How to Audit Depreciation Expense?
Depreciation expense is the allocation of fixed assets value from balance sheet to income statement.
When company purchases fixed assets, they will be recorded on the balance sheet. These assets have a limited useful life which company can enjoy its benefits. The company has to spread the fixed asset cost over this time frame. The fixed assets balance will decrease to zero (or scrap value) at the end of their useful life.
Auditor has to reverify the allocation of assets to expenses. With properly testing of depreciation expense, it will help the auditor to ensure the misstatements in fixed assets balance as well. It is a part of the fixed balance that presents on the balance sheet.
The amount of depreciation expense is purely based on the company calculation. It depends on the internal policy which estimated the useful life of each asset class.
To audit the company balance, auditor has to review the company policy if they are consistent with accounting standard. The fixed assets’ useful life should be estimated properly. It should be aligned with the actual condition of assets.
Moreover, they have to check if the policy is reasonable compared to the nature of business and market. The standard provides only a guideline, company has to use it as a benchmark and review a policy that fits the business. The company may design the fixed assets policy in the favor of company rather than actual usage. They may want to understate the expense to increase profit for any reason.
Regarding the size of fixed assets, the depreciation expense can be a significant account. If the company has a huge amount of fixed assets and ineffective control, it will lead to significant risk on depreciation expense. If the company rents most of the assets and only owns a few fixed assets, the depreciation may not even scope in for testing.
Audit Assertion for Depreciation Expense
- Occurrence: when the fixed assets are ready to use, company has to record depreciation expenses in the accounting period. The depreciation expense will incur as long as the fixed asset exists and the company is using it.
- Cut-off: Depreciation expense is recorded only during the fixed assets used in the company in current accounting period.
- Completeness: All depreciation expenses must be recorded in the income statement. It also reflects the new addition and disposal during the year.
- Accuracy: Depreciation expense record based on the calculation of fixed assets carrying amount and depreciation rate.
- Classification: The depreciation expense has to record in the proper account with the reflection of actual nature.
Substantive Analytical Procedure for Depreciation Expense
Substantive analytical procedure is testing the auditor to validate the account balance without checking the detailed transaction. It is suitable for the account which is supposed to be consistent from month to month. It can also use to test the account that has a close relationship with other accounts. It uses to test an account that is predictable due to trend, ratio, and reasonableness.
Substantive analytics provides the overall picture of the account balance without spending time checking each transaction detail. It is very effective as the auditor can save time but can review the overall balance.
Depreciation is the expense that is based on the fixed assets cost and depreciation rate if they use straight-line depreciation.
The depreciation expense will remain the same if there are no additional and disposal fixed assets. So it is the independent expectation that the auditor can build based on this assumption. If there are multiple classifications under fixed assets that have different depreciation rates, the auditor can group them based on these classifications. Each class will have different independent expectations due to the depreciation rate.
WIthout additional assets and disposal, the depreciation expense must be the same as last year. As the depreciation is equal to the fixed assets cost and depreciation rate. If the rate and cost remain the same, it should be the same. It also is consistent from month to month during the year.
If there is a significant variance, the auditor has to investigate the reasons. It depends on the auditor’s judgment if the variance is acceptable or not.
If there are changes in fixed assets balance during the year, depreciation expense is expected to change as well. Auditor can build the expectations base on the movement of fixed assets in each category. After that, they will compare the balance with expectation. Again, any significant variance needs to investigate and make a conclusion.
It is more effective to perform analytical procedures rather than a physical inspection of the supporting document. There is no strong supporting document, it is just the depreciation listing that prepares by the internal company.
Test of Detail for Depreciation Expense
- Occurrence: Depreciation is charged for the fixed assets that are under company control during the period.
The auditor can validate the occurrence of depreciation expenses by matching them to the actual fixed assets listing. The listing should already be tested to ensure completeness.
- Cut-off: Depreciation expense is the charge of fixed assets from balance sheet to income statement. It bases on the calculation, so it can face the risk of cut-off.
The expense that relies on the calculation will face a cut-off risk when the accountant miss allocates the expense for each period. auditor has to split the depreciation expense at the beginning of the year to prevent last year’s depreciation from being included in the current year. Moreover, they should check the year-end depreciation to ensure the correct cut-off.
- Completeness: The depreciation expense has to record for all applicable fixed assets under company control.
Auditors have to obtain fixed assets listing from the accountant and reconcile the carrying amount with balance sheet. They have to reconcile both beginning and ending balance.
This same listing is also used to test the completeness of fixed assets balance. Based on this listing, auditors can use it to ensure the completeness of depreciation expenses. When all fixed assets are included in the listing, it means the depreciation expense is also complete.
The depreciation expense will cover 12 months for the fixed assets purchased in prior periods and not yet disposed of before year-end. If the fixed assets are purchased during the year, they must be depreciated from the purchased months to year-end. If the assets are disposed of during the year, the depreciation must cover from the beginning of the year to the disposed month.
- Accuracy: The amount of depreciation expense record must be the same as the actual transaction. Due to the nature of depreciation, the record depends on the calculation, so auditor can recalculate the depreciation to ensure accuracy.
Before recalculation, auditors have to perform reliability testing over the fixed assets listing as we have mentioned above. In addition, they have to check the depreciation rate and compare it with the company policy which has already been reviewed.
With the help of an Excel spreadsheet, auditors can recalculate the depreciation and compare it with client calculations. Any variance must be investigated. They have to pay attention to the new fixed purchases and the disposal during the year. Most clients make mistakes in this area.
- Classification: Depreciation expense is only recorded in one account and presented properly on the income statement.
Auditor can review the classification of depreciation expenses that are present on the income statement.