Review Questions: (Chapter 9: Audit of Investing Activities)

1. Identify the transactions involved in investing and explain their relationship to other cycles.
Answer: Generally, there are two classes of transactions involved in investing cycle. First is
Acquisitions and disposals of securities whether for temporary or long-term investments,
corporate bonds and government securities, plant assets, natural resources, intangible assets
and other assets fall in transaction involves investing cycle. Second is Lending to other except
open trade accounts with customers. Transactions in First class which is acquisitions
transactions also falls under Expenditure cycle wherein if an entity purchased securities or long-
term assets in cash or on account, it will affect both investing and expenditure cycle because it
will increase an asset account which is the asset purchased, also decrease an asset account
which is Cash account if purchased in cash and increase in Liability account which is Accounts
Payable if purchased on account. Asset purchase which is either securities or long-term assets
fall in investing cycle, the payment which is cash falls under expenditure cycle, cash
disbursement cycle transaction in particular and if it was purchased on account which is
accounts payable falls also under expenditure cycle, recognizing the liability in particular.
Related documents and records used in Expenditure Cycles was also used under Investing Cycle
such as cash disbursement transaction file/journal if long-term asset was purchased in cash and
accounts payable master file/subsidiary ledger if long-term asset was purchased on account.

2. Identify major frauds that occur in investing activities.

Answer: There are many fraudulently misstatements occurred on financial statements under
investing activities such as overstatement of securities and long-term assets by means of over-
valuating of existing securities and long-term assets, such as including fictitious securities and
long-term assets or capitalizing expenses. There are many fraudulent activities occurred in long-
term assets, such as but not limited to, sales of assets are not recorded and proceeds are
misappropriated, assets that have been sold are not removed from the books, inappropriate
residual values or lives are assigned to the assets that resulting in miscalculation of depreciation,
amortization of intangible assets is miscalculated, costs that should been expensed are
improperly capitalized, impairment losses on long-lived assets are recognized and fair value
estimates are unreasonable or unsupportable.

3. Describe the important investment-related duties that must be separated if controls are to be
effective.
Answer: In order to have effective internal control on investment, responsibility for authorizing
transaction shall be separated wherein purchases and sales of investment should be made only
on proper authorization also securities must be physically controlled in order to prevent
unauthorized usage and they must be registered in the name of the owner. Next, responsibility
for keeping record should be separated also wherein access to securities should not be vested in
one person only also revenues received from investment periodically should be reconciled with
the amounts that should be received. Lastly, responsibility for having custody of the asset
should be separated also wherein custodianship of investment securities and accounting for
securities should be separated.
4. What is asset impairment and what inherent risk factors are associated with asset impairment?
Answer: According to IAS 36 – Impairment of Assets, asset impairment is conducted by an entity
in order to ensure that an entity’s assets are not carried at more than their recoverable amount.
If an entity’s carrying amount of their assets exceeds it recoverable amount, an impairment
expense will recognized by means of difference of asset’s carrying amount and recoverable
amount wherein recoverable amount is the higher of fair value less cost to sell and value in use.
Normally, inherent risk associated with asset impairment has three factors. First can be that
management is not interested in identifying and writing down assets. Second can be that
management sometimes wants to write down every potentially impaired asset to a minimum
realizable value wherein this will cause to one-time reduction to current earnings and leads to
higher reporting earnings. Third can be that determining asset impairment requires a good
information system, a systematic process, effective controls and professional judgment.

5. What are some inherent risks of material misstatement associated with natural resources?
Answer: Inherent risks associated with natural resources has unique risk. First, it is often difficult
to identify costs associated with discovery of the natural resources. Second, once the natural
resources has been discovered, it is often difficult to estimate the amount of commercially
available resources to be used in determining depletion rate. Third, the client may be
responsible for restoring the property to its original condition, wherein this process was called
reclamation, after the resources are removed. Reclamation costs may be difficult to estimate.

6. What are some inherent risks of material misstatement associated with intangible assets?
Answer: Inherent risk associated with intangible assets can be that determination of cost for
intangible assets is not as straightforward just like for tangible assets, such as but not limited to,
tangible assets wherein Intangible Assets should be recorded at cost.

7. What audit procedures might an auditor use to identify fully depreciated equipment? How
might the auditor determine that such equipment is properly valued?
Answer: Auditor can use two audit procedures to identify fully depreciated equipment. First is
Re-computation wherein auditor do this in order to determine whether client’s calculation is
correct. Auditor re-compute depreciation expense for equipment to determine whether the
client is following a proper and consistent depreciation policy. Second is Footing wherein auditor
do this in order to determine whether the total is the same as the client’s. In order to be
relevant, the detailed re-computation of depreciation expense should be tied in to the total
depreciation calculations of the clients by footing the depreciation expense on Equipment
Master File and reconciling the total in General Ledger. Auditor can determine that such
equipment is properly valued by considering the useful life of current period acquisition of
equipment, method of depreciation, estimated salvage value and policy of depreciating
equipment in the year of acquisition and disposition. It can also be done by comparing
information obtained through audit tests of the equipment’s depreciation expense to
 information disclosed in footnotes to ensure that the information presented is consistent with
the actual method and assumptions used to calculate and record depreciation for equipment.

8. What evidence might an auditor gather to determine the proper valuation of an impaired asset?
Answer: For impairment of assets, there are many audit evidence to gather by the auditor in
order to determine proper valuation of it, such as but not limited to, identify impairment
indicators, models being used for impairment assessment and the assumption to support the
value of the impaired asset. Auditor also need to inquire management about current market
conditions supporting the evaluation of potential impairment indicators. By gathering this,
auditor can perform re-computation in order to determine whether the value of impaired asset
calculated by client is correct. Also, auditor shall perform footing in order to be relevant the re-
computed amount of impaired asset and to determine whether the total is the same as the
client’s balance.

9. Describe the basic approach to auditing leases.

Answer: There are two basic approach in auditing leases. First, auditor should carefully examine
lease agreements to determine whether the accounting for the assets involved is proper.
Second, auditor should determine whether the client is applying the appropriate standards
depending on whether the lease terms indicate a sales type, direct financing or operating lease.
If there are variable payments involved, auditor must carefully evaluate whether variable
payments shall recognized. Under Accounting Standards Codification (ASC) 842, auditor shall
perform six audit assertions in assessing lease accounting. First is completeness, auditor asserts
that all leases have been captured and properly capitalized on the balance sheet. In order to
prove this assertion, auditor shall perform searching through file cabinets with relevant to lease
agreement, interviewing everyone in the contracting process, physical inventorying of assets
being leased and reconciling rent expense. Second is Existence/Occurrence, auditor asserts
whether or not the lease actually exists. In order to prove this assertion, auditor shall spend
more time to ensure that physical assets and contracts exist and/or occurred. Third is
Valuation/Allocation, auditor asserts proper present value calculation of leases. In order to
prove this assertion, auditor shall determine whether payment streams, lease term and discount
rates are properly valued. Fourth is Cut-off, auditor asserts whether or not the lease has been
recorded in the correct accounting period. In order to prove this assertion, auditor shall select
leases before and after reporting date and ensure they are recorded within proper period. Fifth
is Rights/Obligations, auditor asserts that assets are actually owned and liabilities are actually
owed. In order to prove this assertions, auditor shall perform the performance used in
Existence/Occurrence. Lastly is Classification/Presentation and Disclosure, auditor asserts that
transactions have been properly classified in the financial statements. In order to prove this
assertion, auditor might select a sample leases and re-perform classification testing.
Exercises: (Chapter 9: Audit of Investing Activities)

1. A 20X0 study on fraudulent financial reporting noted ways in which long-lived assets can be
fraudulently overstated, including:
 Fictitious assets on the books
 Improper and incomplete depreciation
 Failure to record impairment of assets, specially goodwill
 Expired or worthless assets left on a company’s books
 Assets overvalued upon acquisition, especially in the purchase of a company

Requirements:

A. What might motivate management to overstate fixed assets?

Answer: Management may have incentives to overstate their fixed assets and may do so by
including fictitious fixed assets on financial statement by means of overvaluing existing
assets. Management may capitalize costs, such as repairs and maintenance costs, which
should be expensed. Management estimates may be subject to management bias such as
estimation for depreciation and asset impairment wherein management reducing the
accumulated depreciation by debiting that account and crediting depreciation expense. Upon
making new acquisitions, management boosted the value of the assets but establishing
reserves for plant closings and related expense wherein when actual expenses were less,
management debited the liability and credited the expense, thereby increasing net income in
subsequent periods.

B. What other factors should the auditor consider when assessing fraud risk related to long-
lived assets?
Answer: Auditor should examine supporting documentation of individual long-lived asset
transaction by means of examining a schedule of additions that usually prepared by the
client, after schedule is agreed to the general ledger, auditor should select a few items for
testing. Auditor also needs to determine whether capitalized additions were appropriate and
that none of them should have been expensed as repairs and maintenance or other costs.
Companies often have to make judgments as to whether a particular expenditure should
capitalized or expensed as repair. Most companies have policies, usually based on materiality
and cost of bookkeeping, as whether expenditures under certain amount are expenses, even
if they appear to be capitalized in nature that’s why auditor need to determine if such policy
is reasonable. Auditor need consider also whether management attempt to not comply with
the policy because of an incentive to manipulate reported earnings. Auditor should physically
inspect tangible assets, including major additions and agree serial numbers with invoices or
other supporting documents. Request that the client perform a complete inventory of long-
lived assets at year end. Carefully scrutinize appraisals and other specialist reports that seem
out of line with reasonable expectations and challenge the underlying assumptions. Use the
work of a specialist for asset valuations, including impairments. When vouching long-lives
asset additions, accept only original invoices, purchase order, receiving reports or similar
supporting documentation. Lastly, confirm the terms of significant additions of property or
intangibles with other parties involved in the transactions.
2. Explain how skeptical auditor might come to understand management’s potential for adjusting
earnings through manipulation of fixed-asset accounts.
Answer: Auditor should be skeptical to understand management’s potential for adjusting
earnings because there are manipulation of fixed-asset accounts that management can omits.
Such as the accounting scandal conducted by WorldCom wherein they have a weak control
environment that allowed management override of existing controls and ultimately commit
large fraud. WorldCom’s management improperly released approximately $984 million in
depreciation reserves to increase pretax earnings by decreasing depreciation expense or
increasing miscellaneous income. They done by omitting fraud such as the cost of equipment
returned to vendors for credit after being placed in service was credited to the reserve or
accumulated depreciation rather that the asset itself and unsupported additions to an asset
account were recorded with corresponding increase in reserve. WorldCom also inappropriately
capitalized line expense as fixed assets. This serves as a lesson for an auditor to as a lesson to be
skeptical if there are extensive amount of adjusting of earnings in relation with long-lived assets
because this may lead to bankruptcy.

3. Identify potential fraud schemes related to long-lived assets.

Answer: One of the common techniques used to fraudulently misstate financial statements
involves the overstatement of long lived assets through overvaluing existing assets, including
fictitious assets or capitalizing expenses. Management also misstate assets by routinely
capitalizing a line expense. Upon making new acquisitions, management boosted the value of
assets but it established reserves for plant closings and related expenses. Sales of assets are not
recorded and proceeds are misappropriated. Assets that have been sold are not removed from
the books. Inappropriate residual values or lives are assigned to the assets resulting in
miscalculation of depreciation. Amortization of intangible assets is miscalculated. Costs that
should have been expensed are improperly capitalized. Impairment losses on long-lived assets
are not recognized. Lastly, fair value estimates are unreasonable or unsupportable.

4. Consider the risks typically associated with intangible long-lived assets and identify the internal
controls over these assets that you would expect a client to have in place.
Answer: When it comes to Intangible Assets, Inherent Risk associated to it is that, intangible
should be recorded at cost but determination of cost of intangible assets is not straightforward
as it for tangible assets. Fraud Risk associated with Intangible Assets can be that amortization of
intangible assets is miscalculated and impairment losses are not recognized. When it comes to
intangible’s internal control, controls should be designed to provide reasonable assurance that
decisions are appropriately made as to when to capitalize or expense research and development
expenditure, develop amortization schedules that reflect the remaining useful life of patents or
copyrights associated with the asset and identify and account for intangible asset impairments.
When it comes to Long-lived Asset, Inherent Risk associated to it is that, long lived assets is due
to the importance of management estimates, such as estimating useful lives and residual values
and determining whether asset impairment has occurred; incomplete recording of asset
disposals, obsolescence of assets, incorrect recording of assets due to complex ownership
structures and amortization or depreciation schedules that do not reflect economic impairment
 or use of the assets. When it comes to its Fraud Risk associated with Long lived Assets, one of
the more common fraudulent misstate financial statements techniques involves overstatement
of assets through overvaluing existing assets, including fictitious assets or capitalizing expenses.
Management also misstated assets by routinely capitalizing a line expense. Sales of assets are
not recorded and proceeds are misappropriated, assets that have been sold are not removed
from the books, inappropriate residual values or lives are assigned to the assets resulting in
miscalculation of depreciation, amortization of intangible assets is miscalculated, costs that
should have been expensed are improperly capitalized, impairment losses on long-lived assets
are not recognized and fair value estimates are unreasonable or unsupportable. When it comes
to Control Risk associated with Long-lived Assets it can be that, formal budgeting process with
appropriate follow-up variance analysis, written policies for acquisition and disposals of long-
lived assets including required approvals, limited physical access to assets where appropriate,
periodic comparison of physical assets to subsidiary records and periodic reconciliations of
subsidiary records with the general ledger. Control over Long-lived Assets includes systematic
process to identify assets that are not currently in use, projections of future cash flows by
reporting unit that is based on management’s strategic plans and economic conditions and
systematic development of current market values of similar assets prepared by the client.

5. Consider the risks typically associated with intangible long-lived assets and identify the internal
controls over these assets that you would expect a client to have in a place.
Answer: When it comes to Intangible Assets, Inherent Risk associated to it is that, intangible
should be recorded at cost but determination of cost of intangible assets is not straightforward
as it for tangible assets. Fraud Risk associated with Intangible Assets can be that amortization of
intangible assets is miscalculated and impairment losses are not recognized. When it comes to
intangible’s internal control, controls should be designed to provide reasonable assurance that
decisions are appropriately made as to when to capitalize or expense research and development
expenditure, develop amortization schedules that reflect the remaining useful life of patents or
copyrights associated with the asset and identify and account for intangible asset impairments.
When it comes to Long-lived Asset, Inherent Risk associated to it is that, long lived assets is due
to the importance of management estimates, such as estimating useful lives and residual values
and determining whether asset impairment has occurred; incomplete recording of asset
disposals, obsolescence of assets, incorrect recording of assets due to complex ownership
structures and amortization or depreciation schedules that do not reflect economic impairment
or use of the assets. When it comes to its Fraud Risk associated with Long lived Assets, one of
the more common fraudulent misstate financial statements techniques involves overstatement
of assets through overvaluing existing assets, including fictitious assets or capitalizing expenses.
Management also misstated assets by routinely capitalizing a line expense. Sales of assets are
not recorded and proceeds are misappropriated, assets that have been sold are not removed
from the books, inappropriate residual values or lives are assigned to the assets resulting in
miscalculation of depreciation, amortization of intangible assets is miscalculated, costs that
should have been expensed are improperly capitalized, impairment losses on long-lived assets
are not recognized and fair value estimates are unreasonable or unsupportable. When it comes
to Control Risk associated with Long-lived Assets it can be that, formal budgeting process with
appropriate follow-up variance analysis, written policies for acquisition and disposals of long-
 lived assets including required approvals, limited physical access to assets where appropriate,
periodic comparison of physical assets to subsidiary records and periodic reconciliations of
subsidiary records with the general ledger. Control over Long-lived Assets includes systematic
process to identify assets that are not currently in use, projections of future cash flows by
reporting unit that is based on management’s strategic plans and economic conditions and
systematic development of current market values of similar assets prepared by the client.

6. The following questions might be addressed when an auditor is completing an internal control
question.
Requirements:
A. Indicate the purpose of the control
B. Indicate the impact of the planned substantive audit procedures if the answer to the
question indicates weak controls

For each question (labeled as 1 through 8 below):

1. Does the client periodically take a physical inventory of property and reconcile to the
property ledger?
Answer:
A. Purpose of this control is to prove the existence and completeness of management's
claims Furthermore, it gives fair confidence that the property on the balance sheet is
stated correctly.
B. Planned substantive audit procedure is impacted by periodic inventory by asking the
auditor to visit the facilities to confirm their presence and to observe the physical
inventory process

2. Does the client have a policy manual to classify property and assign an estimated life for
depreciation purposes to the class of assets?
Answer:
A. Purpose of this control is to provide fair confidence that depreciation costs are correct
and in accordance with market standards for equipment projected life. A policy manual
is meant to create continuity in property classification and depreciation.
B. Planned substantive audit procedure is impacted by test of details by comparing
estimated life and property classification to the policy manual. The auditor should use
substantive analytical procedures to establish consistency with the manual.
3. Does the client have a policy on minimum expenditures before an item is capitalized? If yes,
what is the minimum amount?
Answer:
A. Purpose of this control is to create consistency and efficiency in accounting processes
with capitalization policy. It is a simpler process to expense items under a threshold
amount.
B. Planned substantive audit procedure is impacted by the effect of audit in financial
statements should be consistent with capitalization policy

4. Does the client have a mechanism to identify pieces of equipment that have been
designated for scarp? If yes, is it effective?
Answer:
A. Purpose of this control is to make sure assets are not being overstated. Once a piece of
equipment has reached its useful life it should be disposed of or scrapped.
B. Planned substantive audit procedure is impacted by observing obsolete equipment
when touring client’s property. The auditor should also review balance sheet to make
sure the equipment was removed and properly written off.

5. Does the client have an acceptable mechanism to differentiate major renovation from repair
and maintenance? If yes, is it effective?
Answer:
A. Purpose of this control is to make sure repairs and maintenance are differentiated from
capital improvements, because the latter of the two can increase the useful life of an
asset.
B. Planned substantive audit procedure is impacted by reviewing renovations or capital
improvements accounts to make sure the expenditures are appropriately capitalized.
The auditor should also review repairs and maintenance expenses to verify transactions
are accurately classified.

6. Does the client regularly self-construct its own assets? If yes, does the client have an
effective procedure to appropriately identify and classify all construction costs?
Answer:
A. Purpose of this control is to make sure the combined costs of building an asset were
captured.
B. Planned substantive audit procedure is impacted by inspecting self-constructed asset
when touring the facility and review the costs of building it.

7. Does the client systematically review major classes of assets for potential impairment?
Answer:
A. Purpose of this control is to make sure assets are appropriately valued. It needs to be
based on fair value and remaining useful life.
B. Planned substantive audit procedure is impacted by paying closely attention to the
current operation status of assets. Depreciation and amortization schedules should also
be reviewed when considering asset impairments.
 8. Does management periodically review asset disposal or the scrapping of assets as a basis for
reviewing the assignment of estimated life for depreciation purposes?
Answer:
A. Purpose of this control is to provide reasonable assurance assets are valued
appropriately and depreciation expenses are correctly accounted for.
B. Planned substantive audit procedure is impacted by reviewing asset lives and estimated
lives are reasonable

7. The audit senior has asked out to perform analytical procedures to obtain substantive evidence
on the reasonableness of recorded depreciation expense of the delivery vehicles of a client.
Changes in the account occurred pretty much evenly during the year. The estimated useful life is
six years. Estimated salvage value is 10% of original cost. Straight-line depreciation is used.

Additional information:

Delivery Equipment (per General Ledger)

Beginning balance 380,000
Additions 154,000
Disposals (95,600)
Ending balance 436,000

Current year depreciation expense per books = 60,500

Based on this information, estimated the amount of depreciation expense for the year using
analytical procedures. Does the recorded depreciation expense seem acceptable? Explain. What
is the impact of the result of this analytical procedure on other substantive procedures that the
auditor may perform?
Answer: In order to determine the exact amount of current year depreciation expense per book,
calculate first the average balance of equipment by adding the opening and ending balance of
the delivery equipment and divide it by two to get the average. So the average balance is
408,000 (380,000+436,000/2). Next is to determine the adjusted value of the delivery
equipment net of salvage value, in order to achieve that, just simply deduct the salvage value to
the average balance of delivery equipment. So the amount of delivery equipment net of salvage
value is 367,200 (408,000-10%). By the amount of calculation generated, auditor can now
determine the current year depreciation expense per book by simple divide the adjusted
amount of delivery equipment net of salvage value by its useful life. So the amount of
depreciation is 61,200 (367,200/6 years). Recorded depreciation expense seems to be
reasonable because the understated amount of 700 (60,500 recorded amount less 61,200
calculated amount) seems to be immaterial if I will the one who will conduct an audit to this
company. That’s why the 6,500 recorded amount of depreciation is reasonable. There will be no
additional substantive test procedures to be conducted because after recalculating the amount
of depreciation, recorded amount is seems to be reasonable enough.