CPA Exam — AUDPerforming Further Procedures and Obtaining EvidenceHard
An auditor is performing substantive analytical procedures on a client's operating expenses. The auditor notes a significant, unexpected decrease in 'Repairs and Maintenance' expense compared to the prior year, despite stable production levels. What is the most likely audit implication of this observation?
- AThe client may have capitalized expenses that should have been expensed, leading to an overstatement of assets and understatement of expenses.
- BThe client may have understated liabilities by not recording accrued repairs and maintenance expenses.
- CThe decrease suggests a potential overstatement of revenue, as management might be shifting focus from maintenance to sales.
- DThe decrease indicates improved operational efficiency, reducing the risk of material misstatement.
Show answer & explanationAnswer & explanation
Correct answer: A. The client may have capitalized expenses that should have been expensed, leading to an overstatement of assets and understatement of expenses.
An unexpected decrease in a recurring expense like repairs and maintenance, especially with stable production, often signals that the entity may have improperly capitalized these costs, thereby overstating assets and understating current period expenses to boost profitability.
Why the other options are wrong
- B. Understating accrued liabilities would typically lead to an understatement of expenses, but the primary concern with a significant *decrease* in recorded expense is often related to capitalization errors, not just unrecorded accruals which might be less material.
- C. An understatement of repairs and maintenance expense has no direct link to an overstatement of revenue; these are largely independent accounts.
- D. While improved efficiency is possible, an unexpected significant drop without explanation during stable production warrants further investigation for misstatement, not an immediate reduction in risk.
Analytical Procedure Anomaly: Expense Decrease
An unexpected decrease in a recurring operating expense, when other related accounts are stable, often indicates potential misstatement through improper capitalization of expenses.
- Analytical procedures highlight unusual fluctuations.
- Capitalization of expenses overstates assets and understates expenses.
- Requires further investigation to determine the cause and impact.
Memory trick: Hidden costs in assets, a profit's disguise.