CHAPTER 5

5. AUDIT OF PROPERTY, PLANT AND EQUIPMENT

Chapter Outline

 Comparison of Audit of Fixed Assets with Audit of Current Assets

 Objectives for the Audit of Property, Plant and Equipment
 Internal Control over Fixed Assets
 Audit Program for Property, Plant and Equipment and Related Accounts
 Tests in the Audit of Fixed Assets

Introduction
Property, plant and equipment are 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. The primary accounting record for property, plant, and equipment accounts is
generally a fixed asset master file.

Property, plant and equipment are also known as plant assets, fixed assets or tangible assets.
Three major subgroups of property, plant and equipment are:
 Land
 Buildings, machinery, equipment and land improvements
 Natural resources

5.1 Comparison of Audit of Fixed Assets with Audit of Current Assets

In many companies (especially in industrial firms), the investment in plant, property and
equipment amounts to 50 percent or more of the total assets. However, the audit required to
verify these properties is usually a much smaller proportion of the total audit time spent
on the engagement. Auditors verify equipment differently from current asset accounts for
three reasons:

1. There are usually fewer current period acquisitions of equipment (little change in
property and equipment account from year to year), especially in manufacturing

1
 firms. The equipment is likely to be kept and maintained in the accounting records
for several years.

• For example, the Land account often remains unchanged for a long span of
years. The durable nature of building and equipment also tend to hold
accounting activity to a minimum for these accounts. In contrast, such
current assets as accounts receivable and inventory may have a complete
turnover several times a year.
2. The amount of any given acquisitions is often material.
• A typical unit of property and equipment has a high dollar value, and few
transactions may lie behind a large balance sheet amounts.
3. Year-end Cut-off transaction in fixed assets is less.
• For current assets the year end cut-off is a critical issue. However, it is almost
non-existent for plant assets. An error in the cut-off of a $50,000 purchases
or sales transaction may cause a $50,000 error in year –end pre-tax income.
For plant assets, on the other hand, a year end cut-off error in recording an
acquisition or retirement ordinarily will not affect net income for the year.

5.2 Objectives for the Audit of Property, Plant and Equipment

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

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

2
3. To 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

5.3 Internal Control over Fixed Assets

Importance of fixed assets audit arises from the following facts:

a. The amount of capital investment in fixed assets represents a large portion of total
assets (especially in industrial companies).

b. Maintenance and depreciation of these assets are major expense in the income
statements.

Therefore, the total expenditure for these assets and related expenses make strong internal
control essential to the preparation of reliable financial statements.

• Errors in measurement of income may be material if the distinction between

capital and revenue expenditure is not maintained consistently.

• The losses that arise from uncontrolled method of acquisition, and retiring
fixed assets are often greater than losses from fraud of cash handling.
Common Internal controls: Companies need to apply the following internal
control over fixed assets.

a. Acquisition and retirement of fixed assets must be based on plan/budget.

b. There must be proper recording of acquisition and disposal of fixed assets.

3
 c. Maintain a subsidiary ledger for each unit of fixed asset (e.g. separate ledger for
equipment, another for machinery, furniture, etc).

d. Acquisition and disposals of fixed assets must be approved by concerned higher

management.

e. Any variance between authorized expenditure and actual costs must be disclosed,
reported and analysis for the cause for the variance must be investigated.

f. There must be company policy that distinguishes between capital expenditure and
revenue expenditure.

g. Receipt of purchased fixed asset should be made with proper inspection and goods
receiving report must be issued to suppliers.
h. Periodic physical inventory must be undertaken in order to ascertain existence,
location and condition of all fixed assets.

i. There must be a system of retirement procedure stating reasons for retirement and
bearing appropriate approval.
5.4 Audit Program for Property, Plant and Equipment and Related Accounts
The auditor's program for plant asses audit includes the following.
(I) Internal Control consideration—tests of controls
 Obtain an understanding of client’s internal control
 Preliminary review
 System documentation
 Transaction walk-through
 Determine whether controls are potentially reliable in assessing control risk
below maximum

 Physically inspect sampled fixed assets

 Review adequacy insurance coverage
 Inquire about the nature of training to a select sample of personnel (Inquiry)
 Observe property management actions in process (Observation)
 Review documentation showing completion of the training (Inspection of
documentation)

4
(II) Substantive Audit 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.
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 disclosures for plant assets and for
related revenue and expenses.
(III) Audit of Plant Asset Related Accounts
1) Analyze Repairs and Maintenance Expense Accounts Analyze repairs and
maintenance expense accounts to:
a. Discover items that should have been capitalized
b. Use company policy to determine consistency in application
c. Analyse monthly amounts for significant variations from (Month to month
and/ orBetween corresponding months of two years
2) Auditors’ Approach for Depreciation
The auditor should audit depreciation because it is an estimate that needs due consideration.
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

5
 – Independently develop an estimate of the amount to compare to
management’s estimate
3) Audit Program – Depreciation
o 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.
o Obtain or prepare a summary analysis 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.
o Test the provisions for depreciation. o Test deductions from accumulated
depreciation for assets retired. o Perform analytical procedures for depreciation.
o Overall test
5.5 Tests in the Audit of Fixed Assets
Although the approach to verifying equipment differs from that used for current assets,
several other asset accounts are verified in much the same manner. These include patents,
copyrights, and all property, plant, and equipment accounts. In the audit of equipment and
related accounts, it is helpful to separate the tests into the following categories:

1. Perform analytical procedures

2. Verify current year acquisitions
3. Verify current year disposals
4. Verify the ending balance in the asset account
5. Verify depreciation expense
6. Verify the ending balance in accumulated depreciation

Next, let’s examine the use of these categories of tests in the audit of equipment,
depreciation expense, accumulated depreciation, and gain or loss on disposal accounts.

1. Perform Analytical Procedures

This involves the comparison of relationship among financial and non-financial data. This
is used to assess whether account balances or other data appear reasonable.

6
Examples:

• Compare gross profit margin of this year with last year.

• Compare amount of payable of this year (month) with last year (month).
• Compare current year’s repair expense with previous year’s repair expense and
investigate the cause for any difference.

The purpose of analytical procedure is to investigate the cause for any unusual or
unrealistic deviation (difference) among (between) data.
As in all audit areas, the type of analytical procedures depends on the nature of the client’s
operations. The following Table illustrates analytical procedures often performed for
equipment.

Analytical Procedure Possible Misstatement

Compare depreciation expense divided by Misstatement in depreciation expense and
gross equipment cost with previous years. accumulated depreciation
Compare accumulated depreciation divided Misstatement in accumulated depreciation
by gross equipment cost with previous years.
Compare monthly or annual repairs and Expensing amounts that should be
maintenance expense, small tools expense, capitalized
and similar accounts with previous years.
Compare gross manufacturing cost divided Idle equipment or equipment that was
by some measure of production with disposed of but not written off.
previous years
As you can see, most of the typical analytical procedures assess the likelihood of material
misstatements in depreciation expense and accumulated depreciation.

2. Verify Current Year Acquisitions

Companies must correctly record current year additions because the assets have long-term
effects on the financial statements. For example, failure to capitalize a fixed asset
(recording fixed asset cost as expenses) affects balance sheet and income statement.

a. Understates assets in the balance sheet.

b. Overstates current period’s operating expenses and understates income of the
period. On the other hand depreciation expenses of the subsequent years will
be understated thereby overstates income of the years.

7
Because of the importance of current period acquisitions in the audit of equipment, auditors
use seven of the eight balance-related audit objectives as a frame of reference for tests of
details of balances: existence, completeness, accuracy, classification, cut-off, detail tie-in,
and rights and obligations (Realizable value is discussed in connection with verifying
ending balances.) The balance-related audit objectives and common audit tests are
shown in the following table Existence, completeness, accuracy, classification, and rights
are usually the major objectives for this part of the audit.
As in all other audit areas, the actual audit tests and sample size depend heavily on tolerable
misstatement, inherent risk, and assessed control risk. Tolerable misstatement is important
for verifying current year additions because these transactions vary from immaterial
amounts in some years to a large number of significant acquisitions in others.
Balance-Related Audit Objectives and Tests of Details of Balances for Equipment
Additions
Balance Related Audit Common Tests of Details of Comments
Objective Balances Procedures
Current year acquisitions Foot the acquisitions schedule. Footing the acquisitions
in the acquisitions schedule and tracing individual
schedule agree with Trace the acquisitions should be limited
individual
acquisitions to the unless controls are deficient.
master file
related master file
All increases in the general
for amounts and descriptions.
amounts and the total
ledger balance for the year
agrees with the general
Trace the total to the general
should reconcile to the
ledger (detail tie-in).
ledger. schedule.
Current year acquisitions Examine vendors’ invoices and It is uncommon to physically
as listed exist (existence). receiving reports. examine assets acquired unless
Physically examine assets. controls are deficient or
amounts are material.
Existing acquisitions are Examine vendors’ invoices of This objective is one of the
recorded (completeness). closely related accounts such as most important for equipment.
repairs and maintenance to
uncover items that should be
recorded as equipment.
Current year acquisitions Examine vendors’ invoices. Extent depends on inherent risk
as listed are accurate and effectiveness of internal
(accuracy). controls.

8
Current year acquisitions Examine vendors’ invoices in The objective is closely related
as listed are correctly various equipment accounts to to tests for completeness. It is
classified (classification). uncover items that should be done in conjunction with that
office equipment, part of the
objective and tests for
buildings, classified as
manufacturing or repairs. accuracy.
Examine vendors’ invoices of
closely related accounts such as
repairs to uncover items that
should be recorded as
equipment.
Examine rent and lease expense
for capitalizable leases.
Current year acquisitions Review transactions near the Usually done as part of
are recorded in the correct balance sheet date for correct accounts payable cut-off tests.
period (cutoff). period.
The client has rights to Examine vendors’ invoices. Ordinarily the main concern is
current year acquisitions whether equipment is owned or
(rights). leased.
Purchase or lease contracts are
examined for equipment and
property deeds, abstracts, and
tax bills are frequently
examined for land or major
buildings.
The starting point for the verification of current year acquisitions is normally a schedule
obtained from the client of all acquisitions recorded in the general ledger property, plant,
and equipment accounts during the year. A typical schedule lists each addition separately
and includes the date of the acquisition, vendor, description, notation of whether it is new or
used, life of the asset for depreciation purposes, depreciation method, and cost.

Sample Plant Assets Master File (Schedule)

S.No Description Date of Supplier Estimated Cost Method Remark
Acquisition Life of Dep. (New/ Used)
1 Equipment
2 Machinery

3 . Verify Current Year Disposals

Transactions involving the disposal of equipment are often misstated when company
internal controls lack a formal method to inform management of the sale, trade-in,
abandonment, or theft of recorded machinery and equipment. If the client fails to record
9
disposals, the original cost of the equipment account will be overstated indefinitely, and net
book value will be overstated until the asset is fully depreciated.

Formal methods of tracking disposals and provisions for proper authorization of the sale or
other disposal of equipment help reduce the risk of misstatement. There should also be
adequate internal verification of recorded disposals to make sure that assets are correctly
removed from the accounting records.

The auditor’s main objectives in the verification of the sale, trade-in, or abandonment of
equipment are to gather sufficient appropriate evidence that all disposals are recorded and at
the correct amounts. The starting point for verifying disposals is the client’s schedule of
recorded disposals. The schedule typically includes the date when the asset was disposed
of, name of the person or firm acquiring the asset, selling price, original cost, acquisition
date, and accumulated depreciation.

The nature and adequacy of the controls over disposals affect the extent of the search. The
following procedures are often used for verifying disposals:

• Review whether newly acquired assets replace existing assets.

• Analyze gains and losses on the disposal of assets and miscellaneous income for
receipts from the disposal of assets.

• Review plant modifications and changes in product line, changes in major costly
computer-related equipment, property taxes, or insurance coverage for indications of
deletions of equipment.
• Make inquiries of management and production personnel about the possibility of the
disposal of assets.
When an asset is sold or disposed of without having been traded in for a replacement asset,
the accuracy of the transaction can be verified by examining the related sales invoice and
property master file. The auditor should compare the cost and accumulated depreciation in
the master file with the recorded entry in the general journal and re-compute the gain or loss
on the disposal of the asset for comparison with the accounting records. When trade-in of
an asset for a replacement occurs, the auditor should be sure that the new asset is
capitalized and the replaced asset correctly eliminated from the records, considering the
book value of the asset traded in and the additional cost of the new asset.

10
 4. Verify Ending Balance of Asset Account
Two of the auditor’s objectives when auditing the ending balance in the equipment accounts
include determining that:
1. All recorded equipment physically exists on the balance sheet date (existence)
2. All equipment owned is recorded (completeness)
When designing audit tests to meet these objectives, auditors first consider the nature of
internal controls over equipment or assess the control risk (Examine the effectiveness of
internal control) and following audit programs:
1. Typically, the first audit step concerns the detail tie-in objective-equipment, as listed
in the master file, agrees with the general ledger.
2. Based on the auditor’s assessment of control risk for the completeness objective, the
auditor may physically examine a sample of major equipment items and trace them
to the master file. If a physical inventory is taken, the auditor normally observes the
count.
3. The auditor normally does not need to test the accuracy or classification of fixed
assets recorded in prior periods because, presumably, they were verified in previous
audits at the time they were acquired. But if there is an idle plant asset with material
balance, the auditor should evaluate whether they should be written down to net
realizable value (realizable value objective) or at least classified separately as “no
operating equipment.”
4. A major consideration in verifying disclosures related to fixed assets is the
possibility of legal encumbrance (impediment). Auditors may use several methods to
determine whether equipment is encumbered, including:

a. Read the terms of loan and credit agreements

b. Mail loan confirmation requests to banks and other lending institutions
c. Have discussions with the client or send letters to legal counsel
5. The proper presentation and disclosure of equipment in the financial statements
must be evaluated carefully to make sure that accounting standards are followed.
Equipment should include the gross cost and should ordinarily be separated from
other fixed assets. Leased property should also be disclosed separately, and all liens
on property must be included in the footnotes. Auditors must perform sufficient tests
to verify that all presentation and disclosure objectives are met.

11
5 . Verify Depreciation Expense
Depreciation expense is one of the few expense accounts not verified as part of tests of
controls and substantive tests of transactions. The recorded amounts are determined by
internal allocations rather than by exchange transactions with outside parties. When
depreciation expense is material, more tests of details of depreciation expense are required
than for an account that has already been verified through tests of controls and substantive
tests of transactions.
The most important balance-related audit objective for depreciation expense is accuracy.
Auditors focus on determining whether the client followed a consistent depreciation policy
from period to period, and the client’s calculations are correct. In determining the former,
auditors must weigh four considerations:
1. The useful life of current period acquisitions
2. The method of depreciation
3. The estimated salvage value
4. The policy of depreciating assets in the year of acquisition and disposition
The client’s policies can be determined by discussions with appropriate personnel and
comparing their responses with information in the auditor’s permanent files. In deciding on
the reasonableness of the useful lives assigned to newly acquired assets, the auditor must
consider the physical life of the asset, the expected life (taking in to account obsolescence
or the company’s normal policy of upgrading equipment), and established company policies
on trading in equipment.
A useful method of auditing depreciation is an analytical procedures test of reasonableness
made by multiplying un-depreciated fixed assets by the depreciation rate for the year. In
making these calculations, the auditor must make adjustments for current year additions and
disposals, assets with different lengths of life, and assets with different methods of
depreciation.

Because accounting standards require footnote disclosures related to fixed asset

depreciation, including disclosure of depreciation methods and related useful lives by asset
class, auditors perform procedures to obtain evidence that the presentation and disclosure-
related audit objectives for depreciation are satisfied. For example, auditors compare
information obtained through audit tests of the depreciation expense accounts to

12
information disclosed in footnotes to ensure the information presented is consistent with the
actual method and assumptions used to calculate and record depreciation.

6 . Verify Ending Balance in Accumulated Depreciation

The debits to accumulated depreciation are normally tested as a part of the audit of
disposals of assets, while the credits are verified as a part of depreciation expense . If the
auditor traces selected transactions to the accumulated depreciation records in the property
master file as a part of these tests, then little additional testing should be required for the
ending balance in accumulated depreciation.

Two objectives are usually emphasized in the audit of the ending balance in accumulated
depreciation:

1. Accumulated depreciation as stated in the property master file agrees with the
general ledger. This objective can be satisfied by test-footing the accumulated
depreciation in the property master file and tracing the total to the general ledger.

2. Accumulated depreciation in the master file is accurate.

In some cases, the life of equipment may be significantly reduced because of reductions in
customer demands for products, unexpected physical deterioration, a modification in
operations, or other changes. Because of these possibilities, auditors must evaluate the
adequacy of the allowances for accumulated depreciation each year to make sure that the
net book value does not exceed the realizable value of the assets.

13