedures do not support the client’s
depreciation expense, the auditor should use audit
software to take a sample of items contained in the
detailed property ledger, foot the ledger and agree it to
the general ledger, and then recalculate depreciation for
the sample of items chosen. If there are significant
differences the auditor should investigate to determine
the “root cause” of the problem and have the client fix
ii. Evaluating Changes
1. The auditor should make sure that the depreciation methods
used are consistent with the prior year unless the client has
reasonable justification for changing. The footnotes should be
carefully read to be sure all relevant information is disclosed.
i. First-Time Audits
i. The predecessor auditor should be contacted to determine if assurance
can be gained from their prior audits as to the beginning balances. If it
cannot, a statistical sample might be taken to observe existence and to
review original invoices to verify cost and ownership. The
depreciation schedule should also be recalculated. A complete PP&E
physical inventory may be required.
IV. Intangible Assets
a. As is true of all fixed assets and goodwill, management must determine if
there has been any impairment to the current value of intangible assets based
on the present value of expected future cash flows.
V. Natural Resources
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a. It is often difficult to identify the costs associated with the discovery of
natural resources and it is difficult to estimate the amount of commercially
recoverable resources discovered. Most established companies have sound
procedures for dealing with these problems and use geologists to estimate
reserves. In addition to reviewing these procedures, the auditor may wish to
use a specialist to review geological analyses, etc. Most organizations
periodically reassess the amount of reserves as more information becomes
available; the auditor should review these estimates and determine their
impact on revisions of the depletion rate.
b. Estimation of Reclamation Expenses
i. Environmental protection regulations have increased corporate
responsibility to restore land used in mining to an agreed-upon natural
state. The auditor should examine the procedures used by
management to estimate such expenses for their reasonableness.
VI. LEASES: A SPECIAL CONSIDERATION
a. Motivation to Lease
i. Companies engage in leasing transactions for a variety of reasons.
Most of the reasons are economic, but in some cases, achieving a
particular financial statement treatment motivates the lease transaction.
Transparency 14-5 lists some of the reasons for leases. The risks of
ownership (obsolescence, physical deterioration) are usually built into
the pricing model by the lessor or the seller. Many companies want to
have control of the assets for the economic life, but want to structure
the purchase contract so that it looks like a lease thereby keeping the
assets and liabilities off the balance sheet. Although there is disclosure
of the lease obligations, the company still keeps the assets off the
balance sheet. While accounting has not yet moved to a complete
“principles-based” approach, the guidance is that the economic
substance of transactions, not its form, should guide accounting.
b. Proper Accounting Treatment
i. Current accounting principles in the U.S. require that leases should be
capitalized if they meet at least one of four conditions:
1. The present value of the minimum lease payments is at least
equal to 90 percent of the asset’s fair market value.
2. The lessee can acquire title to the asset at the end of the lease
for a bargain purchase price.
3. The lease term covers at least 75 percent of the useful life of
4. The lease transfers ownership to the lessee by the end of the
ii. Capitalized leases are initially recorded at the present value of the
future minimum lease payments. The cost of the asset is amortized in
the same way as owned assets are depreciated. Periodic lease
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 9
payments include interest expense and reduction of principle. If the
lease does not meet one of the above tests, it is accounted for as an
operating lease, in which case only rent expense is recorded.
c. Audit Approach
i. The audit approach for leases should follow along the following lines:
1. Obtain all copies of lease agreements, read the agreements, and
develop a schedule of lease expenditures, bargain purchases,
2. Review the lease expense account, select entries to the account
and determine if there are entries that are not covered by the
leases identified in step 1. Review to determine if the expenses
are properly accounted for.
3. Review the four criteria from SFAS #13 (see above) and
determine if any of the leases meet the requirement of capital
4. For all capital leases, determine that the assets and lease
obligations are recorded at their net present value. Determine
the economic life of the asset. Calculate amortization expense,
interest expenses, and determine any adjustments to correct the
financial statements. Consider bargain purchase agreements to
determine the economic life for depreciation purposes.
5. Develop a schedule of all future lease obligations, or test the
client’s schedule by reference to underlying lease agreements
to determine that the schedule is correct.
6. Review the client’s disclosure of lease obligations to determine
that it is in accordance with GAAP.
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 10
Fixed Assets Related Risks
Earnings management related to fixed asset accounts:
Changing estimated useful lives and residual values
Capitalizing costs that should be expensed, such as
repairs and maintenance costs
Accounting for capital leases as operating leases.
Other risks associated with fixed assets and related
Incomplete recording of asset disposals
Environmental issues such as violation of safety and
protection regulations, or violation of environmental
Obsolescence or impairment of assets
Restructuring charges related to changes in the nature of
Incorrect recording of assets, hidden by complex
ownership structures designed to keep assets (and related
liabilities) off the books
Incorrect valuation of assets acquired as part of a group
purchase, including assets acquired as part of an
acquisition of another business
Amortization schedules or depreciation schedules that do
not reflect economic impairment or use of the asset
Failure to recognize impairment in value.
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 11
TRANSPARENCY 14-2. Exhibit 14.2 Audit Program: Manufacturing Equipment
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 12
TRANSPARENCY 14-2. Exhibit 14.2 Continued
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 13
TRANSPARENCY 14-2. Exhibit 14.2 Continued
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 14
Internal Control Objectives for PP&E
The control procedures should be designed
Identify existing assets, inventory them,
and reconcile the physical asset inventory
with the property ledger.
Ensure that all purchases are authorized.
Periodically reassess the appropriateness
of pre-established depreciation categories.
Identify obsolete or scrapped equipment
and write the equipment down to scrap
Safeguard the assets.
Prevent unauthorized journal entries to the
Periodically review management strategy
and systematically assess the impairment
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 15
TRANSPARENCY 14-4. Exhibit 14.3 Fixed-Asset Audit Documentation—Equipment
December 31, 2006
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 16
Some Reasons For Leases
To finance the purchase
To acquire the use of the asset for
relatively short periods of time without
having to buy and then sell it.
To acquire the use of the asset for an
extended period of time, but keep the asset
and related liability off of the balance
To maintain a flexible operating profile,
i.e. substitute short-term variable costs for
Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 17
Audit Approach For Leases
1. Obtain all copies of lease agreements, read the
agreements, and develop a schedule of lease
expenditures, bargain purchases, etc.
2. Review the lease expense account, select entries to the
account and determine if there are entries that are not
covered by the leases identified in step 1. Review to
determine if the expenses are properly accounted for.
3. Review the four criteria from SFAS #13 and
determine if any of the leases meet the requirement of
4. For all capital leases, determine that the assets and
lease obligations are recorded at their net present
value. Determine the economic life of the asset.
Calculate amortization expense, interest expenses, and
determine any adjustments to correct the financial
statements. Consider bargain purchase agreements to
determine the economic life for depreciation purposes.
5. Develop a schedule of all future lease obligations, or
test the client’s schedule by reference to underlying
lease agreements to determine that the schedule is
6. Review the client’s disclosure of lease obligations to
determine that it is in accordance with GAAP.