All Posts by Charles Hall

Today, I tell you how to audit plant, property, and equipment (or capital assets if you work with governments).

Plant, property, and equipment is often the largest item on a balance sheet. But the risk is often low to moderate. After all, it’s difficult to steal land or a building. And the accounting is usually not difficult. So the dollar amount can be high but the risk low.

In this post, we’ll answer questions such as, “how should we test additions and retirements of property?” and “what should we do in regard to fair value impairments?” 

I will—at times—refer the plant, property, and equipment as property.

Property is purchased for use in a business. For example, a corporate office might be bought or constructed. The building is an asset that is depreciated over its economic life. As depreciation is recorded, the book value (cost less accumulated depreciation) of the building decreases as depreciation is recognized. In other words, you expense the building as it is used.

In most reporting frameworks, including GAAP, assets are recorded at cost. Appreciation in market value is not recorded, but significant decreases, known as impairments, are booked. Property improvements (e.g., adding a new room to an existing building) are capitalized and depreciated. Repairs (e.g., painting a room) that don’t extend the life of an asset are expensed.

Also, most businesses elect to use a capitalization threshold such as $5,000. For these entities, amounts paid below the threshold are not capitalized, even if they extend the life of the asset. The amounts below the threshold are expensed as incurred.

So, how do most entities track property purchases and compute the related depreciation? They use depreciation software. Then when property is purchased, it is added to the depreciation software and an economic life (e.g., ten years) is assigned.

Below we will cover the following:

• Primary property assertions
• Property walkthroughs
• Directional risk for property
• Primary risks for property
• Common property control deficiencies
• Risk of material misstatement for property
• Substantive procedures for property
• Common property work papers

The primary relevant property assertions are:

• Existence and occurrence
• Completeness
• Valuation
• Classification

Of these assertions, I believe—in general—existence, occurrence, and classification are most important. So, the client is asserting that property exists, that depreciation expense is appropriate, and that amounts paid for property are capitalized (and not expensed).

As we perform walkthroughs of property, we are looking for ways that property might be overstated (though understatements can occur as well). 

As we perform the property walkthrough, we ask, “what can go wrong, whether intentionally or by mistake?”

In performing the walkthrough, ask questions such as:

• Are property ledgers reconciled to the general ledger?
• Does the entity use reasonable and consistent depreciation methods?
• Are the depreciation methods in accordance with the reporting framework (e.g., straight line for GAAP or accelerated for tax basis)
• Who records depreciation? 
• Are the economic lives assigned to property appropriate?
• What controls ensure that property is recorded in the right period?
• What controls ensure that capital leases are capitalized as property (if applicable, see GAAP lease standards)?
• Is there appropriate segregation of duties between persons that purchase, record, reconcile, and physically possess property?
• What software is used to compute depreciation?
• Does the company perform periodic physical inventories of property?
• Are assets removed from the depreciation schedule upon sale?
• What controls ensure that property purchases are added to the depreciation schedule (and not expensed as repairs and maintenance)?
• What controls ensure that repair expenses are not capitalized as property?
• What is the capitalization threshold (e.g., $5,000)?

As we ask questions, we also inspect documents (e.g., depreciation reports) and make observations (e.g., who has access to moveable property?).

If control weaknesses exist, we create audit procedures to respond to them. For example, if—during the walkthrough—we see that one person purchases property, has physical access to equipment, and performs the related accounting, then we will perform theft-related substantive procedures.

The directional risk for property is overstatement. So, in performing your audit procedures, perform procedures to ensure that property is not overstated. For example, vouch all significant property additions to invoices. See if the amounts added are equal to or greater than the capitalization threshold (e.g., $5,000).

The primary risks for property are:

1. Property is intentionally overstated
2. Repair expenses (or any other expenses) are improperly capitalized as property
3. Purchases that should be recorded as property are expensed
4. Depreciation is improperly computed and recorded (e.g., accelerated depreciation is used when straight-line is more appropriate)
5. Moveable property (e.g., equipment) is stolen

In smaller entities, it is common to have the following control deficiencies:

• One person performs more than one of the following:
• Authorizes the purchase of property
• Enters the property in the general ledger and depreciation schedule
• Has physical custody of the property
• Has responsibility for reconciling the depreciation schedule to the general ledger
• The person computing depreciation doesn’t have sufficient knowledge to do so 
• A second person does not review the depreciation methods for appropriateness and economic lives assigned to each property
• No one performs surprise audits of property
• No one performs physical inventories of property
• There are no controls over the disposal of property
• Appropriate bidding procedures are not used
• No one reconciles the depreciation schedule to the general ledger
• Property is not reviewed for potential impairments of value

In smaller engagements, I usually assess control risk at high for each assertion. If control risk is assessed at less than high, then controls must be tested to support the lower risk assessment. Assessing risks at high is usually more efficient than testing controls.

When control risk is assessed at high, inherent risk becomes the driver of the risk of material misstatement (controls risk X inherent risk = risk of material misstatement). The assertions that concern me the most are existence (for additions to property), occurrence (for depreciation), and classification (of property). With regard to classification, the business determines whether the amount should be capitalized or expensed. So my RMM for these assertions is usually moderate to high.

My response to higher risk assessments is to perform certain substantive procedures: namely, the vouching of additions to property. As RMM increases I lower the dollar threshold for vouching property additions.  

If controls related to bids are weak, your RMM for existence can be high. Bid rigging or kickbacks—fraudulent vendor actions—can result in overstatements of asset additions. 

My customary audit tests are as follows:

1. Vouch property additions to related invoices

2. Agree opening property balances in the depreciation schedule to the prior year ending balances

3. Review economic lives assigned to new property for appropriateness

4. Review the selected depreciation method in light of the property’s life

5. Compute a ratio of depreciation to property and compare the result with prior periods

6. Review new lease agreements to determine if they should be capitalized

7. Inquire about potential decreases in the value of property and request valuations if necessary

My property work papers normally include the following:

• An understanding of property-related internal controls
• Risk assessment of property at the assertion level
• Documentation of control deficiencies related to property
• Property audit program
• A copy of the depreciation schedule that agrees to the general ledger
• A summary of additions and retirements of property in the current audit period
• Bid documents for significant construction projects or other property purchases
• A valuation of a significant asset by a valuation specialist, if merited (potential impairment)

In this article, we looked at how to perform property risk assessment procedures, the relevant property assertions, the property risk assessments, and substantive property procedures.

Next it’s time to turn our attention to the audit of accounts payable and expenses.

Today we take a look at auditing receivables and revenues.

Revenues are the lifeblood of any organization. Without cash inflows, the entity may cease to exist. So, it’s important that each business generate sales or some type of revenue. For you, the auditor, it’s important to verify the revenue.  

Along with revenues, auditors need to prove receivables. Why? Some companies manipulate their earnings by inflating their period-end receivables.  When trade receivables increase, revenues increase. So, a company can increase its net income by recording nonexistent receivables.

In this post, we’ll answer questions such as, “should I confirm receivables or examine subsequent receipts?” and “why should I assume that revenues are overstated?"

Auditing Receivable and Revenues — An Overview

In this post, we will cover the following:

1. Primary accounts receivable and revenue assertions
2. Accounts receivable and revenue walkthrough
3. Directional risk for accounts receivable and revenues
4. Primary risks for accounts receivable and revenues
5. Common accounts receivable and revenue control deficiencies
6. Risk of material misstatement for accounts receivable and revenues
7. Substantive procedures for accounts receivable and revenues
8. Common accounts receivable and revenue work papers

Primary Accounts Receivable and Revenue Assertions

First, let’s look at assertions. The primary relevant accounts receivable and revenue assertions are:

• Existence and occurrence
• Completeness
• Accuracy
• Valuation
• Cutoff

Of these assertions, I believe—in general—existence (of receivables), occurrence (of revenues) and valuation (of receivables) are most important. So, clients assert that:

• Receivables exist 
• Receivables are properly valued, and 
• Revenues occurred

Accuracy comes into play if the customer has complex receivable transactions. Additionally, the cutoff assertion is often relevant, especially if the client has incentives to inflate the receivables balance (e.g., bonuses triggered at certain income levels).

Accounts Receivable and Revenue Walkthrough

Second, think about performing your risk assessment work in light of the relevant assertions.

As we perform walkthroughs of accounts receivable and revenue, we are looking for ways they are overstated (though they can also be understated as well). We are asking, “What can go wrong, whether intentionally or by mistake?”

In performing accounts receivable and revenue walkthroughs, ask questions such as:

• Are receivables subsidiary ledgers reconciled to the general ledger?
• Is a consistent allowance methodology used?
• What method is used to compute the allowance and is it reasonable?
• Who records and approves the allowance?
• Who reviews aged receivables?
• What controls ensure that revenues are recorded in the right period?
• Is there adequate segregation of duties between persons recording, billing, and collecting payments? Who reconciles the related records?
• What software is used to track billings and collections?
• Are there any decentralized collection locations?
• When are revenues recognized and is the recognition in accordance with the reporting framework?
• What receivables and revenue reports are provided to the owners or the governing body?

As we ask questions, we also inspect documents (e.g., aged receivable reports) and make observations (e.g., who collects the payments?).

If controls weaknesses exist, we create audit procedures to respond to them. For example, if—during the walkthrough—we see inconsistent allowance methods, we will perform more substantive work to prove the allowance balances.

Directional Risk for Accounts Receivable and Revenues

Third, consider the directional risk of accounts receivable and revenues.

The directional risk for accounts receivable and revenue is an overstatement. So, in performing your audit procedures, perform procedures to ensure that accounts receivables and revenues are not overstated. For example, review the cutoff procedures at period-end. Be sure that no subsequent period revenues are recorded in the current fiscal year. 

Audit standards require that auditors review estimates for management bias. So, consider the current year allowance and bad debt write-offs in light of the prior year allowance. This retrospective review allows the auditor to see if the current estimate is fair. The threat is that management might reduce allowances to inflate earnings.

Moreover, the audit standards state there is a presumption (unless rebutted) that revenues are overstated. Therefore, we are to assume revenues are overstated, unless we can explain why they are not.

Primary Risks for Accounts Receivable and Revenues

Fourth, think about the risks related to receivables and revenues.

The main risks are:

1. The company intentionally overstates accounts receivable and revenue 
2. Company employees steal collections 
3. Without proper cutoff, an overstatement of accounts receivables and revenue occurs 
4. Allowances are understated
5. Revenue recognition

Risks related to revenue also vary from company to company. For example, one telecommunications company might sell bundled services while another may not. Revenue recognition is more complex (risky) for the company selling bundled services.

Also, revenue risks vary from industry to industry. For example, the allowance for uncollectible is normally a high risk area for healthcare entities, but may not be so for other industries.

Common Accounts Receivable and Revenue Control Deficiencies

Fifth, think about the control deficiencies noted during your walkthroughs and other risk assessment work.

In smaller entities, the following control deficiencies are common:

• One person performs one or more of the following: 
• bills customers
• receipts monies
• makes deposits 
• records those payments in the general ledger
• reconciles the related bank account
• The person computing allowances doesn’t possess sufficient knowledge to do so correctly
• No surprise audits of receivables and revenues 
• Multiple people work from one cash drawer
• Receipts are not appropriately issued
• Receipts are not reconciled to daily collections
• Daily receipts are not reviewed by a second person
• No one reconciles subsidiary receivable ledgers to the general ledger
• Individuals with the ability to adjust customer receivable accounts (with no second-person approval or review) also collect cash 
• Inconsistent bad debt recognition with no second-person review process
• The revenue recognition policy may not be clear and may not be in accordance with the reporting framework

Risk of Material Misstatement for Accounts Receivable and Revenues

Sixth, now it’s time to assess your risks.

In smaller engagements, I usually assess control risk at high for each assertion. Controls must be tested to support any lower control risk assessments. Assessing risks at high is often more efficient than testing controls.

When control risk is assessed at high, inherent risk becomes the driver of the risk of material misstatement (inherent risk X control risk = risk of material misstatement). The assertions that concern me the most (those with higher inherent risks) are existence, occurrence, and valuation. So my RMM for these assertions is usually moderate to high.

My response to higher risk assessments is to perform certain substantive procedures: namely, receivable confirmations and tests of subsequent collections. As RMM increases, I send more confirmations and examine more subsequent collections.

Additionally, I thoroughly test management’s allowance computation. I pay particular attention to uncollected amounts beyond 90 days. Uncollected amounts beyond 90 days should usually be heavily reserved. And amounts beyond 120 days should—generally—be fully reserved.  

Substantive Procedures for Accounts Receivable and Revenues

And finally, it’s time to determine your substantive procedures in light of your identified risks.

My customary audit procedures are as follows:

1. Confirm accounts receivable balances (especially larger amounts)
2. Vouch subsequent period collections, making sure the subsequent collections relate to the period-end balances (sampling can be used)
3. Thoroughly review allowance computations to see if they are consistent with prior years; compare allowance percentages to industry averages; agree to supporting documentation (e.g., histories of uncollectible amounts); recompute the related numbers
4. Create comparative summaries of all significant revenue accounts, comparing the current year amounts with historical data (three or more years if possible)
5. Create summaries of average per customer income and compare with prior years (you may want to do this by specific revenue categories)
6. Compute average profit margins by sales categories and compare with previous years

Common Accounts Receivable and Revenue Work Papers

My accounts receivable and revenue work papers frequently include the following:

• An understanding of accounts receivable and revenue-related internal controls
• Risk assessment of accounts receivable and revenue at the assertion level
• Documentation of any control deficiencies
• Accounts receivable and revenue audit program
• A detail of receivables comprising amounts on the general ledger
• Copies of confirmations sent
• A summary of confirmations received
• Subsequent collections work papers
• Allowance work paper
• Revenue comparison work papers

In Summary

In this chapter, we’ve looked at the following for receivables and revenues:

• How to perform risk assessment procedures, 
• Relevant assertions, 
• Risk assessments (as a result of the risk assessment procedures), and
• Substantive procedures

Next, we’ll see how to audit plant, property, and equipment.