Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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CHAPTER 14
AUDITING THE FINANCING/INVESTING PROCESS:
PREPAID EXPENSES, INTANGIBLE ASSETS, AND
PROPERTY, PLANT, AND EQUIPMENT
Answers to Review Questions
14-1 Prepaid expenses provide a legal right to services or an economic benefit for less than a
year. Intangible assets provide economic benefit for longer than a year, therefore
misstatements can occur which affect multiple periods.
Examples of prepaid expenses include:
• Prepaid insurance
• Prepaid rent
• Patents
• Franchises
• Goodwill
• Computer software development costs
14-2 Intangible assets often present serious inherent risks because there are possible judgment
14-3 The purchasing process affects prepaid insurance and property, plant, and equipment
transactions because such transactions are subject to the control activities included in the
purchasing process. For example, control activities in the purchasing process may
14-4 Examples of two substantive analytical procedures that can be used to test prepaid
insurance are:
• Compare the current-period balance in prepaid insurance and insurance expense with
the prior periods’ balances after considering any changes in operations.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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• Compute the ratio of insurance expense to assets or sales and compare it with the
prior periods’ ratios.
14-5 A confirmation from insurance brokers would include information on the policy number,
coverage, expiration date, deductibles, and premiums.
14-6 The categories of intangible assets are (only four are required to be listed):
• Marketing—trademark, brand name, and Internet domain names.
• Customer—customer lists, order backlogs, and customer relationships.
Four types of property, plant, and equipment transactions are:
• Acquisition of capital assets for cash or other nonmonetary considerations.
14-7 a) Inherent risk factors to be considered when assessing inherent risk for intangible
assets are:
1. Nature of the judgments required to establish the assets value:
Considerable judgment is involved in valuing intangible assets acquired in a
transaction. Inherent risk may be reduced if a specialist was hired by the client
to assist in the valuation of the intangible assets.
2. Complexity of the accounting rules:
resulting from improper valuation will be detected through the audit procedures.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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b) Inherent risk factors that should be considered when assessing inherent risk for
property, plant, and equipment are:
1. Complex accounting issues:
3. Misstatements detected in prior audits:
If the auditor has detected misstatements in prior audits, the likelihood of
misstatements in the current year is higher.
14-8 Most entities have some type of authorization table for approving capital asset
transactions. Control activities should be present to ensure that the authorization to
purchase capital assets is consistent with the authorization table. For example, the
control activities should specify dollar limits at each managerial level to ensure that
larger projects are brought to the attention of higher levels of management for approval
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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14-9 Some of the key segregation of duties for property, plant, and equipment and possible
errors or fraud that can occur if they are not present are:
Segregation of Duties
Possible Errors or Fraud as a
Result of Conflicts in Duties
The initiation function should be
segregated from the final approval
function.
Fictitious or unauthorized purchases of assets
could occur, resulting in purchases of
unnecessary assets, assets that do not meet
the company’s quality control standards, or
illegal payments to suppliers or contractors.
The property, plant, and equipment
records function should be segregated
from the general ledger function.
A defalcation that would normally be
detected by reconciling the subsidiary
records with the general ledger control
account could be concealed.
The property, plant, and equipment
records function should be segregated
from the custodial function.
Tools and equipment could be stolen and the
theft could be concealed by adjusting the
accounting records.
If a periodic physical inventory of
property, plant, and equipment is
taken, the individual responsible for
the inventory should be independent
of the custodial and record-keeping
functions.
Theft of the entity’s capital assets could be
concealed.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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14-10 The following substantive analytical procedures can be used in the audit of property,
plant, and equipment:
• Compare prior-year balances in property, plant, and equipment and depreciation
expense with current-year balances taking into account any changes in conditions or
• Compute the ratio of insurance expense to the related property, plant, and equipment
account and compare to prior years’ ratios.
• Review capital budgets and compare the amounts spent with the amounts budgeted.
14-11 The following audit procedures can be used to verify the completeness, rights and
obligations, and valuation assertions:
Completeness: Physically examine a sample of capital assets and trace them into
the property, plant, and equipment subsidiary ledger.
Rights and Examine or confirm deeds or title documents for proof of
Obligations: ownership.
Valuation: Vouch additions and dispositions to vendor invoices or other
supporting documentation. Test depreciation calculations for a
sample of capital assets.
Answers to Multiple-Choice Questions
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c
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d
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a
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a
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b
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d
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b
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b
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a
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a
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a
Solutions to Problems
14-23 a. Two substantive analytical procedures that can be used to test prepaid insurance are:
• Examine the trend in prepaid insurance over 3-5 years to develop an expectation
for the current year balance after considering any changes in operations. Compare
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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• Compute the ratio of insurance expense to assets or sales and compare it with the
prior years’ ratios.
b. The following substantive tests should be performed on the schedule of prepaid
insurance:
• Foot the schedule and trace the ending balance to the prepaid insurance account in
the general ledger.
• Send confirmations to the entity’s insurance brokers, requesting information on
each policy’s number, coverage, expiration date, and premiums; alternatively,
allocated to the various insurance expense accounts.
• Inquire of management or its insurance broker about the adequacy of the entity’s
insurance coverage.
14-24 a. Taylor should consider performing the following procedures in the audit of Palmer’s
goodwill and trademark accounts:
• Obtain a copy of the entity’s detailed listing of intangible assets, which should
agree with the total amount of intangible assets reported on the entity’s balance
sheet.
• Examine the entity’s impairment documentation to ensure that each asset is
• The result of the valuation of the trademark assets is compared with the current
book values of the trademark assets to verify if the assets are impaired.
• If the trademark assets are impaired, verify if the amount of the impairment
exceeds materiality.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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b. When specialists are used, the auditor is required to evaluate the specialist’s
qualifications and objectivity. The auditor also must determine if the valuation model
14-25 The key internal controls related to Grant’s property, equipment, and related transactions
that Nakamura may consider in assessing control risk include the following:
• Advance approval in accordance with management’s criteria is required for property
and equipment transactions.
• Approval authority for transactions above an established dollar value is required at a
higher level, such as the board of directors.
• Property and equipment transactions are adequately documented.
• There are written policies covering capitalizing expenditures, classifying leases, and
determining estimated useful lives, salvage values, and methods of depreciation and
detailed property records.
• The entity employs internal auditors to test whether the internal controls are operating
effectively.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
14-26 a. Property, plant, and equipment normally include only fixed tangible assets. Fixed
tangible assets are capital assets with useful lives generally in excess of one year that
are used in the operation of the business and that are not purchased for resale
purposes. In connection with the examination of property, plant, and equipment
(PP&E), the auditor must be satisfied that:
• Internal controls over PP&E and PP&E acquisitions are adequate.
• Assets included in PP&E exist and are being used in the normal operations of the
• Maintenance accounts do not include items that should be capitalized.
• The valuation and the disclosure of the method of evaluation are acceptable.
• Important information relating to the assets is properly disclosed.
b.
Item
Number
Reasons Why Audit Adjustment or
Reclassification Is Required or Not Required
1.
Commissions paid to real estate agents are costs
directly related to the acquisition of the property
and should be included in the land cost. The
costs of removing, relocating, or reconstructing
property of others to acquire possessions are
costs that are directly attributable to conditioning
the property for use and should be included in
land costs. An adjustment is required for these
items so that total land costs can properly be
included in property, plant, and equipment.
2.
No adjustment is required because clearing costs
are costs that are directly attributable to
conditioning the property for use and should be
included in land costs, which are part of
property, plant, and equipment.
reduction of the cost of the land and should not
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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be recorded as other income.
4.
All costs relating to the purchase of machinery
and equipment should be capitalized. For
purchased items such costs would include
invoice price, freight costs, and unloading
charges. Royalty payments, however, should not
be included in the cost of the machinery. Such
payments should be charged to expenses as they
accrue. Machinery costs, other than royalty
payments, should be included in property, plant,
and equipment.
14-27 a. 4
14-28 Substantive audit procedures that Pierce should use in examining Wong’s mobile
construction equipment and related depreciation would include the following:
• Determine that the equipment account is properly footed.
• Determine that the subsidiary accounts agree with controlling accounts.
• Test the calculation of depreciation expense and accumulated depreciation balance.
• Perform analytical procedures such as comparing depreciation expense to balance
sheet accounts for proper relationship and compare the current year’s depreciation
expense with prior year’s depreciation expense.
• Evaluate the financial statement presentation and disclosures for conformity with
generally accepted accounting principles.
• Review insurance coverage.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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Solution to Discussion Case
14-29 a. The relevant accounting standard for this is found in FASB ASC Topic 360-20, “Real
Estate Sales.” Under the standard, full recognition of profit requires that (1) the profit
is determinable and (2) the earnings process is virtually complete. The standard
further requires that a sale is not consummated until (1) the parties are bound by the
contract, (2) all consideration has been exchanged, (3) any permanent financing for
recognizing revenue, including (1) the deposit method and (2) the cost recovery
method. Under the deposit method, no profit is recognized because the sale has not
been consummated. The cost recovery method can be used if the receipt of the
irrevocable letter of credit is treated as a separate transaction from the total sales
transaction and profit is recognized on this portion of the transaction independently of
consummate the transaction. It can also be argued that the criteria in paragraph 5
have been met for this portion of the transaction, since it meets the requirement of an
adequate initial investment (greater than 15% for commercial and industrial
property). Following the cost recovery method at March 31, 2013, a gain of
$1,580,000 would be recognized on the difference between the book value of the
property and the amount of the irrevocable letter of credit. The property would be
removed from Leno’s balance sheet, and the letter of credit would be presented as a
“deposit received under contract of sale.”
b. Prior to recognizing any gain on the transaction, the auditor should:
• Examine the sales contract.
• Examine the letter of credit.
Chapter 14 – Auditing the Financing/Investing Process: Prepaid Expenses, Intangible Assets, and
Property, Plant, and Equipment
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Solutions to Internet Assignments
14-30 It is difficult to get information directly on some of EarthWear’s competitors. While
Lands’ End was formerly a stand-alone public company, it is now part of the Sears
Holding Corporation. The Sears’ annual report indicates that it uses a straight-line
method over the estimated useful lives of the respective assets for financial statement
purposes and accelerated methods for tax purposes. For example, Sears’ uses 3 to 5 years
capital leases are amortized over the shorter of their estimated useful lives or the lease
terms.” Eddie Bauer, L.L. Bean and Patagonia are privately held companies and there are
no publicly available financial statements.
14-31 A search of the SEC’s website should identify a company that has been recently cited by
the SEC for problems related to property, plant, and equipment.