Chapter-Five

Audit of Property, Plant, and Equipment and the Related

Depreciation
4.1. Overview of property, plant and equipment

The term property, plant and equipment (fixed assets) include all 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 of such assets are generally
recognized.
1) Land, such as property used in the operation of the business, has the significant
characteristics of not being subject to depreciation.
2) Building machinery, equipment and land improvements, such as fences and parking lots,
have limited service lives and are subject to depreciation.
3) Natural resources (wasting assets), such as oil wells, coal mines, and tracts of timber, are
subject to depletion as the natural resources are extracted or removed.

Fixed asset constitute a significant proportion of the total assets of many organizations
particularly those engaged in manufacturing activities. Audit of fixed asset is, therefore generally
considered to be an important part of an independent financial audit. Though the number of
transactions involving fixed assets is smaller in number, the amount involved in these
transactions will be very high. Hence the auditor has to give more attention while auditing the
transactions relating to fixed asset.

4.2. Auditors’ objectives in auditing property, plant and equipment

The auditor’s objectives in the audit of fixed assets are

1. Consider internal control over property, plant and equipments.

2. Determine the existence of recorded property, plant and equipment.
3. Establish the completeness of recorded property, plant and equipment.
4. Establish that the client has ownership rights to the recorded property, plant and
equipments
5. Establish the clerical accuracy of schedules of property, plant, and equipment.
6. Determine that the valuation or allocation of the cost of property, plant, and equipment
is in accordance with generally accepted accounting principles.
7. Determine that the presentation and disclosures of property, plant, and equipment,
including disclosure of depreciation methods is appropriate.

In conjunction with the audit of property, plant, and equipment, the auditors also obtain evidence
about the related accounts of depreciation expenses, accumulated depreciation, and repair and
maintenance expenses.
4.3. Internal controls relating to fixed assets

The auditor studies and evaluates the accounting system and the effectiveness of internal control
relating to fixed assets. The auditor’s study and evaluation of internal control relating to fixed
assets covers the following aspects:
1. Segregation and rotation of duties.
2. Authorization of acquisition, transfer and disposal of fixed assets
3. Maintenance and record of documents.
4. Accountability for and safeguarding of fixed assets.
5. Independent checks.

1. Segregation and rotation of duties: The auditor has to see whether there is proper
segregation of various duties relating to fixed assets such as
 Authorization of acquisition and disposals
 Execution of transactions relating to execution and disposals.
 Recording of transactions
 Physical custody of items.
The auditor also has to see whether the duties of various persons relating to fixed assets are
rotated periodically or not.

2. Authorization of acquisition, transfer and disposal of fixed assets:

a) The auditor has to check the internal control relating to capital budgeting. i.e., whether
the proposal for capital expenditure has been received in time in the proper format,
approved by the top management and whether it is properly communicated to the
various departments after the approval.
b) Whether a written authorization from a senior level of the management is included in
the budget.
c) Whether the organization have laid down proper procedures for acquisition of fixed
assets i.e. for inviting quotations, selection of suppliers, approval of prices, payment
terms, safeguard for timely delivery etc.
d) Whether the purchases are made on the basis of competitive bids. And whether there is
requirement for documenting the reasons for making purchases other than at lowest
price.
e) Whether the control over receipt of fixed assets are effective ie., whether the technical
specifications of the assets received are verified with the purchase orders before
accepting and if rejected whether the debit notes are raised promptly.
f) Whether periodic comparisons of the actual expenditures of the fixed assets are
compared with the capital expenditure budget and whether approval from the
competent authority is received if there is a deviation form the budget.
g) Whether there any system of getting prior approval from the competent authority in
case of transfer of fixed assets from one department to another?
h) Whether adequate controls exist for disposal of fixed assets i.e. with proper
authorization, invitation of quotations, approval of prices, proper documentation etc
 3. Maintenance of records and documents

a) The auditor has to check whether the company maintains proper records of fixed
assets including those items, which are fully depreciated.
b) Whether the organization maintains the record of assets given on lease or used by
the organization but owned by others.
c) Whether a register containing title deeds of the assets are maintained properly.
d) Whether the title deeds or registration documents are kept in safe custody and
verified periodically.
e) Whether the organization maintained a detail record of projects which are in
progress.
f) Whether the expenditures incurred are properly allocated between capital and
revenue.

4. Accountability for and safeguarding of fixed assets

a) Whether there is any system for identification of fixed assets.

b) Whether adequate safeguards are made to protect the fixed assets from fire, theft
accessibility to unauthorized persons, and use of locks burglar alarms etc.
c) Whether the fixed assets are properly insured and the auditor has to check regarding
the adequacy of the cover the time period, etc.
d) Whether the fixed assets are physically verified on a periodic basis including those
assets lying with third parties.
e) Whether follow up action has been taken for the discrepancies between the record
books and physical verifications.
f) Whether there is any system for identifying and reporting damaged, obsolete and
idle fixed assets.

5. Independent checks:
The auditor has to see whether there is any internal audit for fixed assets and determining the
coverage and effectiveness of the internal audit. The auditor has to examine the scope of the
work of the internal auditors and their reports.

Substantive procedures for fixed assets

The auditor determines the nature timing and extent of substantive procedures relating to
fixed assets after evaluating the effectiveness of internal controls. The procedures normally
followed are the following

(A). Examination of records and documents.

1. Verify the opening balances from the previous years financial statements or ledger
accounts.
 2. Verify the additions made during the year from the approval of appropriate authority
copies of purchase orders, invoices receiving reports, acknowledgement form the
supplier and bank statement.
3. Verify the assets constructed during the year by examining work order records,
statement of allocation and apportionments of costs, certificate of work performed,
contractors bills, invoices of suppliers of materials, bank statement etc.
4. Verify the major repairs and maintenance to ensure no revenue expenditure related to
the capital assets is included.
5. Verify the disposal or retirement of fixed assets by examining the approval of
appropriate authority, quotations invited from buyers, contract with the buyer, copy of
the sale bills, evidence of physical deliveries etc.
6. Examine whether the book values and accumulated depreciation of the fixed assets
disposed or discarded are properly adjusted accounting the resulting gains or losses
properly.
7. Verify the minutes of the board of directors, agreements, and correspondence with
lawyers to identify any charges or encumbrances on the fixed assets.
8. Verify the arithmetical accuracy of the fixed asset records.
9. Verify whether the value shown in the financial statement is after charging adequate
depreciation.
10. Examine the evidence of ownership of fixed assets.

(B). Review or observation of a second verification

Though the physical verification is the duty of the management, the auditor can review or
observe the verification by examining the documents relating to the physical verification.

The procedures followed are:

1. Review the instructions issued to the staff entrusted with the responsibility of physical
verification and judges the appropriateness and adequacy of the instructions.
2. Assess the competence of the personnel conducting the physical verification.
3. Examine the frequency of the verification and verify whether it is reasonable in the
circumstances of the case.
4. When direct physical verification is not possible examine any indirect evidence of the
existence of the fixed assets.
5. Tests check the fixed asset record with the physical verification records.
6. Examine the appropriate follow up action taken for the discrepancies revealed by
physical verification with the fixed asset records.
7. Examine whether appropriate adjustments have been made in the fixed asset records
and financial accounts for obsolescence, damage, or other losses reveled by the
physical verification.
(C). Examination of Valuation and disclosure

1. Examine whether the fixed assets have been valued according to the generally
accepted accounting principles.
2. Examine whether adequate depreciation have been provided.
 3. Examine whether the fixed assets have been revalued in a systematic/ scientific/
appraisal basis considering the future life and the possibility of obsolescence.
4. Examine the basis on which the consideration has been approportionated to various
assets when several assets have been purchased for a consolidated price.
5. Examine the relevant documents such as title deeds agreements etc in order to
ascertain the extent of the shares of the organization when the organization owns
assets jointly with others.

(D). Analytical Procedures: -The analytical procedures employed by the auditors in the audit
of fixed assets are the following:

1. Compare the additions or disposals of fixed assets made during the year with the
budgeted figures.
2. Compare the ratio of depreciation for the current year to the average book value of
the fixed assets with the corresponding figures of the previous year.
3. Compare the amount of repairs and maintenance of the current year with the figures
of the previous year.
4. Compare the ratio of actual capacity utilization with the installed capacity of the
current year with the figures of the previous year.

(E). Obtaining Management Representation

The auditor has to obtain an appropriate representation form the management concerning the
fixed assets stating that the fixed assets shown in the balance sheet are arrived at after
considering all capital expenditures on additions, eliminating the cost and accumulated
depreciation relating to the items discarded, destroyed and disposed off and adequate
depreciation has been provided for during the current year.

4.4. Audit program for auditing fixed assets

The following procedures are typical of the work required in many engagements for the
verification of property, plant and equipments.

A) Consider internal control over property, plant and equipment

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

Auditors may use written description, flow chart or internal control questionnaire to describe the
nature of client’s internal control structure. After preparing description of internal control, the
auditors will determine whether the controls as described to them have been placed in operation,
whether there is appropriate segregation of duties and considered the misstatements that may
occur.

2. Assess control risk and design additional tests of control for the assertions
about property, plant, and equipment.
Based on an understanding of the client’s internal control over property, plant and equipment, the
auditors develop their planned assessed level of control risk for the various financial statement
assertion assertions and obtain additional evidences of the operating effectiveness of the client’s
controls by designating additional tests of control.

3. Perform additional tests of controls for those controls that the auditors plant to consider to
support their planned assessed levels of control risk.
As auditors obtain an understanding of the client’s internal control; certain tests of control are
performed.
E.g. select a sample of purchase of plant and equipment to test the control related to
authorization, receipts and proper recording of the transactions.

4. Reassess control risk for each of the major financial statements assertions about property,
plant, and equipments based on the results of tests of controls and, if necessary, modify
substantive tests.

The final step in the auditor’s consideration of internal control involves a reassessment of control
risk based on the results of the tests of control. On the basis of the reassessed level of control risk
auditor modify their planned program of substantive testing procedures for property, plant, and
equipment assertions.

B. Perform substantive tests of property, plant and equipments and related

depreciation transactions and balances

The objective of major substantive testing procedures of property, plant and equipment
balances are given in the following table.

Subjective Test Primary audit objective to be

addressed
5. Obtain a summary analysis of changes in property owned
and reconcile to ledgers -The summary analysis shows the
beginning balances of property, plant, and equipment, Clerical accuracy
additions to and/or retirement from property, plant, and
equipments and ending balances of property plant and
equipments. Auditors reconcile subsidiary ledgers with the
Controlling accounts
6. Vouch additions to property, plant and equipment during
year – The vouching process utilizes a working paper
analysis of the general ledger controlling accounts and
includes the tracing of entries through the journal to
original documents such as contracts, construction work
orders, invoices canceled checks authorization by
appropriate individuals
7. Make physical inspection of major acquisitions Existence and right
 The auditors usually make a physical inspection of valuation or allocation
major units of plant and equipment acquired during
the year under audit by comparing the physical assets
 with underlying records.
 Helps to maintain good working knowledge of the
Client’s operations and also in interpreting the
accounting entries for both additions and
retirements.
8. Analyze repair and maintenance expenses accounts
 The auditors principal objective in in analyzing repair and
maintenance expense accounts is to discover items that
should have capitalized Valuation and allocation
 To determine that there is proper repair and maintenance
charges, the auditors will trace the ledger expenditures to
written authorizations for the transactions.
9. Investigate the status of property, plant and equipment
 Auditors investigate plant assets currently in use, plant
assets not currently in use but expected to be used in Valuation and allocation
the future operation (depreciate at normal rate); and Presentation and disclosure
plant assets dismantled, found to be unsuitable for
future operating use(should be written down their net
realizable value and should not be classified as plant
assets.

10. Test the client’s provision for depreciations

 Review and test management’s process of developing
the estimate
 Review subsequent events or transactions bearing on
the estimates Valuation and allocation
 Independently develop an estimate of the amounts to
compare to management’s estimates
11. Investigate potential impairments of property, plant, and
equipments - Whenever events or changes in
circumstances indicate that the carrying amount of long
lived assets may not be recoverable ie if the sum of the
expected future cash flows from the assets is less than its
carrying amounts, an impairments loss is recognized.

12. Investigate retirement of property, plant and equipment

during the year
 The principal purpose of this procedures is to determine
Whether any property has been replaced, sold, dismantle
or abandoned without such actions being reflected in the
Accounting records.
13. Examine evidence of legal ownership Existence and right
 To determine that plant assets are property of the client,
the auditors look for such evidences as a deeds, title,
insurance policy, property tax bills, receipts, for payments
to mortgages and fire insurance policies.
14. Review rental revenues-rental revenues from land, building,
 equipments, machinery, and so on should be reviewed and
the party responsible to pay cost of electricity, water,
telephone should be reconciled against with provisions of
utility expenses.

15. Examine lease agreements on property, plant and

equipments i.e. lease to and/ or form other party. The
auditors should carefully examine lease agreements to
determine whether the accounting for assets involved in
proper (in accordance with the requirements of GAAP) Existence and right
E.G Capitalization of assets leased by the client company. Completeness
Valuation or allocation
16. Perform analytical procedures for property, plant, and
equipments
 Auditors may use trends and ratios to judge the
reasonableness of recorded amounts for plant and
equipments
e.g. - Cost of plant assets/ annual out put in dollar or
other units
 Monthly repair and maintenance expense to yearly
amounts
 Compare acquisition and retirements of current year to
prior years.

17. Evaluate financial statements presentation and disclosure Presentation and disclosure
for property, plant and equipment and for related revenues
and expenses.
 The balance sheet or accompanying notes should
disclose balances of major classes of depreciable assets,
accumulated depreciation, method(s) for computing
depreciation, base of valuation, property pledged and
property not in current use.

4.5 Auditors perspective towards depreciation

Depreciation is the decrease in the value of the asset due to wear and tear, obsolescence, lapse of
time etc. Fixed assets are to be disclosed in the balance sheet at their cost or at the revalued
amount less depreciation

Determining the annual depreciation expense involves two rather arbitrary decisions by the
client company: first, an estimate of the useful economic lives of various groups of assets, and
second, a choice among several depreciation methods, each of which would lead to a different
answers. The wide range of possible amounts for annual depreciation expense because of these
decisions by the client suggests that the auditors should maintain a perspective of looking for
 assurance of overall reasonableness. Specifically, overall tests of the year/s depreciation expense
are of special importance.
Accordingly, the auditor has to examine whether adequate depreciation has been provided in the
books in respect of all depreciable assets according to the provisions of the relevant statutes.

While auditing depreciation, the auditor has to examine the following points in respect of
depreciation

1. Whether adequate depreciation has been provided during the current year.
2. Whether the depreciation has been calculated by appropriate methods.
3. Whether appropriate method has been selected after considering the useful life of the
asset and salvage value.
4. Whether the method of calculating depreciation has been consistent over the years.
5. Whether any change in the method has been properly disclosed in the financial
statements.
6. Whether accumulated depreciation in respect of discarded or disposed assets have been
adjusted in the accumulated depreciation amount.
7. Whether depreciation has been provided properly on the assets added or disposed of
during the current year.
8. Whether depreciation has been provided on revalued assets
9. Whether the depreciation has been properly disclosed in the financial statements.

4.5.1 The auditors’ objectives in auditing depreciation

When evaluating the reasonableness of depreciation (with accounting estimate), auditors use one
or more of the following three basic approaches.
1). Review and test management’s process of developing the estimates
2). Review subsequent events or transactions that might have bearing on the estimate to
management’s estimate
3). Independently develop an estimate of the amounts to compare to managements
estimate.

4.5.2 Audit program-Depreciation expense and accumulated depreciation

The following outlines of substantive tests to be performed by the auditors in reviewing

depreciation are stated in sufficient detail to be largely self-explanatory.

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 technology or economic developments.
2) Obtain or prepare a summary analysis of accumulated depreciation for the major property
classification as shown by general ledger 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 accumulated depreciation recorded in the plant and equipment
subsidiary records agree with the applicable general ledger controlling accounts.
3). Test the provisions for depreciations
(a). Compare rates used in prior years and investigate any variance.
(b). Test computations of depreciations for provisions for a representatives
number of units and trace to individuals records in the property ledger. Be alert for
excessive depreciation on fully depreciated assets.
(c). Compare credits to accumulated depreciation accounts the year’s depreciation
provisions with debits entries in related depreciation expenses accounts.
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 retirements.
5). Perform analytical procedures for depreciation
(a) Compute the ratio of depreciation expenses to total cost of plant and compare with
prior years.
(b). Compare the percentage relationships between accumulated depreciation and related
property accounts with that prevailing in prior years. Discuss significant variations from
normal depreciation program with appropriate members of managements.