Unit 5: Auditing Objectives and Procedures for Property, Plant and Equipment Including

Depreciation
Introduction:
Transactions in the acquisition and payment cycle affect several asset accounts: supplies,
property, plant and equipment, and prepaid expenses accounts, to name a few. Payments made
for services also affect many expense accounts. To continue our discussion of the acquisition and
payment cycle, this section examines audit issues related to other accounts commonly found in
the acquisition and payment cycles of most businesses.
Property, plant, and equipment are assets that have expected lives of more than one year, are
used in the business, and are not acquired for resale. The intent to use the assets as part of the
operation of the client’s business and their expected lives of more than one year are the
significant characteristics that distinguish these assets from inventory, prepaid expenses, and
investments.
Chapter topics:
1. The auditors’ approach in examination of property plant, and equipment
2. Objectives for the Audit of Property, Plant and Equipment
3. Audit procedure for property, plant, and equipment.

5.1 The auditors’ approach in examination of property, plant and equipment

Property plant and equipments 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
Three major subgroups:
• Land
• Buildings, machinery, equipment and land improvements
• Natural resources
Acquisitions and disposals of property, plant, and equipment are usually large in dollar amount,
but concentrated in only a few transactions. Individual items of plant and equipment may remain
unchanged in the accounts for many years.

5.2 Objectives for the Audit of Property, Plant and Equipment

The auditors’ objectives are to determine that:

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1. Use the understanding of the client and its environment to consider inherent risk, including
fraud risks, related to property, plant, and equipment.
2. Obtain an understanding of internal control over property, plant, and equipment.
1. 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
In conjunction with the audit of property, plant and equipment, the auditors also obtain evidence
about the related accounts of depreciation expense, accumulated depreciation, and repairs and
maintenance expense.

Contrast with audit of current assets

In many companies, the investment in plant and equipment amounts to 50 percent or more of the
total assets. However, the audit work required to verify these properties is usually a much
smaller proportion of the total audit time spent on the engagement.

The verification of plant and equipment is facilitated by several factors not applicable to audit
work on current assets.
First, a typical unit of property or equipment has a high dollar value, and relatively few
transactions may lie behind a large balance sheet amount. Second, there is usually little change in
the property accounts from year to year. The land account often remains unchanged for a long
span of years. The durable nature of buildings and equipment also tends to hold accounting
activity to a minimum for these accounts. By way of contrast, such current assets as accounts
receivable and inventory may have a complete turnover several times a year.

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A third point of contrast between the audit of plant asset and the audit of current assets is the
significance of the year-end cut off of transactions for current assets, the year end cutoff is a
critical issue; for plant assets, it is generally not.

Audit approach – current accounts vs. non current accounts

Cash accrued high turnover accounts

securities accounts payable audit approach –audit
the balance
Accounts receivable short-term note
Inventories

Property, plant and equipment long-term liabilities low turnover

accounts
Intangible assets owner’s equity Audit approach-
audit the changes
In the accounts

Internal controls over plant and equipment

The principal purpose of internal controls relating to plant and equipment is to obtain maximum
efficiency from the dollars invested in plant assets.

The amounts invested in plant and equipment represents a large portion of the total assets of
many industrial concerns. The expenses of maintenance, rearrangement, and depreciation of
these assets are a major factor in the income statement. The sheer size of the amounts involved
makes strong internal controls essential to the production of reliable financial statements.
Major control devices
Important controls applicable to plant and equipment are as follows:
1. There should be an annual plant budget used to forecast and to control acquisitions and
retirements of plant and equipment.
2. A subsidiary ledger consisting of a separate record for each unit of property.
3. A system of authorization requiring advance executive approval of all plant and
equipment acquisitions, whether by purchase, lease, or construction.

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 4. A reporting procedure assuring prompt disclosure and analysis of variances between
authorized expenditures and actual costs.
5. An authoritative written statement of company policy distinguishing between capital and
revenue expenditures. A dollar minimum ordinarily will be established for
capitalization; any expenditures of lesser amount automatically are classified as charges
against current revenue.
6. A policy requiring all purchases of plant and equipment to be handled through the
purchasing department and subjected to standard routines for receiving, inspection, and
payment.
7. Periodic physical inventories, designed to verify the existence, location, and condition of
all property listed in the accounts and to disclose the existence of any unrecorded units.
8. A system of retirement procedures, including serially numbered retirement work orders,
stating reasons for retirement and bearing appropriate approvals.

5.3 Audit procedure for property, plant, and equipment.

The following procedures are typical of the work required in many engagements for the
verification of property, plant and equipment.
A. Use the understanding of the client and its environment to consider inherent risks, including
fraud risks, related to property, plant, and equipment.
B. Obtain an understanding of internal control over property, plant, and equipment.
In the study of internal control for plant and equipment, the auditors may utilize a written
description, flowcharts, or an internal control questionnaire.

The following are typical of the questions included in a questionnaire;

 Are plant ledgers regularly reconciled with general ledger controlling accounts?
 Are periodic physical inventories of plant asset compared with the plant ledgers?
 Are variances between plant budgets and actual expenditures for plant assets subject to
review and approval of executives?
 Does the sale, transfer, or dismantling of equipment require written executive approval on
a serially numbered retirement work order?
 Is there a written policy for distinguishing between capital expenditures and revenue
expenditures?

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C. Assess the risks of material misstatement and design further audit procedures.
Control risk for a financial statement assertion may be assessed below the maximum only when
tests indicate that related controls are designed and operating effectively. The auditors must
decide which additional tests of controls will likely result in cost justified restrictions of
substantive tests.
D. Perform further audit procedures—tests of controls.
1. Nature of tests of controls.
2. If necessary, revise the risks of material misstatement based on the results of tests of
controls.
The purpose of tests of controls for plant assets is to determine whether the internal controls
established by the client are being followed consistently in practice. For example, if the client
uses serially numbered retirement work orders to authorize the disposal of plant assets, the
auditors may test this control by matching known retirements with retirement work orders and by
comparing individual work orders with entries in the subsidiary ledgers for plant and equipment.
Another test is to examine copies of reconciliations of the subsidiary ledgers with general ledger
controlling accounts to determine whether these reconciliations have, in fact, been regularly
prepared and have been approved by an appropriate official.
E. Perform further audit procedures—substantive procedures for property, plant, and equipment.

1. Obtain a summary analysis of changes in property owned and reconcile to ledgers.

The auditors may verify the beginning balances of plant and equipment assets by reference to the
prior year’s audit working papers. In addition to beginning balances, the summary analysis will
show the additions and retirements of plant and equipment during the year under audit. As the
audit progresses, the auditors will verify in detail these additions and retirements.

2. Vouch additions to property, plant, and equipment during the year.

The vouching of additions to the property accounts during the period under audit is one of the
most important substantive tests of plant and equipment. The extent of the vouching is
dependent up on the auditors’ assessment of control for plant and equipment expenditures. The
vouching process utilizes a working paper analysis of the general ledger controlling accounts and

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includes the tracing of entries through the journals to original documents, such as contracts,
deeds, construction work orders, invoices, canceled checks, and authorization by directors.
3. Make a physical inspection of major acquisitions of plant and equipment.
The auditors usually make a physical inspection of major units of plant and equipment acquired
during the year under audit. This step is helpful in maintaining a good working knowledge of the
client’s operations and also in interpreting the accounting entries for both additions and
retirements. Physical inspection is particularly appropriate if there appear to be weaknesses in
the client’s internal controls over plant assets.

The audit procedure of Physical inspection may flow in either direction between the plant assets
and the records of plant assets. By tracing items in the plant ledger to the Physical assets, the
auditors prove that the assets shown in the accounting records actually exist and are in current
use. The alternative testing procedure is to inspect selected assets in the plant and trace these
assets to the detailed records. This test provides evidence that existing assets are recorded.

4. Analyze repair and maintenance expense accounts.

The auditors’ principal objective in analyzing repair and maintenance expense accounts is to
discover items that should have been capitalized. Many companies have a written policy setting
the minimum expenditure to be capitalized. For example, company policy may prescribe that no
expenditure for less than Br. 300 shall be capitalized regardless of the service life of the item
purchased. In such cases, the auditors will analyze the repair and maintenance accounts with a
view toward determining the consistency of application of this policy as well as compliance with
generally accepted accounting principles.

5. Investigate the status of property, plant, and equipment not in current use.
Land, buildings, and equipment not in current use should be investigated thoroughly to
determine the prospects for their future use in operations. Plant assets that are temporarily idle
need not be reclassified, and depreciation may be continued at normal rates. On the other hand,
idle equipment that has been dismantled, or that for any reason appears unsuitable for future
operating use, should be written down to an estimated realizable value and excluded from the
plant and equipment classification.

6. Test the client’s provision for depreciation.

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We have emphasized the importance of determining the overall reasonableness of the amount of
depreciation expense, which is usually a very material amount on the income statement. An
overall test of the annual provision for depreciation requires the auditors to perform the
following steps:
1. List the balances in the various asset accounts at the beginning of the year.
2. Deduct any fully depreciated assets, since these items should no longer be subject to
depreciation.
3. Add one half of the asset additions for the year.
4. Deduct one half of the asset retirements for the year (exclusive of any fully depreciated
assets).

These four steps produce average amounts subject to depreciation at the regular rates in each of
the major asset categories. By applying the appropriate rates to these amounts, the auditors
determine on an overall average basis- the amount of the provision for depreciation. The
computed amount is then compared with the client’s figures. Precise agreement is not to be
expected, but any material difference between the depreciation expense computed in this manner
and the amount set up by the client should be investigated fully.
 Perform analytical procedures
 Vouch entries to capital stock accounts
 Vouch entries to retained earnings
 Review articles of incorporation and bylaws
 Review authorizations and terms of stock issues
 Confirm shares outstanding with registrar and transfer agent
 Inspect stock certificate book
 Inspect certificates of shares held in treasury

Auditors’ Approach for Depreciation

 Important because depreciation is an estimate.
 Client makes
• Estimate of useful economic life
• Choice of several depreciation methods

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  Audit approach for estimate
• Review and test management’s process of developing the estimate
• Review subsequent events or transactions bearing on the estimate
• Independently develop an estimate of the amount to compare to management’s
estimate

Audit Program – Depreciation

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 technological or economic developments.
2. 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.
a. Compare beginning balances with the audited amounts in last year’s working
papers.
b. Determine that the totals of accumulated depreciation recorded in the plant and
equipment subsidiary records agree with the applicable general ledger controlling
accounts
3. Test the provisions for depreciation.
a. Compare rates used in the current year with those employed in prior years and
investigate any variances.
b. Test computations of depreciation provisions for a representative number of units
and trace to individual records in the property ledger. Be alert for excessive
depreciation on fully depreciated assets. Generalized audit software can be used to
test the depreciation calculations in the client’s records if the client maintains
computer based records.

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 c. Compare credits to accumulated depreciation accounts for the year’s depreciation
provisions with debit entries in related depreciation expense 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 retirement.
c. Perform analytical procedures for depreciation.
d. Compute the ratio of depreciation expense to total cost of plant and compare with
prior years.
e. Compare the percentage relationships between accumulated depreciation and
related property accounts with those prevailing in prior years. Discuss significant
variations from the normal depreciation program with appropriate members of
management.
Overall test
1. List the balances in the various asset accounts at the beginning of the year.
2. Deduct any fully depreciated assets, since these items should no longer be subject to
depreciation.
3. Add one-half of the asset additions for the year.
4. Deduct one-half of the asset retirements for the year (exclusive of any fully depreciated
assets).
7. Investigate potential impairments of property, plant, and equipment.
Long-lived assets must be reviewed for impairment whenever events or changes in
circumstances indicate that carrying value may not be recoverable, Test involves projecting
future cash flows, If impairment is indicated by cash flows asset must be written down to fair
value, May require the use of a valuation specialist

8. Investigate retirements of property, plant, and equipment during the year.

The principal purpose of this procedure is to determine whether any property has been replaced,
sold, dismantled, or abandoned without such action being reflected in the accounting records.
Nearly every thorough Physical inventory of plant and equipment reveals missing units of
property: units disposed of without a corresponding reduction of the accounts.
9. Examine evidence of legal ownership of property, plant, and equipment.

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10. Review rental revenue from land, buildings, and equipment owned by the client but leased to
others.
Examination of leases will indicate whether tenants are responsible for the cost of electricity,
water, gas, and telephone service. These provisions should be reconciled with utility expense
accounts. Rental revenue accounts should be analyzed in all cases and the amount compared
with lease agreements and cash records.

11. Examine lease agreements on property, plant, and equipment leased to and from others.
The auditors must be aware that generally accepted accounting principles require differing
accounting treatments, depending up on whether they qualify as an operating or a capital lease.
The auditors should carefully examine lease agreements to determine whether the accounting for
the assets involved is proper. For example, the auditors must determine whether assets leased by
the client should be capitalized.
12. Perform analytical procedures for property, plant, and equipment.
The specific trends and ratios used in judging the overall reasonableness of recorded amounts for
plant and equipment will vary with the nature of the client’s operations. Among the ratios and
trends often used by auditors for this purpose are the following:
a) Total cost of plant assets divided by annual output in dollars, pounds, or other units.
b) Total cost of plant assets divided by cost of goods sold.
c) Comparison of repairs and maintenance expense on a monthly basis and from year to
year.
d) Comparison of acquisitions for the current year with prior years.
e) Comparison of retirements for the current year with prior years.

13. Evaluate financial statement presentation and disclosure for plant assets and for related revenue and expenses.
The balance sheet or accompanying notes should disclose balances of major classes of depreciable assets.
Accumulated depreciation may be shown by major class or in total, and the method or methods
of computing depreciation should be stated.
The total amount of depreciation should be disclosed in the income statement or supporting notes.
In addition, adequate financial statement presentation and disclosure will ordinarily reflect the
following principles:

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The basis of valuation should be explicitly stated. At present, cost is the generally accepted basis
of valuation for plant and equipment; property not in use should be valued at estimated realizable
value.
Property pledged to secure loans should be clearly identified.
Property not in current use should be segregated in the balance sheet.

Figure 2.7: potential misstatements –investment in property, plant and equipment

Description of Example Internal control weakness or
misstatement factors that increase the risk of
the misstatement
Misstatement of Fraud: .undue pressure to meet earnings
acquisition of property, .expenditures for repairers and targets.
plant and equipment. maintenance expenses recorded as
PPE acquisition to overstate income
Error:
.purchase of equipment erroneously
reported in maintenance and repair .inadequate accounting manual;
expense account incompetent accounting
personnel.
Failure to record Error: .inadequate accounting policies
retirement of PPE .an asset that has been replaced is e.g. failure to use retirement
discarded due to its lack of value, work orders.
without an accounting entity.
Improper reporting of Error: .inadequate accounting manuals;
unusual transactions A “gain” recorded on an exchange of incompetent accounting
monetary assets that lacks commercial personnel
substance.

Figure: Summary of Substantive Tests of Property, Plant, and Equipment

Substantive procedures Primary audit objective
obtain summary analysis of changes in property Valuation
owned and reconcile to ledger
Vouch additions during year. Existence, occurrence and rights
Make physical inspection of major acquisitions. Valuation or allocation
Accuracy
Cutoff
Analyze repair and maintenance expense account Valuation or allocation
Investigate the status of property not in current use. Valuation or allocation
Presentation and disclosure
Test the client’s provision for depreciation. Valuation and allocation
Investigate potential impairments.
Investigate retirement of property during the year. Existence, occurrence and rights
Examine evidence of legal ownership.
Review rental revenue.
Examine lease agreement. Existence and rights
Perform analytical procedures. Completeness
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 Valuation or allocation
Evaluate financial statement presentation and Presentation and disclosure
disclosure

Auditor’s consideration of internal controls for PP&E

There are 4 internal control objectives and associated potential errors or frauds and their related
audit procedures of conversion cycle-fixed assets.
These objectives are:
 Authorization
 Execution
 Recording
 Access to assets
Table 2.10 Authorization: Fixed Assets Objective, Error, Procedure
Objective Error Procedure
Plant additions, disposals, Assets may be purchased, or sold Prepare Written procedures
retirements should be without management knowledge, for all additions, disposals
authorized in accordance with potentially resulting in misapplied cash and retirements
management’s criteria. and misstated fixed asset records Periodically Compare scrap
Assets may be disposed of or sold at prices received with
unfavorable prices, potentially resulting published prices.
in lost resources.

Execution: Fixed Assets Objective, Error, Procedure

Objective Error Procedure
Procedures for operating, using Unauthorized personnel may Establish procedures for
and physically moving fixed assets Circumvent existing operating, using moving and
should be established in procedures ,potentially resulting in otherwise controlling fixed
accordance with management’s Stolen, or misused equipment assets;
authorization. Equipments may be misplaced,
potentially resulting in unused Restrict access to movable
assets. fixed assets

Recording: Fixed Assets Objectives, Errors, Procedures

Objectives Errors Procedures
Fixed asset Additions, disposals, or Fixed assets transactions may go Establish Procedures for
retirements should be recorded at unreported, potentially resulting processing and recording fixed
the correct amounts, proper period in misstated balances. assets transactions.
and properly classified Establish Procedures for
identifying fixed assets eligible
for disposal and retirement.
maintain detailed fixed assets

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 records periodically reconcile
fixed asset records with existing
assets and investigate differences.
Depreciation and amortization Depreciation could be Establish Policies for determining
should be calculated in accordance miscalculated or recognized on depreciation methods and for
with management’s authorization, fixed assets not in service, calculating depreciation on all
be recorded in the proper period, potentially resulting in misstated categories of fixed assets.
and be properly classified. depreciation expense and asset
book value.
Access: Fixed Assets Objectives, Errors, Procedures
Objectives Errors Procedures
Access to fixed assets should be Fixed Assets could be lost Establish Physical controls over
restricted to personnel authorized by or stolen, potentially unused fixed assets
management resulting in misapplied Maintain adequate insurance
assets and misstated coverage.
accounts
Access to asset and records should Fixed assets and Establish physical controls over
be restricted to personnel authorized depreciation records could unused forms and records;
by management restricted. be misused, destroyed, or Perform periodic compliance audits,
lost, potentially resulting in reconciling recorded assets with
misstated assets. existing assets.

Table 2.11: Summary of financial statement assertions and audit objectives for PPE
Financial statement Audit objective
assertion

Existence and – Additions represent assets acquired in

occurrence the year and disposal represent assets sold
or scrapped in the year
– Recorded assets represent those in use
at the year-end
Completeness – All additions and disposals that occurred in the year have been
recorded
– All assets in use at the year-end are included in balances
Rights and obligations – The entity has rights to the assets purchased and those
recorded at the year-end
Accuracy, classification – Non-current assets are correctly stated at cost less
and valuation accumulated depreciation
– Additions and disposals are correctly recorded
– Review any impairment indicators, test or impairment

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Assertions relating to – Disclosures relating to cost, additions and disposals,
presentation and depreciation policies, useful lives and assets held under finance
disclosure leases are adequate and in accordance with accounting standards

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