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Home (/) /  Auditing Principle and Practice 2 (/auditing-principle-and-practice-2) /  Audit of Property, Plant, and Equipment

Audit of Property, Plant, and Equipment

Chapter-Four

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.

Primary audit
Subjective Test 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, additions to Clerical
and/or retirement from property, plant, and accuracy
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                                                                        
Existence and
7. Make physical inspection of major right
acquisitions                  
valuation or
The auditors usually make a physical allocation
inspection of 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 Valuation and
have capitalized                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 Valuation and
expected to be used in the future operation allocation
(depreciate at normal rate); and               plant Presentation
assets dismantled, found to be unsuitable for and disclosure
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                                         
Independently develop an estimate of the
amounts to compare to management’s
estimates Valuation and
allocation
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

To determine that plant assets are property

of the client, the auditors look for such Existence and
evidences as a deeds, title, insurance policy, right
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)

E.G Capitalization of assets leased by the client

company.

16. Perform analytical procedures for property, Existence and

plant, and equipments right

Auditors may use trends and ratios to judge Completeness

the reasonableness of recorded amounts for Valuation or
plant and equipments allocation
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 for property, plant and equipment
and for related revenues and expenses.

The balance sheet or accompanying notes

Presentation
should disclose balances of major classes of
and disclosure
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.

 
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