Property, Plant, and Equipment: Depreciation and Depletion

Chapter 13

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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Property, plant and equipmentProperty, plant and equipment

Tangible assets with a service life of more than one year that are used in the operation of the business and are not acquired for the purpose of resale

Three major subgroups: Land Buildings, machinery, equipment and land

improvements Natural resources

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Objectives for the Audit of Property, Objectives for the Audit of Property, Plant and EquipmentPlant and Equipment

1.Use the understanding of the client and its environment to consider inherent risk, including fraud risks, related to property, plant, and equipment.

2.Obtain an understanding of internal control over property, plant, and equipment.

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Objectives cont.Objectives cont.

1. Assess the risks of material misstatement and design tests of controls and substantive procedures that:

a. Substantiate the existence of property, plant, and equipment

b. Establish the completeness of recorded property, plant, and equipment

c. Verify the cutoff of transactions affecting property, plant, and equipment

d. Determine that the client has rights to recorded property, plant, and equipment

e. Establish the proper valuation or allocation of property, plant, and equipment and the accuracy of transactions affecting property, plant, and equipment

f. Determine that the presentation and disclosure of property, plant, and equipment are appropriate

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Audit Approach—Current AccountsAudit Approach—Current AccountsVersus Noncurrent AccountVersus Noncurrent Account

Cash

Securities

Accounts Receivable

Inventories

Accrued Liabilities

Accounts Payable

Short-Term Notes

Property, Plant & Equipment

Intangible Assets

Long-Term Liabilities

Owner’s Equity Accounts

High turnover accounts

Audit approach—audit the balance

Low turnover accounts

Audit approach—audit the changesin the accounts

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Controls Over Plant Controls Over Plant and Equipmentand Equipment

Use of a plant and equipment capital budget Maintenance of a subsidiary ledger A system of authorizations Analysis of variances from budgeted expenditures A statement of policy distinguishing between capital and

revenue expenditures A requirement that purchases of plant and equipment are

subjected to normal purchasing procedures Periodic physical inventories A system of retirement authorization and documentation

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Audit DocumentationAudit Documentation

Working papers Summary analysis that emphasizes changes

during the year under audit Analyses of additions and retirements for the

current year Analyses of repairs and maintenance

expense accounts Tests of depreciation

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Initial Audits Initial Audits

Beginning balances Substantiated by review of predecessor firm’s

working papers If not previously audited, a complete historical

analysis of property accounts is needed • Thorough review of all major charges and credits

to property accounts

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PPE Audit Steps (1 of 3)PPE Audit Steps (1 of 3)

A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to property, plant, and equipment.

B. Obtain an understanding of internal control over property, plant, and equipment.

C. Assess the risks of material misstatement and design further audit procedures.

D. Perform further audit procedures—tests of controls.1. Nature of tests of controls.

2. If necessary, revise the risks of material misstatement based on the results of tests of controls.

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PPE Audit Steps (2 of 3)PPE Audit Steps (2 of 3)E. Perform further audit procedures—substantive procedures for

property, plant, and equipment.

1. Obtain a summary analysis of changes in property owned and reconcile to ledgers.

2. Vouch additions to property, plant, and equipment during the year.

3. Make a physical inspection of major acquisitions of plant and equipment.

4. Analyze repair and maintenance expense accounts.

5. Investigate the status of property, plant, and equipment not in current use.

6. Test the client’s provision for depreciation.

7. Investigate potential impairments of property, plant, and equipment.

8. Investigate retirements of property, plant, and equipment during the year.

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PPE Audit Steps (3 of 3)PPE Audit Steps (3 of 3)

E. Perform further audit procedures (cont.)9. Examine evidence of legal ownership of property, plant, and

equipment.

10. Review rental revenue from land, buildings, and equipment owned by the client but leased to others.

11. Examine lease agreements on property, plant, and equipment leased to and from others.

12. Perform analytical procedures for property, plant, and equipment.

13. Evaluate financial statement presentation and disclosure for plant assets and for related revenue and expenses.

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Summary of Substantive Tests of Property, Summary of Substantive Tests of Property, Plant, and EquipmentPlant, and Equipment

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Vouch Additions (1 of 2)Vouch Additions (1 of 2)

Specific steps:a. Review changes during the year in construction in progress and

examine supporting work orders, both incomplete and closed.

b. Trace transfers from the Construction in Progress account to the property accounts, observing propriety of classification. Determine that all completed items have been transferred out of the account.

c. On a test basis, vouch purchases of property, plant, and equipment to invoices, deeds, contracts, or other supporting documents. Recompute extensions, footings, and treatment of discounts. Make certain repairs and maintenance expenses were not improperly capitalized.

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Vouch Additions (2 of 2)Vouch Additions (2 of 2)

Specific steps (cont.)

d. Investigate all instances in which the actual cost of acquisitions substantially exceeded authorized amounts. Determine whether such excess expenditures were analyzed and approved by appropriate officials.

e Investigate fully any debits to property, plant, and equipment accounts not arising from acquisition of physical assets.

f. Determine that the total cost of any plant and equipment assets purchased on the installment plan is reflected in the asset accounts and that the unpaid installments are set up as liabilities.

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Analyze Expense AccountsAnalyze Expense Accounts

Analyze repairs and maintenance expense accounts to: Discover items that should have been

capitalized Use company policy to determine consistency

in application Analyze monthly amounts for significant

variations from:• Month to month• Between corresponding months of two years

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Impairment of Long-Lived AssetsImpairment of Long-Lived Assets

Long-lived assets must be reviewed for impairment whenever events or changes in circumstances indicate that carrying value may not be recoverable

Test involves projecting future cash flows If impairment is indicated by cash flows

asset must be written down to fair value May require the use of a valuation specialist

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Investigate RetirementsInvestigate Retirements

Determine if property sold, dismantled, or abandoned without being reflected in accounting records

Steps to discover unrecorded retirements:1. For new additions, determine status of old equipment

2. Analyze miscellaneous revenue account for cash proceeds

3. If company’s products discontinued, investigate disposition of plant facilities

4. Inquire of executives and supervisors of plant asset retirements

5. Examine retirement work orders for proper authorization

6. Investigate any reduction in insurance coverage

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Analytical ProceduresAnalytical Procedures

Ratios and trends for overall reasonableness of recorded amountsa. Total cost of plant assets divided by annual output in

dollars, pounds, or other units.

b. Total cost of plant assets divided by cost of goods sold.

c. Comparison of repairs and maintenance expense on a monthly basis and from year to year.

d. Comparison of acquisitions for the current year with prior years.

e. Comparison of retirements for the current year with prior years.

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Presentation and DisclosurePresentation and Disclosure Disclose major classes of depreciable assets Accumulated depreciation Principles:

a. The basis of valuation should be explicitly stated. At present, cost is the generally accepted basis of valuation for plant and equipment; property not in use should be valued at the lower of cost or estimated realizable value.

b. Property pledged to secure loans should be clearly identified.

c. Property not in current use should be segregated in the balance sheet.

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Auditors’ Approach for DepreciationAuditors’ Approach for Depreciation

Important because depreciation is an estimate. Client makes

Estimate of useful economic life Choice of several depreciation methods

Audit approach for estimate Review and test management’s process of developing

the estimate Review subsequent events or transactions bearing on

the estimate Independently develop an estimate of the amount to

compare to management’s estimate

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Audit Program – Depreciation Audit Program – Depreciation (1 of 5)(1 of 5)

1. Review the depreciation policies set forth in company manuals or other management directives. Determine whether the methods in use are designed to allocate costs of plant and equipment assets systematically over their service lives.

a. Inquire whether any extra working shifts or other conditions of accelerated production are present that might warrant adjustment of normal depreciation rates.

b. Discuss with executives the possible need for recognition of obsolescence resulting from technological or economic developments.

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Audit Program – DepreciationAudit Program – Depreciation(2 of 5)(2 of 5)

2. Obtain or prepare a summary analysis (see Figure 13.1) of accumulated depreciation for the major property classifications as shown by the general ledger control accounts, listing beginning balances, provisions for depreciation during the year, retirements, and ending balances.

a. Compare beginning balances with the audited amounts in last year’s working papers.

b. Determine that the totals of accumulated depreciation recorded in the plant and equipment subsidiary records agree with the applicable general ledger controlling accounts.

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Audit Program – Depreciation Audit Program – Depreciation (3 of 5)(3 of 5)

3. Test the provisions for depreciation.a. Compare rates used in the current year with those employed in

prior years and investigate any variances.

b. Test computations of depreciation provisions for a representative number of units and trace to individual records in the property ledger. Be alert for excessive depreciation on fully depreciated assets. Generalized audit software can be used to test the depreciation calculations in the client’s records if the client maintains computer based records.

c. Compare credits to accumulated depreciation accounts for the year’s depreciation provisions with debit entries in related depreciation expense accounts.

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Audit Program – Depreciation Audit Program – Depreciation (4 of 5)(4 of 5)

4. Test deductions from accumulated depreciation for assets retired.a. Trace deductions to the working paper analyzing retirements of

assets during the year.

b. Test the accuracy of accumulated depreciation to date of retirement.

5. Perform analytical procedures for depreciation.a. Compute the ratio of depreciation expense to total cost of plant

and compare with prior years.

b. Compare the percentage relationships between accumulated depreciation and related property accounts with those prevailing in prior years. Discuss significant variations from the normal depreciation program with appropriate members of management.

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Audit Program – Depreciation Audit Program – Depreciation (5 of 5)(5 of 5)

Overall test1. List the balances in the various asset accounts at the

beginning of the year.

2. Deduct any fully depreciated assets, since these items should no longer be subject to depreciation.

3. Add one-half of the asset additions for the year.

4. Deduct one-half of the asset retirements for the year (exclusive of any fully depreciated assets).

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Natural ResourcesNatural Resources

Properties subject to depletion Similar to depreciation

Recorded consistently and in accordance with GAAP

Test mathematical accuracy Often rely on specialists for valuation Establish ownership

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Audit of IntangiblesAudit of Intangibles

Assets with definite useful lives are audited similar to property, plant and equipment

Assets with indefinite useful lives (e.g., goodwill) must be tested for impairment

Auditors generally rely on business valuation specialists to value goodwill for tests of impairment

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Audit of PPE in AdvanceAudit of PPE in Advance

Most work can be done in advance Consideration of internal control can be

carried out at any convenient time Many firms audit during interim work in

October and November After balance sheet date, only need to

exam transaction for final two or three months