Chapter 14

1. Chapter 14 Audit of Long-Lived Assets and Related Expense Accounts

2. Business Risk and Business Environment Fixed assets are often the large category of assets Because there is typically limited activity in fixed assets • Auditors usually focus on testing transactions rather than tests of account balances • Audit period transactions include additions, disposals, write-offs, and depreciation

3. What is earnings management? Ways fixed assets can be used to manage earnings: • Change estimated useful lives and residual values • Capitalize costs that should be expensed, such as repairs and maintenance • Account for capital leases as operating leases

4. Risks Associated with Fixed Assets and Related Expenses • Unrecorded asset disposals • Environmental issues • 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

5. Risks Associated with Fixed Assets and Related Expenses (continued) • Amortization or depreciation which does not reflect the economic use of the asset • Failure to recognize impairments in value • Incorrect computation of gains/losses on asset disposal • Improper recording of capital leases as operating leases • Capitalization of costs that should be expensed

6. How does the auditor become aware of the risks? Auditor will normally be aware of these risks through review of: • Industry trends, technological advances, and changes in location of production facilities • Business plan for major acquisitions • Major contracts regarding capital investments or joint ventures • Minutes of board of director meetings • Company filings with the SEC describing actions, risks, strategies

7. Analytical Analysis for Possible Misstatements Analyze industry trends and changes in product lines • Helps identify assets that are not as useful as in previous years • Tour the plant and note idle equipment Analyze Depreciation for Consistency and Economic Activity • Review gains/losses on equipment disposals • Perform analytical estimate of depreciation

8. Evaluating Control Risk and Control Effectiveness Controls issues: • Periodic inventories of physical assets reconciled to the equipment subsidiary ledger • Ensure all purchases are authorized and properly valued • Classify new equipment according to expected use and useful life • Periodic review of estimates • Identify obsolete or scrapped equipment and write down to scrap value • Safeguard assets • Prevent unauthorized journal entries • Periodic review of management strategy to determine continued usefulness of equipment The auditor should assess both the existence and effectiveness of client controls in determining which direct tests need to be performed

9. Tests of Property Additions and Disposals If the beginning balance is established, testing can be limited to additions and disposals during the year Additions: • Auditor can usually test existence and valuation by the same procedures • Schedule of property additions is agreed to additions shown in the ledger to ensure schedule is complete • Auditor vouches recorded additions to vendor invoice and other supporting documentation (existence and valuation) • Auditor may trace recorded additions to the physical assets to establish existence (particularly if client controls are weak) • Auditor will vouch fixed asset additions and repair and maintenance expense transactions to vendor invoices or other supporting documentation to determine if transactions are properly recorded • Auditor will review lease contracts signed during the audit year to determine if they are properly recorded

10. Disposals and Fully Depreciated Equipment Many organizations do not exercise the same degree of control over asset disposals as they do for acquisitions Audit procedures are designed to test that ALL disposals have been recorded • Select a sample of (nearly) fully depreciated property from the property ledger and trace to the physical assets to determine existence • Review acquisition documents for trade-ins. Review the property ledger to make sure that the traded-in asset has been removed • Ask client about any assets that have been removed. Trace to the property ledger to make sure asset has been removed

11. Asset Impairment There may be significant declines in the value of fixed assets due to technological obsolescence, or new manufacturing techniques If there is evidence of asset impairment, valuation must be assessed The FASB has developed two approaches to valuing impaired assets: 1. Estimate the future economic benefits to be derived from the asset 2. Obtain an independent assessment of the value of the asset

12. Asset Impairment (continued) For the first approach, auditors perform a recoverability test to determine if asset is impaired. • If future cash flows exceed asset's carrying value, asset is not impaired • If future cash flows do not exceed carrying value, asset is impaired. • Amount of impairment is difference between net present value of future cash flows and asset's carrying value For the second approach, the auditor may • Obtain appraisal from independent and qualified appraisal firm • Review current transactions to determine if there has been a decrease in purchase price

13. How are discontinued operations treated? Company should write net assets down to net realizable value In assessing fair market value, auditor will normally: • Request estimate of value from an investment broker • Discount estimated future cash flows to develop estimate of value The nature of the discontinuance decision and the amount of write-down should be fully disclosed in the notes to the financial statements

14. What is different aboutfirst-time audits? During first-time audit of a new client, the auditor will need to verify the beginning balances If the client has been audited before, the predecessor auditor should be contacted If the predecessor documentation cannot be used, or if this is the client's first audit, • Auditor will sample property in the beginning balance and • Vouch back to supporting documents to verify cost • Trace back to physical assets to verify existence • Auditor should also recalculate depreciation expense and accumulated depreciation

15. Depreciation Expense and Accumulated Deprecation The procedures used to test deprecation will depend on the controls over depreciation and the risk associated with the engagement and account balance Low risk - analytical procedures: • Current estimate of depreciation is calculated and modified for additions and disposals during the year • Ratios are computed to determine reasonableness of current deprecation High risk - tests of details: • Foot the property ledger and agree to the general ledger • Recalculate depreciation for sample of items

16. Intangible Assets May be difficult to determine which costs should be capitalized • Especially for internally developed intangibles • Auditor will review client accounting to ensure per GAAP • May be difficult to determine appropriate amortization period • Expected economic life or legal life, whichever is shorter • Auditor should review trade publications for competition and new product introductions • Auditor should make inquiries of client and legal counsel • Auditor should review client procedures for determining when intangibles become impaired

17. Handling Natural Resources May be difficult to determine which costs should be capitalized • Most companies have procedures for identifying costs • Auditor should test capitalization of new assets by examining documents May be difficult to estimate the amount of the natural resource • Many companies use geologists to estimate amount of natural resources • Auditor may hire a specialist to review any geological analysis

18. Handling Natural Resources (continued) Depletion should be based on amount extracted during the year • Depletion is based on units of production approach • Auditor may use analytics like current depletion compared to prior years • Auditor may analyze production data and then recompute depletion May be difficult to estimate reclamation expenses • Auditor should examine the reasonableness of procedures used by management to estimate cost

19. Leases: Audit Approach Obtain copies of lease agreements • Review agreements to determine if capital or operating leases • Review client records to determine if leases properly accounted for Review lease expense account • Select entries and review to make sure they are for operating leases For all capital leases • Determine assets and obligations are recorded at net present value • Determine the economic life of the asset • Calculate amortization and interest expense • Consider bargain purchase agreements to determine economic life