Asset Impairment and Earnings Management - DOC

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					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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