AUDITING OTHER ASSETS AND LONG TERM FINANCING

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CHAPTER 13

• AUDITING OTHER ASSETS AND LONG TERM FINANCING

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AUDITING OTHER ASSETS AND LONG TERM FINANCING

• I. Audits of Property, Plant, and Equipment. PPE
  often represents the largest single category of
  assets of manufacturing organizations. The
  beginning balance is established in previous
  year's audits, thus the audit focuses on material
  transactions affecting the account balance during
  the year additions, disposals and write-offs of
  existing assets, and depreciation. Transparency
  13-1 illustrates an audit program for the audit
  of equipment.
• A. First Time Audits. 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 PPE physical
  inventory may be required.

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• B. Inherent Risks. Major risks common to most
  audits of PPE concern (1) impaired assets and (2)
  properly distinguishing between repair and
  maintenance costs and those that should be
  capitalized. Management may intentionally
  misclassify these costs, either to improve
  profits or minimize income taxes.
• C. Evaluating Control Risk and Control
  Effectiveness. Transparency 13-2 lists internal
  control objectives and procedures for PPE. 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.

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• D. Tests of Property Additions and Disposals.
  Audit procedures should determine that all
  additions have been properly authorized, properly
  classified, and properly valued. Transparency
  13-3 illustrates typical fixed asset audit
  documentation. Such procedures will 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 auditors knowledge of the clients strategic
  plans and industry changes is used to determine
  whether additional work should be performed.
• 1. Disposals and Fully Depreciated Equipment.
  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

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• 2. Decommissioning Costs. 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.
• E. Audit Considerations for Capitalized Leases.
  Depreciation of capitalized leases should reflect
  the economic or lease life of the asset,
  whichever is shorter.
• F. Asset Impairment. The auditor needs 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 write down
  the assets (only) when there is incontrovertible
  evidence that there has been a permanent decline
  in economic value of the asset.

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• G. Discontinued Operations. 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. Analytical procedures can be very
  effective for estimating the reasonableness of
  depreciation expense and accumulated
  depreciation. The auditor should follow up on
  ratios or other reasonableness tests that produce
  unexpected results. Data for these analyses can
  be easily derived from client records using IDEA.
• I. Natural Resources. 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.

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• 1. Disclosure of Natural Resources. The
  disclosure of natural resources reserves, as
  required by the SEC, is quite complex and
  includes an estimate of oil and gas reserves.
  The auditor needs to determine whether the
  information complies with SEC reporting
  standards.
• 1. Estimation of Reclamation Expenses.
  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.
• II. Audits of Mergers and Acquisitions. Merger
  and acquisition activity represents a significant
  amount of capital movementand new valuation
  problems for both client and auditor.

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• A. An Overview of Accounting Issues Associated
  with Mergers and Acquisitions. The FASB requires
  business combinations to be accounted for using
  the purchase method. The acquiring organization
  is required to allocate the total purchase price
  to (1) the fair market value of tangible assets
  of the acquired company, and (2) the fair market
  value of specifically identifiable and
  contractually based intangible assets, such as
  patents and trademarks. Any excess purchase
  price is recorded as goodwill. Existing
  liabilities are also adjusted to FMV.
• B. Audits of Mergers and Acquisitions. Major
  audit problems associated with a purchase involve
  estimating the fair market value of the net
  assets acquired. An independent appraisal firm
  usually does this. The appraisal of intangible
  assets normally includes a specification of the
  assumptions associated with the estimate of
  value. Auditors must determine whether such
  assumptions are reasonable.

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• 1. Goodwill. The auditor should determine
  factors that cause the acquirer to pay more than
  fair market value for the companys identifiable
  assets.
• 2. Testing for Impairment of Goodwill. FASB
  Statement No. 142 changed the accounting
  treatment for goodwill to recognize that goodwill
  is not necessarily an asset that systematically
  expires over a defined number of years. Thus
  goodwill is no longer amortized on a systematic
  basis, but is tested for impairment on at least
  an annual basis. The impairment tests of
  goodwill constitute a significant audit problem
  where auditor judgment must absolutely be tied to
  the auditors knowledge of business and business
  risk. Situations may arise, other than the
  annual review, in which the impairment of
  goodwill should also be addressed.

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• 3. Overpaying for An Acquisition. A significant
  valuation problem may exist when a company
  overpays for its acquisitions. Evidence of a bad
  business decision by management in acquiring a
  new entity should be reflected in the goodwill
  impairment tests.
• III. Audits of Financing Activities. Although
  stocks and bonds are usually issued as a means of
  raising long-term capital, the auditor may
  encounter other types of financing which may be
  significantly more complex (Transparency 13-4) if
  the auditor needs to determine, for example,
  whether mandatory redeemable stock in substance
  has more characteristics of debt than equity.
  The accounting issues cannot be divorced from the
  audit issues.
• A. Bonds. Bond transactions are few, but usually
  highly material to the financial statements.
  Transparency 13-5 lists some of the major
  considerations in auditing bonds or other
  long-term debt.

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• 1. Bond Issuance and Amortization Schedule.
  Proceeds from the bond issuance can be traced to
  a bank deposit. The bond indenture can be used
  to set up a bond amortization spreadsheet which
  the auditor can use each year.
• 2. Periodic Payments and Interest Expense. The
  auditor generally verifies the current payments
  with the trustee who makes the periodic interest
  payments to the bondholders and updates the
  amortization schedule spreadsheet.
• 3. Disclosure Examination of Bond Indenture.
  Because violation of the bond indenture
  agreements makes the bonds currently due and
  payable, the auditor must clearly understand the
  important provisions of the agreement to
  determine if (1) there is violation of the
  agreement, and (2) that material restrictions are
  disclosed.

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• B. Common Stock and Owner's Equity. Transparency
  13-6 lists the major transactions affecting
  stockholders equity that the auditor should
  address. Although all the assertions apply to
  the audit of owners equity, the valuation and
  disclosure assertions receive the most attention.
• 1. Valuation. Valuation issues arise when stock
  is issued for noncash consideration. Treasury
  stock transactions should be examined to
  determine whether they are recorded in accordance
  with the board of directors authorization and
  state corporation laws and are properly valued.
• 2. Disclosure. Disclosure includes a proper
  description of each class of stock outstanding
  and the number of shares authorized, issued, and
  outstanding special rights associated with each
  class, stock options outstanding, convertible
  features, and the existence of stock warrants.
  The potential dilutive effect of convertible debt
  or preferred stock, stock options, and warrants
  should be disclosed in accordance with APB No.
  15.

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• Internal Control Objectives for PPE
• 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.
• Appropriately classify new equipment according to
  the pre-established depreciation categories.
• Identify obsolete or scrapped equipment and write
  the equipment down to scrap value.
• Safeguard the assets.
• Periodically review management strategy and
  systematically assess the impairment of assets.

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• Accounts the Auditor May Encounter in Auditing
  Financing Activities
• Notes Payable
• Mortgages payable or contracts payable
• Special Bonds
• o Payment-in-kind bonds
• Convertible bonds, which are convertible into
  equity
• Mandatory redeemable preferred stock
• Stock options and warrants
• Stock options as part of a stock compensation
  scheme

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• Considerations in Auditing Bonds or Other
  Long-Term Debt
• Proper valuation and amortization of premium or
  discount.
• Correct computation of interest expense.
• Gains or losses on refinancing debt are properly
  accounted for.
• Major restrictions contained in the bond
  indentures are disclosed in the financial
  statements.