Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 1 Chapter 14 Audit of Long-Lived Assets and Related Expense Accounts 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 expenses. 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 in value. 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 Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 2 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 Controls 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. ii. Additions 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 documentation. 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 assets. 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 realizable value. 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. Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 5 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 use 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 major approaches: 1. Estimating the future economic benefits to be derived from the asset 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. Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 6 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 value. d. The value would be compared to the carrying cost of the asset to determine the amount of the impairment to be recognized. 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 Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 7 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 reasonableness. 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 the problem. 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 Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 8 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 the asset. 4. The lease transfers ownership to the lessee by the end of the lease term. 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, 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 (see above) and determine if any of the leases meet the requirement of capital leases. 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 TRANSPARENCY 14-1 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 expenses: Incomplete recording of asset disposals Environmental issues such as violation of safety and protection regulations, or violation of environmental regulations Obsolescence or impairment of assets Restructuring charges related to changes in the nature of the business 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 TRANSPARENCY 14-3 Internal Control Objectives for PP&E The control procedures should be designed to: 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 value. Safeguard the assets. Prevent unauthorized journal entries to the account balances Periodically review management strategy and systematically assess the impairment of assets. 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 TRANSPARENCY 14-5 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 sheet. To maintain a flexible operating profile, i.e. substitute short-term variable costs for fixed costs. Chapter 14: Audit of Long-Lived Assets and Related Expense Accounts 17 TRANSPARENCY 14-6 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 capital leases. 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.
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