As auditors, we usually perform substantive analytical procedures in the audit of depreciation. However, where the risk is high in this area and we assess that the internal control cannot rely upon, we might need to perform the test of details instead.
In the accounting or audit, depreciation is the way the company spread the cost of a fixed asset over the useful life of the asset. The spreading cost is based on the economic value that the asset provides to the company.
Likewise, there are several commonly seen depreciation methods of the fixed asset that we may need to know when we audit depreciation. In this case, such depreciation methods may include the straight-line depreciation method, declining balance, units of production, and sum of the years’ digits.
The primary inherent risk of depreciation in the financial statements is that the depreciation expense may be understated. This can be due to the company may use the inappropriate depreciation method and the estimated useful life of the assets to manipulate depreciation expenses in order to increase the company’s profit in the current year.
Hence, it is important for us to carefully assess the reasonableness of the depreciation method and the estimated useful life that the client used in the calculation of the fixed asset depreciation.
Audit Procedures for Depreciation
As auditors, we have responsibility to design appropriate audit procedures in order to obtain sufficient appropriate audit evidence to support our opinion. In this case, the type of audit procedures for depreciation may depend entirely on the risk of material misstatement that can occur in the depreciation expense accounts.
Hence, based on the risk level of the depreciation expense that is exposed to the client’s financial statements, we may perform either analytical procedures or substantive tests of details.
Usually, we perform analytical procedures on depreciation expense when the assessed risk in this area is low. On the other hand, we need to perform the test of details in order to gather sufficient audit evidence to make a conclusion on depreciation expense account if the assessed risk of material misstatement here is high.
Analytical Procedures for Depreciation
When we determine that the risk is low and the client has proper internal control on fixed assets and depreciation, we usually audit depreciation by performing substantive analytical procedures. In this case, substantive analytical procedures for the audit of depreciation may include the reasonableness test, trend analysis, and examining the related accounts.
Like other accounts, we usually perform the substantive analytical procedures for depreciation by starting with building our expectations; and then we compare our expectations with the client’s record.
However, it is useful to note that we should always consider the reliability of the data that we use to build our expectations when performing analytical procedures. Also, we need to properly determine the suitability of particular procedures in testing certain assertions.
Example of Analytical Procedures for Depreciation
For example, we audit depreciation by performing a reasonableness test on the assets that use the straight-line method. To do this, we build our expectations with the estimated amount of depreciation by using the average depreciation rate and the average cost of fixed assets.
In this case, fixed assets should be breakdown by types of assets as they should have some differences in depreciation rate. Also, new added fixed assets and fixed assets disposal should be taken into account as the adjustment to the estimate depreciation.
Then we compare the result with the depreciation expense in the client’s record. If there is a significant difference that is outside of our expected range, we will investigate further e.g. by performing the test of details.
Other procedures may also be performed including:
- Comparing the current year depreciation expense with the previous year
- Reviewing the relationship and fluctuation of depreciation expense comparing those of fixed asset costs
- Reviewing the average age of fixed assets comparing to our estimate of fixed asset depreciation rate
Test of Details for Depreciation
In a situation where we determine that there are high risk and no proper internal control in place to prevent or detect material misstatement related to depreciation expense accounts, we usually audit depreciation by performing the test of details.
In this case, we usually perform the test of details by selecting a sample of depreciation recorded in the general ledger and perform the recalculation procedure.
Below is an example of test of details for depreciation:
- Obtain fixed assets register or listing containing all important information including fixed assets cost, estimated useful life, residual value and depreciation method.
- Reconcile fixed assets register to the general ledger
- Select a sample of fixed assets in the fixed assets register
- Recalculate depreciation expense on the selected sample of the fixed asset
- Compare the result of recalculation to the client’s record of each selected fixed assets