Auditing Property: The Why and How Guide

Here's an overview of how to audit property

Are you wondering about how to audit property?

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

how to audit property

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Auditing Property — An Overview

Property is sometimes referred to as plant, property, and equipment or capital assets. In this post, I’ll use the word “property.”

We will cover the following:

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

Primary Property Assertions

The primary relevant property assertions are:

  • Existence and occurrence
  • Completeness
  • Valuation
  • Classification

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

Property Walkthroughs

As we perform walkthroughs of property, we are looking for ways that property is overstated (though it can also be understated as well). We are asking, “What can go wrong—whether intentionally or by mistake?” 

In performing property walkthroughs, ask questions such as:

  • Are property ledgers reconciled to the general ledger?
  • Does the entity use reasonable and consistent depreciation methods?
  • Are the depreciation methods in accordance with the reporting framework (e.g., straight line for GAAP or accelerated for tax basis)
  • Who records depreciation? 
  • Are the economic lives assigned to property appropriate?
  • What controls ensure that property is recorded in the right period?
  • Is there appropriate segregation of duties between persons paying for property, those recording property, and those with physical possession of property?
  • What software is used to compute depreciation?
  • Does the company perform periodic physical inventories of moveable property?
  • Are assets removed from the depreciation schedule upon sale?
  • What controls ensure that all property-related purchases are added to the depreciation schedule (and not expensed as repairs and maintenance)?
  • What is the capitalization threshold (e.g., $5,000)?
  • What controls ensure that all capital leases are reported as additions to the depreciation schedule?

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

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

Directional Risk for Property

The directional risk for property is overstatement. So, in performing your audit procedures, perform procedures to ensure that property is not overstated. For example, vouch all significant property additions to invoices.

Primary Risks for Property

The primary risks for property are:

  1. Property is intentionally overstated 
  2. Expenses are improperly capitalized as property 
  3. Transactions that should be recorded as property are expensed 
  4. Capital leases are treated as operating leases (and the property is not added to the depreciation schedule)
  5. Depreciation is improperly computed and recorded (e.g., an accelerated depreciation method is used when straight-line is more appropriate)
  6. Moveable property (e.g., equipment) is stolen 

Common Property Control Deficiencies

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

  • One person performs one or more of the following: 
    • Buys property, 
    • Enters the property in the general ledger and depreciation schedule, 
    • Has physical custody of the property,  
    • Has responsibility for reconciling the depreciation schedule to the general ledger
  • The person computing depreciation doesn’t possess sufficient knowledge to do so correctly
  • A second person does not review the depreciation methods or economic lives
  • No one performs surprise audits of property 
  • No one performs periodic physical inventories of property 
  • There are no controls over the disposal of property 
  • Bidding procedures are not properly used
  • No one reconciles the depreciation schedule to the general ledger
  • Property is not reviewed for possible impairment of value
  • Company personnel don’t understand capital lease accounting standards

Risk of Material Misstatement for Property

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

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

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

Substantive Procedures for Property

My customary audit tests are as follows:

1. Vouch property additions to related invoices

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

3. Review economic lives assigned to new property 

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

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

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

Common Property Work Papers

My property work papers normally include the following:

  • An understanding of property-related internal controls 
  • Risk assessment of property at the assertion level
  • Documentation of any property control deficiencies
  • Property audit program
  • A copy of the depreciation schedule that agrees to the general ledger
  • A summary of additions and retirements of property in the current audit period

In Summary

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

If you audit property differently, please share your ideas in a comment below. 

Continuing Audit Series

This post is a part of my series titled the Why and What of Audits. If you’ve missed the prior series articles, click here

Next week, we’ll look at how to audit accounts payable and expenses.

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