Substantive Testing of Ppe
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Testing a clients plant, property and equipment (PPE) is an important part of the financial audit. While there may be a relatively small number of PPE transactions in a given period, the value of these transactions are material and any undetected errors may result in a material misstatement. The appropriate audit strategy is substantive testing on detailed transactions and account balances related to PPE. It is also important that the auditor gains an understanding of the clients policies on PPE as well as the industry practices with regards to PPE.
Plant, property and equipment 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. An asset can be considered as PPE, or not, depending on use. Assets classified as PPE in one business may be inventory in another. Consider the example of a real estate business classifying land as inventory while in most other businesses it would be considered as PPE. In some circumstances major spare parts, servicing equipment and stand-by equipment the client expects to use during more than one period may be considered PPE. These two examples illustrate the importance of understanding a client and the nature of his business.
There exist three major subgroups of PPE: land; building, machinery and land improvements; and natural resources. For each of these groups there are four types of PPE transactions: acquisition of capital assets for cash or other non-monetary considerations; disposition of capital assets through sale, exchange, retirement or abandonment; depreciation expense charged for a capital asset; and leasing of a capital asset. An auditor must test a sample of each of these transaction groups in order to assess the accuracy of a clients PPE records and form their opinion. This substantive testing follows the initial assessment of risk and internal controls.
When preparing for the audit, the auditor will consider some important points on PPE and the risk of material misstatement. The auditor will assess inherent risk, including fraud risk; he will assess control risk and obtain an understanding of internal controls in place to monitor PPE; and he will design tests of controls and substantive procedures accordingly.
OBJECTIVE OF SUBSTANTIVE PROCEDURES
The objective of substantive audit procedures is to detect material misstatements at the assertion level and to provide audit evidence on the reliability of the clients accounting records in order to form and support the auditors audit opinion. Substantive procedures involve analytical procedures, substantive testing of account balances at the balance sheet level and substantive testing of transactions at the income statement level.
At the balance sheet level, the auditor will assess the risk of material misstatements and design substantive procedures to test for the following: (a) existence of PPE, (b) the client has the rights to the asset and/or a financial obligation to pay, (c) completeness to ensure that all transactions have been recorded, (d) assets are recorded at the appropriate amounts and any valuation or allocation adjustments are properly recorded, and (e) presentation and disclosure.
At the income statement level, the auditor will assess the risk of material misstatements and design substantive procedures to test for (a) completeness to ensure that all expenses have been recorded, (b) accuracy to ensure that transactions are recorded at the appropriate amounts, (c ) cutoff to ensure that transactions are recorded in the correct period, (d) classification to ensure that transactions are recorded to the appropriate account, and (e) occurrence.
DETERMINING THE SAMPLE SIZE
The auditor must exercise professional judgement in determining his required confidence level, the tolerable error, and expected error, and the risk of incorrect acceptance before selecting the appropriate sampling methods (random selection, systematic selection, haphazard selection, block selection, and judgemental selection). Based on this information, the auditor may begin to determine the required sample size based on the population size. (Please refer to table 1). Example: based on a population size of 5000 transactions at a required confidence level of 95% with a tolerable error of 2.5%,