02 - Audit of Property, Plant and Equipment [PDF]

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University of Southern Philippines Foundation College of Accountancy

Auditing and Assurance: Concepts and Applications 1 Module.01_Audit of Property, Plant and Equipment

Lecture Notes INTERNAL CONTROL MEASURES 1. Additions and dispositions of fixed assets should be properly authorized and approved by the board of directors or executive committee or person to whom authority has been delegated. 2. A clearly defined and sound policy for differentiation of capital and revenue expenditures should be established. 3. Cost of constructed fixed assets should be controlled through work orders. 4. Fixed assets controlling account should be supported by detailed plant records. 5. Physical inspection of fixed assets should be conducted and investigated. SUBSTANTIVE AUDIT OF PROPERTY, PLANT AND EQUIPMENT Existence: Recorded property, plant and equipment exist 1. Physically inspect the assets for a sample of property, plant and equipment recorded in the plant ledger. 2. Physically inspect the assets and examine supporting documentation for additions to property, plant and

equipment. 3. Verify that existing retirements and disposals are recorded and properly valued.

Completeness: All property, plant and equipment are recorded 4. Perform analytical procedures. 5. Analyze repairs and maintenance for expenditures that should have been capitalized. 6. Examine lease and loan agreements to identify any liabilities that should be recorded.

Rights and obligations: Property, plant and equipment are owned by the entity 7. Determine whether liens or mortgages have been placed on property, plant and equipment by examining

bank confirmations and reading minutes of the board of directors’ meetings. Valuation and allocation: Property, plant and equipment are valued in accordance with GAAP 8. Verify accuracy of recorded property, plant and equipment. 9. Verify depreciation.

Presentation and disclosure: Property, plant and equipment are classified and disclosed in accordance with GAAP 10. Review financial statements and perform analytical procedures to determine whether accounts are

classified and disclosed in the financial statements in accordance with GAAP. Land Acquired with Building Before PIC Q&A No. 2012-2 Old building demolished RIGHT AWAY: • Total cost charged to Land including demolition costs Old building USED INITIALLY before demolition:

• Total cost allocated to land and building pro rata based on fair values • Demolition of old building accounted for as derecognition (ie the difference between the proceeds and carrying amount recognized as gain or loss) • Demolition costs are included in computing gain or loss on derecognition In accordance with PIC Q&A No. 2012-2 • • • •

Total cost allocated to land and building pro rata based on fair values REGARDLESS of intention Allocated cost or CA of old building generally recognized in profit or loss as loss on derecognition Exception, old building demolished right away and the new building is inventory Demolition costs are preferably included in the cost of the NEW Building. -- end of lecture notes --

Pre-Assessment Activity for Audit of Property, Plant and Equipment PROBLEM NO. 1 Coreen Company commenced operations on 1 July 2018. During the following year, the company acquired a tract of land, demolished the building on the land and built a new factory. Equipment was acquired for the factory and, in March 2019, the plant was ready to commence operation. During this period, the following inflows and outflows occurred: While searching for a suitable block of land, Coreen Company placed an option to buy with three real estate agents at a cost of P1,000 each. One of these blocks of land was later acquired. Payment of option fees Receipt of loan from bank Payment to settlement agent for title search, stamp duties and settlement fees Payment of arrears in rates on building and land Payment for land Payment for demolition of current building on land Proceeds from sale of material from old building Payment to architect Payment to council for approval of building construction Payment for safety fence around construction site Payment to construction contractor for factory building Payment for external driveways, parking bays and safety lighting Payment for safety inspection on building Payment for equipment Payment of freight and insurance costs on delivery of equipment Payment of installation costs on equipment Payment for safety equipment surrounding equipment Payment for removal of safety fence Payment for new fence surrounding the factory Payment for advertisements in the local paper about the forthcoming factory and its benefits to the local community Payment for opening ceremony Payments to adjust equipment to more efficient operating levels subsequent to initial operation REQUIRED: Compute the cost of the following: 1. Land 2. Land improvements 3. Building 4. Equipment

P 3,000 4,000,000 100,000 50,000 1,000,000 120,000 55,000 230,000 120,000 34,000 2,400,000 540,000 30,000 640,000 56,000 120,000 110,000 20,000 80,000 5,000 60,000 33,000

PROBLEM NO. 2 You were engaged in making your second annual examination of Erika Company. Accumulated Depreciation accounts are shown below:

01/01/19

Balance

06/01/19 09/01/19

Machine No. 23 Dismantling of Machine No. 3

01/01/20

Balance

12/31/19

Balance

Machinery P 500,000 09/01/19 150,000

12/31/19

The Machinery and

Sale of machine No. 3 Balance

4,000 P 654,000

P 10,000 644,000 . P 654,000

P 644,000 Accumulated Depreciation P 344,400 01/01/19 Balance . 12/31/19 Depreciation P 344,400

P 280,000 64,400 P 344,400

01/01/20

P 344,400

Balance

Your examination disclosed the following information: a. The following adjusted balances appeared on December 31, 2018 working papers: Machinery – P500,000; Accumulated Depreciation – P 280,000. b. The company has depreciated all items of machinery at 10% per annum. The oldest item owned is seven years old as of December 31, 2019. c. It is the company’s policy to take full year’s depreciation in the year of acquisition and none in the year of disposition. d. Machine No. 3, which was purchased on March 1, 2015, at a cost of P80,000, was sold on September 1, 2019 for P10,000 cash. e. Included in charges to Repairs and Maintenance account was an invoice for installation of Machine No. 23, in the amount of P35,000. QUESTIONS: Based on the information presented above and the result of your audit, answer the following: 1. How much is the loss on the sale of Machine no. 3? 2. The adjusting entry to correct the entry made in recording sale of Machine no. 3 will include a debit to 3. How much is the adjusted balance of the Machinery account as of December 31, 2019? 4. How much is the total depreciation expense on machinery for 2019? 5. How much is the balance of the Accumulated Depreciation account as of December 31, 2019?

PROBLEM NO. 3 In the audit of the books of Hazel Corporation for the year 2019, the following items and information appeared in the Production Machine account of the client: Date 01/01 02/28 09/01 12/01

Particulars Balance–Machine 1, 2, 3, and 4 at P180,000 each Machine 5 Machine 1 Machine 6 Machine 7

Debit P 720,000 396,000

Credit P 6,000

192,000 432,000

The Accumulated Depreciation account contained no entries for the year 2019. The balance on January 1, 2019 per your audit, was as follows: Machine 1 Machine 2 Machine 3 Machine 4

P168,750 78,750 67,500 45,000

Based on your further inquiry and verification, you noted the following: 1. Machine 5 was purchased for cash; it replaced Machine 1, which was sold on this date for P6,000. 2. Machine 2 was destroyed by the thickness of engine oil used leading to explosion on December 1, 2019. Machine 7 was to replace Machine 2. 3. Machine 3 was traded in for Machine 6 at an allowance of P24,000; the difference was paid in cash and charged to Production Machine account. 4. Depreciation rate is recognized at 25% per annum. QUESTIONS: Based on the above and the result of your audit, answer the following: 1. The adjusting entry to correct the entry made on the sale of Machine 1 2. The adjusting entry to correct the entry made on the destruction of Machine 3. The adjusting entry to correct the entry made on trade-in of Machine 3 4. The total depreciation for the year ended December 31, 2019 is 5. The carrying amount of production machine as of December 31, 2019 is

PROBLEM NO. 4 Lyle Company's property, plant, and equipment, accumulated depreciation, and amortization balances at December 31, 2018 are:

Land Buildings Machinery and equipment Automobile and trucks Leasehold improvements Totals

Cost P 275,000 2,800,000 1,380,000

Accumulated depreciation

210,000 432,000 P5,097,000

P 672,900 367,500 114,326 108,000 P1,262,726

Additional information on depreciation, amortization methods, and useful lives follows: Asset Buildings Machinery and equipment Automobile and trucks (all acquired after 2009) Leasehold improvements

Depreciation method 150%-decliningbalance straight-line 150%-decliningbalance straight-line

Useful life 25 years. 10 years 5 years

Depreciation is computed to the nearest month. Salvage values of depreciable assets are immaterial except for automobiles and trucks which have estimated salvage values equal to 15% of cost. Other additional information: • Lyle entered into a twelve-year operating lease starting January 1, 2016. The leasehold improvements were completed on December 31, 2015 and the facility was occupied on January 1, 2016. •

On January 6, 2019, Lyle completed its self-construction of a building on its own land. Direct costs of construction were P1,095,000. Construction of the building required 15,000 direct labor hours. Lyle's construction department has an overhead allocation system for outside jobs based on an activity denominator of 100,000 direct labor hours, budgeted fixed costs of P2,500,000, and budgeted variable costs of P27 per direct labor hour.

•

On July 1, 2019, machinery and equipment were purchased at a total invoice cost of P325,000. Additional costs of P23,000 to rectify damage on delivery and P18,000 for concrete embedding of machinery were incurred. A wall had to be demolished to enable a large machine to be moved into the plant. The wall demolition cost P7,000, and rebuilding of the wall cost P19,000.

•

On August 30, 2019, Lyle purchased a new automobile costing P25,000.

•

On September 30, 2019, a truck with a cost of P48,000 and a carrying amount of P30,000 on December 31, 2016 was sold for P23,500.

•

On November 4, 2019, Lyle purchased a tract of land for investment purposes for P700,000. Lyle thinks it might use the land as a potential future building site.

•

On December 20, 2019, a machine with a cost of P17,000, a carrying amount of P2,975 on date of disposition, and a market value of P4,000 was sold to a corporate officer.

QUESTIONS: Based on the above and the result of your audit, compute for the following as of and for the year ended December 31, 2017: 1. 2. 3. 4. 5.

Total depreciation Carrying amount of buildings Carrying amount of machinery and equipment Carrying amount of automobiles and trucks Carrying amount of property, plant and equipment

PROBLEM NO. 5 The draft balance sheet of Kathleen Corporation as of December 31, 2019 reported the net property, plant and equipment at P110,000,000. Details of the amount follow: Land at cost Building at cost Less accumulated depreciation at 12/31/18 Plant at cost Less accumulated depreciation at 12/31/18

P10,000,000 P50,000,000 (20,000,000) 94,500,000

30,000,000

(24,500,000)

70,000,000 P110,000,000

The following matters are relevant: •

On 30 June 2019, Kathleen terminated the production of one of its product lines. From this date, the plant used to manufacture the product has been actively marketed at an advertised price of P4.2 million which is considered realistic. Assume that this plant qualified as held for sale in accordance with PFRS 5. It is included in Plant and equipment at a cost of P9 million with accumulated depreciation (at 1 January 2019) of P5 million.

•

On 2 January 2019, the directors of Kathleen decided that the financial statements would show an improved position if the land and buildings were revalued to market value. At that date, an independent valuer valued the land at P12 million and the buildings at P35 million and these valuations were accepted by the directors. The remaining life of the building at that date was 14 years. Kathleen does not make a transfer to retained earnings for excess depreciation. Ignore deferred tax on the revaluation surplus.

•

Plant and equipment is depreciated at 20% per annum using the reducing balance method and time apportioned as appropriate.

•

All depreciation is charged to cost of sales, but none has yet been charged on any non-current assets for the year ended 31 December 2019.

QUESTIONS: Based on the above and the result of your audit, determine the amounts that should be reported as of and for the year ended December 31, 2019 for the following. 1. Plant and equipment 2. Plant held for sale 3. Property, plant and equipment 4. Total depreciation 5. Revaluation surplus PROBLEM NO. 6 On January 2, 2017, Calamba Company purchased land for P450,000, from which it is estimated that 400,000 tons of ore could be extracted. It estimates that it will cost P80,000 to restore the land, after which it could be sold for P30,000. During 2017, the company mined 80,000 tons and sold 50,000 tons. During 2018, the company mined 100,000 tons and sold 120,000 tons. At the beginning of 2019, the company spent an additional P100,000, which increased the reserves by 60,000 tons. In 2019, the company mined 140,000 tons and sold 130,000 tons. The company uses a FIFO cost flow assumption. QUESTIONS: Based on the above and the result of your audit, answer the following: (Round depletion rate to two decimal places) 1. The depletion for 2018 is

2. The depletion for 2019 is 3. The depletion included in cost of sales for the year ended December 31, 2019 is 4. The carrying amount of the natural resources as of December 31, 2019 is PROBLEM NO. 7 Select the best answer for each of the following: 1. Property, plant and equipment is typically judged to be one of the accounts least susceptible to fraud because a. The amounts recorded on the balance sheet for most companies are immaterial. b. The inherent risk is usually low. c. The depreciated values are always smaller than cost. d. Internal control is inherently effective regarding this account. 2. Determining that proper amounts of depreciation are expensed provides assurance about management’s assertions of valuation and a. Presentation and disclosure. b. Rights and obligations. c. Completeness. d. Existence or occurrence. 3. The auditor may conclude that depreciation charges are insufficient by noting a. Insured values greatly in excess of book values. b. Large numbers of fully depreciated assets. c. Continuous trade-in of relatively new assets. d. Excessive recurring losses on assets retired. 4. When few property and equipment transactions occur during the year the continuing auditor usually obtains and understanding of internal control and performs a. Tests of controls b. Analytical procedures to verify current year additions to property and equipment c. A thorough examination of the balances at the beginning of the year. d. Extensive tests of current year property and equipment transactions. 5. Which of the following combinations of procedures is an auditor most likely to perform to obtain evidence about fixed asset addition? a. Inspecting documents and physically examining assets. b. Recomputing calculations and obtaining written management representations. c. Observing operating activities and comparing balances to prior period balances. d. Confirming ownership and corroborating transactions through inquiries of client personnel. 6. If an auditor tours a production facility, which of the misstatements or questionable practices is most likely to be detected by the audit procedures specified? a. Depreciation expense on fully depreciated machinery has been recognized. b. Overhead has been overapplied. c. Necessary facility maintenance has not been performed. d. Insurance coverage on the facility has lapsed. 7. In testing for unrecorded retirements of equipment, an auditor is most likely to a. Select items of equipment from the accounting records and then locate them during the plant tour. b. Compare depreciation journal entries with similar prior-year entries in search of fully depreciated equipment. c. Inspect items of equipment observed during the plant tour and then trace them to the equipment subsidiary ledger. d. Scan the general journal for unusual equipment additions and excessive debits to repairs and maintenance expense. 8. The auditor is least likely to learn of retirements of equipment through which of the following? a. Review of the purchase return and allowance account. b. Review of depreciation. c. Analysis of the debits to the accumulated depreciation account. d. Review of insurance policy.

9. Additions to equipment are sometimes understated. Which of the following accounts would be reviewed by the auditor to gain reasonable assurance that additions are not understated? a. Accounts payable b. Depreciation expense c. Gain on disposal of equipment d. Repair and maintenance expense 10. In violation of company policy, Coatsen Company erroneously capitalized the cost of painting its warehouse. An auditor would most likely detect this when a. Discussing capitalization policies with Coatsen's controller. b. Examining maintenance expense accounts. c. Observing that the warehouse had been painted. d. Examining construction work orders that support items capitalized during the year.

-- end of Pre-Assessment Activity -Assessment 1. Online quiz through Canvas. Optional Activities/Resources 1. Intermediate Accounting 2 2019 Edition by Zeus Vernon B. Millan SMC