Chapter 20 Auditing Prepayments and Accruals

Browse Location: United States\PwC Material\Montgomery's Auditing, Twelfth Edition\Part 3: Auditing Specific Accounts20Auditing Prepayments and Accruals20.1 AUDIT OBJECTIVES20.2 INTERNAL CONTROL20.3 DETERMINING THE AUDIT STRATEGY20.4 SUBSTANTIVE TESTS(a) Accrued Pension Costs,(i) Auditing Insured Plans,(ii) ERISA-Related Procedures,(b) Other Postretirement Benefit Obligations,(i) Accounting for the SubstantivePlan,(ii) Actuarial Assumptions,(c) Postemployment Benefit Obligations,(i) Type s of Postemployment BenefitsOffered by Employers,(ii) Accounting Requirements,(iii) Auditing PostemploymentBenefits,(d) Environmental Liabilities,(i) Accounting Requirements,(ii) Auditing EnvironmentalRemediation Liabilities,(e) Self-Insurance Arrangements,(f) Substantive Tests of Other Prepayments andAccruals,(i) Prepaid Insurance,(ii) Prepaid and Accrued PropertyTaxes,(iii) Prepaid and AccruedCommissions,(iv) Travel and Other Advances,(v) Accrued Profe ssional Fees,(vi) Bonuse s and Profit-SharingPlans,(vii) Unpaid Dividends,(viii) Compensated Absence s,(ix) Royalties Payable,(x) Provisions for Warranty Costs,(xi) Suspense Debits and Credits,Prepayments are assets, most often in the form of services (but sometimes goods such as stationery and supplies), that have been acquired as part of the purchasing cycle but that apply to future periods or to the production of future revenues-for example, unexpired insurance, rent paid in advance, and prepaid taxes other than those on income. There is little conceptual difference between prepayments and assets like inventories, plant and equipment, and intangibles: All are expected to benefit future periods. Prepayments often are assumed to be less readily realizable than inventory or equipment, but there are significant exceptions; it may be easier to realize cash from the contractual right to cancel an insurance polic y than on a custom-built, single-purpose structure.Prepayments consist of prepaid expenses and deferred charges; the distinction is based mainly on whether the asset is current or noncurrent. How precisely that distinction is made depends on custom and materiality considerations. Prepaid insurance, for example, and many types of deposits do not expire and are not realized within one year or the entity's operating cycle, but traditionally are classified as current. The prepaid expense account is seldom material to the financial statements, and noncurrent items that are not material are included in prepaid expenses for convenience. If deferred costs (such as debt issuance costs) are material and will expire over several years, they are properly classified as noncurrent deferred charges.Accruals, often referred to as accrued expenses, are items for which a service or benefit has been received and for which the related liability is acknowledged and reasonably determinable, but that are not yet payable (either because of the terms of the commitment or because the invoice has not been received). Some accrued liabilities accrue with the passage of time-for example, interest, rent, and property taxes-or with some service or activity, for example, payrolls, pensions, vacation pay, royalties, sales commissions, and payroll taxes. Others-for example, accrued environmental remediation costs-are accrued when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Deferred credits (such as unearned revenue and deferred income accounts) result from the receipt ofrevenues in advance of the related delivery of goods or services and are discussed in Chapter 18.Agency obligations, such as payroll withholdings and deductions and sales tax collections, are funds collected for others for which accountability must be maintained until the funds are turned over at the required time to the agency for whom they are held in trust. Those obligations result from transactions that are part of the purchasing cycle, discussed in Chapter 14, and the revenue cycle, discussed in Chapter 13.Many similarities exist among prepaid expenses, accrued liabilities, and agency obligations and among the underlying transactions that affect these accounts. For example, similar types of transactions may result in prepaid insurance or accrued insurance expense; the same is true for rent and property taxes. Items such as insurance premiums and various deposits often are held as agency obligations. All three categories of accounts frequently are subjected to similar types of controls and the general audit approach employed is also similar.Other prepayments and accruals, such as those for pension and other postretirement benefits, are estimates that are highly dependent on assumptions and usually are prepared by specialists, such as actuaries. The audit approach for those accounts focuses on determining the reasonableness of those estimates and on using the work of specialists.20.1 AUDIT OBJECTIVESThe auditor should approach prepayments and accruals with the view that liabilities are more likely to be understated or omitted from the accounts than overstated and, conversely, assets are more likely to be overstated than understated. Therefore, audit objectives should focus on ascertaining that prepaid assets are not overstated and that accrued liabilities are not understated, but without ignoring the possibility that the opposite may occur.In specifying audit objectives for prepaid assets, the auditor should focus on obtaining reasonable assurance that:∙All amounts reported as assets were acquired in authorized transactions and were properly recorded at the time of acquisition (existence/occurrence, accuracy)∙The balance of the expenditure carried forward relates to future periods or can be reasonably expected to be recovered from future income (valuation or allocation)∙The basis of amortization is reasonable and consistent with prior years (valuation or allocation)∙Related expenses are properly classified (presentation and disclosure)Principal audit objectives related to accrued liabilities are to obtain reasonable assurance that:∙All material accrued expenses, agency obligations, and other liabilities existing at the balance sheet date have been authorized, recorded, and properly measured(completeness, existence/occurrence, accuracy, and valuation or allocation)∙Related expenses have been recognized and properly measured on a consistent basis (valuation or allocation)20.2 INTERNAL CONTROLChapter 14 discusses the acquisition of goods and services and the controls to which such expenditures usually are subjected. The transactions that give rise to prepayments and accruals often originate and are processed and controlled in the same way as transactions for other goods and services. Other prepayments and accruals, particularly those that are based on assumptions and estimates prepared by specialists such as actuaries, are not the result of transactions that are considered part of the purchasing cycle and, therefore, may not be subject to extensive control activities.Control activities are applied to recurring prepaid expenses, accrued liabilities, agency accounts, and other liabilities to ensure timely recording of the required entries. Those activities are necessary because of the method of procuring many prepaid and accrued expense items. Recurring services such as utilities and rents, after initial identification, are provided continuously without further request. Specialized services, such as insurance, legal, advertising, and auditing services, also are frequently rendered on an ongoing basis. Real estate and property taxes are assessed and paid according to the taxing authority's fiscal year, and must be properly allocated to the entity's interim accounting periods. Systematic recording of accruals and amortization is best ensured by making standard monthly journal entries, approved by appropriate personnel.After a prepaid expense has been recorded, further monitoring is required to ensure that it is amortized properly and that the unamortized balance does not exceed the value of the future benefit. If the expenditure initially was charged directly to an expense account, the appropriate amount (i.e., the portion deemed applicable to future p eriods) is removed from the expense account at the end of each accounting period and recorded as an asset.Control activities for recurring prepayments, accruals, and the related expense accounts frequently include maintaining detailed files for expenditu res like insurance, rent, and commissions, or schedules that are cross-referenced to the related supporting documents and contain pertinent information like cost, starting date, period covered, and amount to be expensed or accrued each period. The account balances and amortization computations are subjected to periodic monitoring activities. Some liability and agency accounts are treated as part of the purchasing cycle and are subjected to related accounting procedures and control activities. That may be the case for payroll withholdings, customers' deposits, and commissions payable.20.3 DETERMINING THE AUDIT STRATEGYThe auditor may obtain the required understanding of internal control with respect tosystems-derived prepaid and accrued accounts as part of auditing the purchasing cycle. Although the assessment of control risk for these accounts is strongly influenced by the assessed level of control risk for the purchasing cycle, the audit strategy for prepaid and accrued accounts usually emphasizes substantive tests of year-end account balances, largely because of efficiency considerations. In this regard, Statement on Auditing Standards (SAS) No. 78, Consideration of Internal Control in a Financial Statement Audit: An Amendment of SAS No. 55 (AU Section 319), recognizes that "ordinarily audit planning does not r equire an understanding of the control activities related to each account balance, transaction class, and disclosure component in the financial statements or to every assertion relevant to them" (para.33). Also, a single test may serve to both substantiat e a prepaid or an accrued account balance and test the related control activities. Moreover, since substantive tests of balance sheet accounts at the beginning and end of a period also tend to provide assurance about the related expense accounts, it is both conceptually sound and efficient for the auditor to focus on substantive testing of the balance sheet accounts.In formulating the audit strategy for systems-derived prepaid and accrued accounts, the auditor considers the nature and materiality of the specific accounts, the desired timing of their examination, and inherent risks that have been identified. The auditor might perform tests of controls relating to prepayments and accruals on an engagement involving an extremely fast year-end report release or publication of financial data by a large, well-controlled entity. Those tests would focus on control activities addressing the accuracy and authorization of prepayments, and the completeness of accruals.The auditor often reviews and analyzes the composition of prepayments and accruals at an interim date. It is ordinarily more efficient, however, to perform other substantive tests at the balance sheet date, unless there are year-end time constraints that make early testing desirable. Early substantive testing requires the auditor to consider alternative means of obtaining the necessary audit assurance at the balance sheet date. In many cases, this is accomplished by updating the substantive tests performed at an interim date. In other situations, the auditor may perform tests of controls during the intervening period. Even in these cases, however, the auditor would be likely, at a minimum, to review the year-end account balances for reasonableness.In determining the extent of substantive tests, the auditor should consider the inherent risk that the account may be materially misstated. Two key aspects of this risk are how liquid an asset is and the extent to which judgment enters into determining the account balance. Since prepayments by their nature are not particularly liquid, this usually is not a significant factor. Also, little judgment may be required for many of the recurring expenses that are amortized or accrued on a time basis, such as rent, insurance, and interest.The materiality of prepaid asset and accrued liability accounts also may be a significant consideration in determining the extent of substantive tests. Some prepayments and accruals are insignificant, and an auditor may consider it sufficient simply to compare the balance with the corresponding balance in the prior period and scan the current-period activity. On the otherhand, since auditing prepayments and accruals often affords insight into certain controls in the purchasing cycle and therefore may contribute to an auditor's understanding of internal control, some auditors scrutinize individual accrued and prepaid accounts even though the balances are insignificant.Furthermore, while an individual prepaid account may not be significant to the balance sheet, an understanding of the content of the account may alert the auditor to a potential misstatement that could have a material effect on the financial statements. This is especially true of the prepaid insurance account. An understanding of the manner in which the entity manages risk, in particular the types of insurance coverage it maintains, may make the auditor aware of uninsured risks or unrecorded liabilities.In many circumstances, the same auditor audits the financial statements of both the entity that provides pension and other employee benefits (i.e., the employer) and the related benefit plans themselves. When designing the nature, extent, and timing of auditing procedures for financial statement amounts recorded in accordance with Statement of Financial Accounting Standards (SFAS) Nos. 87 and 106, the auditor should not only base materiality judgments on the employer's financial statements, but also consider expected materiality to the plan's financial statements. Considering plan materiality when auditing the employer's financial statements can help avoid later adjustments to amounts in the plan's financial statements.20.4 SUBSTANTIVE TESTSSubstantive testing usually consists of examining the contractual, statutory, or other basis for prepayments and accruals; examining documentation that supports additions to the accounts; ascertaining that the method of calculating periodic amortization or accrual is appropriate; and recomputing the amortization or accrual and the account balance. For many accrued liabilities and some prepaid expenses, the accrual or prepayment is based on an estimate of a liability or a future benefit that cannot be determined precisely. In that case, the basis and rationale for the estimate should be reviewed, compared with prior experience, and evaluat ed in the light of related circumstances. The related expense account usually is audited (at least in part) in connection with the aforementioned amortization or accrual.The balances of agency accounts should be supported by trial balances of the detailed amounts. Based on materiality and risk assessment, the auditor should consider the need for substantive tests directed at the completeness and accuracy of agency accounts.Prepaid expense and accrued liability balances often consist of routine recurring allocations of expenses between periods. When this is the case, the auditor often can obtain the necessary assurance about the accuracy of the account balance by recomputing it or applying analytical procedures, without performing a detailed analysis of the activity in the account. Thus, in some cases, analytical procedures are the principal or even the only substantive tests performed on prepaid and accrued accounts. Balances in those and related expense accounts should be compared with the prior-year balance sheet and income statement amounts. The underlying causes of trends, fluctuations, and unusual transactions should be evaluated for theirimplications for other accounts. If they exist, variance reports and analyses of actual costs and expenses compared with budgeted amounts also may be examined.In a stable business, predictable relationships often exist among certain accounts, and changes in those relationships may signal conditions requiring accounting recognition. The auditor should compute pertinent ratios and compare them with corresponding ones for prior periods. For example, comparing selling expense with sales might lead the auditor to discover sales commissions that should be but were not accrued. Unexplained changes in ratios involving revenue and expense accounts may indicate possible misstatements of related prepayments and accruals.Analytical procedures applied to related expense accounts can provide additional assurance about the reasonableness of prepayments and accruals. The auditor m ay review expense account activity for missing or unusual entries that may indicate unrecorded liabilities or the failure to amortize prepayments. Substantive tests of details normally are not performed on expense account balances unless the controls are extremely ineffective or the auditor wants additional assurance in high-risk or sensitive areas (such as legal expense).(a) Accrued Pension CostsTo ascertain that the liability for pension costs and the related expense have been determined in conformity with generally accepted accounting principles (GAAP), as set forth in SFAS No. 87, Employers' Accounting for Pensions (Accounting Standards Section P16), the auditor must understand the contractual and other arrangements giving rise to pension costs and be aware of the requirements of the Employee Retirement Income Security Act of 1974 (ERISA).1SFAS No. 87 prescribes precisely the way to calculate pension costs. The significance of pension costs to most entities, and the effect of a possible misstatement of them on the financial statements, often calls for substantive testing. The extent of testing will depend on theauditor's risk assessment and on materiality considerations.Many of the basic calculations required by SFAS No. 87 are actuarial calculations that should be considered the work of a specialist, and the auditor should apply the provisions of SAS No. 73, Using the Work of a Specialist (AU Section 336), in auditing those amounts. This does not require the auditor to reperform the actuary's calculations. Rather, the auditor needs to be satisfied that the assumptions provided by the entity and the methods used by the actuary are reasonable and in conformity with GAAP. It is particularly important for the auditor to understand the reasons for fluctuations in pension information from one period to the next, for example, changes in the settlement rate assumption, the methods and time periods for amortizing gains and losses, prior service cost, and the transition amount.Under SAS No. 73, the auditor should obtain an understanding with the entity and the actuary about the nature of the actuary's work. This understanding should cover:The objectives and scope of the actuary's work∙The actuary's representations regarding his or her relationship, if any, to the entity∙The methods and assumptions to be used∙ A comparison of those methods and assumptions with the ones used in the preceding period∙The appropriateness of using the actuary's findings to corroborate the representations in the financial statements∙The form and content of the actuary's report needed by the auditorSAS No. 73 requires the auditor to evaluate the actuary's qualifications, reputation, and experience. The auditor also is required to make appropriate tests of the census data and other information the entity provided to the actuary. Those tests include confirming directly with the actuary the information provided by the entity and used by the actuary and reconciling that information to the entity's payroll and other records.In examining actuarially determined amounts, the auditor should be satisfied that the assumptions provided by the entity and the methods used by the actuary conform with the provisions of SFAS No. 87. The auditor should not rely on an actuary's conclusion about whether the actuarially computed amounts conform with GAAP; such a conclusion requires a skilled and experience-based knowledge of accounting principles. The auditor should inquireof management or the actuary about unusual or unexpected shifts from the prior period in components of pension cost or benefit obligation. Analytical techniques can be effective audit tools when performed with an appropriate understanding of the methodologies prescribed in SFAS No. 87, the entity's activities, and the characteristics of its work force.Other suggested procedures are set forth below. They are not intended to be all-inclusive or to apply to all situations. Selecting auditing procedures appropriate for a particular situation is a matter of judgment.∙Identify the entity's pension plans, and obtain an understanding of the nature, coverage, and other relevant matters pertaining to each plan.∙Compare pension cost and related balance sheet and disclosure amounts and other information with the prior year for reasonableness and changes affecting comparability.Trace amounts to the actuary's report and to any supporting schedules or workingpapers used in connection with other auditing procedures.∙Evaluate compliance with ERISA (see below).∙Determine whether plan asset and obligation amounts have been computed as of the measurement date and whether plan assets have been measured in conformity withGAAP. Investments are generally measured at fair value, except that certain contractswith insurance companies may be measured at their contract value, as discussed inSFAS No. 110 (Accounting Standards Section Pe5).∙Examine the entity's records to determine that the basic data (e.g., size, age, and sex distribution of the work force) used by the actuary is appropriate and that employeesultimately entitled to participate in the plan have been included in the actuarialcalculations. Trace (normally in summary form) the employee data tested to theactuary's report or confirm it directly with the actuary.∙Review the actuary's report to determine whether all plan terms have been properly reflected in it and that the actuarial cost method is appropriate.∙Determine whether pension cost and related amounts have been computed on a consistent basis and recognized and disclosed in conformity with GAAP.∙Review the period from the measurement date to the entity's year-end (and beyond, to the extent necessary) to determine whether any significant events (e.g., changes inplan provisions) have occurred that would materially affect the computation of theprovision for pension costs. If such events have occurred, consult with the actuary and obtain an estimate of the dollar effect on the provision.(i) Auditing Insured Plans. The auditor needs to determine the nature of the arrangement between the employer and the insurance company. In some arrangements, an insurance company unconditionally undertakes a legal obligation to provide specified benefits to specific individuals in return for a fixed consideration or premium. For example, the insurance company sells a nonparticipating annuity and assumes the risks and rewards associated with the benefit obligation and the assets transferred. On the other hand, in participating annuity arrangements, the employer participates in the experience of the insurance company, whereby the insurance company typically pays dividends to the purchaser, effectively reducing the employer's cost. Many variations of such contracts exist.Auditing procedures for annuity contracts normally involve examining the contract or insurance company dividend and premium statements. If the annuity is a participating annuity, the participation right should be recognized, at cost, as an asset at its inception. The cost is determined by comparing the participating annuity contract with equivalent contracts without participation rights. In subsequent periods, the auditor should ascertain whether fair value can be reasonably determined and, if it cannot, should review the method used to amortize the cost of the participation right.(ii) ERISA-Related Procedures. In reading minutes of meetings of the entity's board of directors and pertinent committees, and in performing other auditing procedures, t he auditor should be alert to any evidence that a pension plan may potentially be terminated. In addition, the auditor may wish to inquire of management about the possibility of a plan termination. If there is more than a remote possibility, the auditor should ensure that appropriate entries are recorded or disclosures made in the financial statements.The auditor should obtain evidence that the entity is in compliance with ERISA (the Act), since noncompliance may have an impact on the financial statements. In addition to funding requirements, the Act requires compliance in the areas of plan design, reporting and disclosure, fiduciary responsibilities, and record keeping. Determining compliance with the Act is a legal matter; the auditor therefore customarily relies on inquiries of the actuary, plan trustees, and the entity's and the plan's legal counsel for those determinations, as well as obtaining a representation from the entity as part of the management representation letter.(b) Other Postretirement Benefit ObligationsThe provisions of SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (Accounting Standards Section P40), are similar in many respects to those of SFAS No. 87, Employers' Accounting for Pensions (Accounting Standards Section P16), and SFAS No. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits (Accounting Standards Section P16). SFAS No. 106, however, addresses matters unique to nonpension postretirement benefits and provides recognition, measurement, and disclosure requirements related to those benefits.2As SFAS No. 106 notes, "to the extent the promise to provide pension benefits and the promise to provide postretirement benefits are similar, the provisions of this Statement are similar to those prescribed by Statements 87 and 88; different accounting treatment is prescribed only when the Board has concluded that there is a compelling reason for different treatment." Thus, auditing procedures for postretirement benefit costs and obligations are similar to those for pension costs and obligations, although there are some distinctions.(i) Accounting for the Substantive Plan. SFAS No. 106 requires that the accounting reflect the substantive terms of the postretirement benefit plan as understood by the employer and its employees. The substantive plan, however, may not be reflected in the terms described in the written plan. For example, a past practice of regularly increasing benefits or changing the cost-sharing provisions of the plan (e.g., deductibles, coinsurance provisions, or retiree contributions) may indicate that the substantive plan differs from the written plan.An employer's cost-sharing policy will constitute the cost-sharing provisions of the substantive plan if either of the following conditions exist:1. The employer has a past practice of either (1) maintaining a consistent level of costsharing with its retirees or (2) consistently increasing or decreasing its share of thecost of benefits by changing retirees' or active plan participants' contributions,deductibles, coinsurance provisions, out-of-pocket limitations, and so forth, inaccordance with the employer's established cost-sharing policy.2. The employer has the ability, and has communicated to affected plan participants itsintent, to institute different cost-sharing provisions at a specified time or when certainconditions exist (e.g., when health care cost increases exceed a certain level).。