Chapter 13 - Audit of Fixed Assets
and Related Expense Accounts
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
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
Review Risks Associated with Fixed
Assets and Related Expenses:
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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
Review Risks Associated with Fixed
Assets and Related Expenses:
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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
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
Discuss Analytical Analysis for
Possible Misstatements
Analyze industry trends and changes in product
lines
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Helps identify assets that are not as useful as in
previous years
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Tour the plant and note idle equipment
Analyze Depreciation for Consistency and
Economic Activity
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Review gains/losses on equipment disposals
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Perform analytical estimate of depreciation
Explain 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
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Review 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
Review 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
Comment on 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
Comment on 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
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
What’s different about first-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
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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
Discuss 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
Comment on Intangible Assets
May be difficult to determine which costs should be
capitalized
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Especially for internally developed intangibles
Auditor will review client accounting to ensure per GAAP
May be difficult to determine appropriate amortization
period
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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
Review 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
Review 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
Discuss 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