Internal Control of Fixed Assets: A Controller and Auditor's Guide

Preface

FOR MANY COMPANIES, FIXED assets, sometimes referred to as Property, Plant, and Equipment (PP&E) represent the largest single asset category on the balance sheet. Yet rarely do fixed assets command management time that is proportionate to the magnitude of the investment. Companies may devote significant resources to capital expenditure budgeting and approval, making extremely detailed calculations about proposed capital outlays. But once the project is completed, and in operation, subsequent record keeping and controls are often lax.

Management usually assumes that since fixed assets are fixed there should be little trouble monitoring what is going on. Accountants are concerned with calculating annual depreciation charges, for their company’s books and taxes. Occasionally, the property record will be the basis of decisions on insurance coverage for the assets. Even less frequently, property tax assessments may be challenged, but this is often the responsibility of the tax department.

So while there are many uses, and many users, of a good property tax accounting system, the one thing that is usually lacking is a reconciliation of the books of account to the assets actually present physically. While every company takes a physical inventory of raw materials, work in process, and finished goods, very few actually take a look at their fixed assets and compare what is there with what the property record says is there.

In short, there is a gap here in Internal Control, a gap that goes on year after year. The assumption is often made, Well our records might not be perfect, but they were good enough to get by our audit last year, nothing has changed, so we should be okay this year. Further, auditors and managements often are more interested in year to year comparisons rather than the value of absolute amounts. So if this year’s depreciation expense can be reconciled to last year’s depreciation expense, allowing for additions and deletions, everything is assumed to be correct.

Compounding the issue is that while the subject of Internal Control has generated tremendous interest following adoption of Sarbanes-Oxley (SOX), most efforts have been devoted to areas such as revenue recognition and financial instruments. By and large independent auditors review fixed-asset accounting controls, make sure there have been no changes since the previous audit, and wish for the client to take and reconcile a physical inventory. Many management letters from auditors to audit committees and the Chief Financial Officer (CFO) have almost a boilerplate recommendation that such an audit should be undertaken.

Taking, and reconciling, an inventory of PP&E is a major project. Particularly in a period of retrenchment, when the company has to do more with less, the priority of a physical inventory of PP&E inevitably slips until the next year comes around and the process starts again. This state of affairs continues because PP&E is seen as having a lower priority than many other aspects of Internal Control. Items which command the attention of auditors become a priority of the audit committee. In turn, auditors’ priorities are set by their perception of what the Public Company Accounting Oversight Board (PCAOB) is focusing on. And, to date, PCAOB has not put emphasis on their reviews on what the audit firms did with client PP&E. As noted, revenue recognition and financial instruments at fair value seem to have a much higher PCAOB priority.

But what if the PCAOB starts to review auditor workpapers dealing with PP&E on a more intensive basis? Most auditors’ workpapers would likely come up short. Unfortunately, if the PCAOB was to start putting PP&E on a priority basis, companies would feel intensive pressure from their external auditors.

As will be discussed in this book, developing a sound system of internal control for fixed assets, and cleaning up past errors and omissions, are not trivial efforts. Realistically they really cannot be done in less than one to two years, assuming that all other financial and operating functions of the business must continue to be carried on at current rates. Put another way, extra resources will inevitably have to be devoted to fixing existing fixed-asset systems. This will cost time and money, which most management will begrudge—which of course is the reason we are where we are today.

This is the first comprehensive book to focus on Internal Controls for Fixed Assets. It is a step-by-step guide to developing and maintaining a functioning internal control system that will withstand the closest scrutiny from independent public accountants and ultimately the PCAOB.

We recommend strong internal audit involvement in diagnosing the current condition of the present fixed-asset accounting system. Internal audit should also be involved in the development of specific recommendations for the required remedial work. Performing the actual required work should probably be managed by existing accounting and operations staff often with the help of outside consultants. Depending on the speed with which the company wishes to finish the task, some temporary help may be necessary, and use of an outside consultant may be cost effective.

At the time this is written it is not clear whether the United States will or will not have adopted International Financial Reporting Standards (IFRS). Nonetheless, and in order for this to be valuable even to U.S. subsidiaries that do have to report under IFRS, throughout the book similarities and differences between IFRS and Generally Accepted Accounting Principles (GAAP) will be covered. Two major differences are that under IFRS companies are permitted, although not required, to write up certain assets and investment properties. Second, in case an impairment charge has been taken, a subsequent improvement in the value can be booked, thus reversing the prior impairment charge. Neither of these is currently permitted under GAAP.

As the Financial Accounting Standards Board (FASB) increases the use of fair value, it is possible that PP&E at some time may have to be written up in the United States to current fair value. We briefly touch on this topic, although other books cover this specific subject of fair value in much greater detail. We do cover in detail present requirements for testing for impairment, because this is a subject which potentially affects almost every company.

The primary focus of this book is PP&E, but we also cover briefly certain aspects of intangible assets, primarily those that arise in a business combination.

Because of the importance of SOX compliance, we focus on the role of internal auditing in making sure that companies come as close as possible to full compliance. If independent accountants, given a push from the PCAOB, start to focus on internal controls dealing with PP&E, it will be critical for internal audit staffs to become intimately involved. While the primary emphasis is on the accounting and management control aspects, it is clear that internal audit must be fully knowledgeable of what the current state of affairs is, and what the ultimate goal should be.

Inasmuch as this is probably one of the first books written on the subject, the author will welcome comments and suggestions from readers for subsequent editions ([email protected]). It is impossible to cover everything of importance and undoubtedly certain topics will have been inadvertently left out. All help will be graciously accepted.

Readers are not expected to sit down and read this book from cover to cover. Rather it should be considered an overall guide to the total subject. Each chapter more or less stands on its own. References to material in other chapters are given. Nonetheless, there is some overlap, and this represents a conscious decision to make the book as user friendly as possible.

Alfred M. King

April 2011

CHAPTER ONE.1

Internal Control, Sarbanes-Oxley, and the Public Company Accounting Oversight Board

AS WILL BE DISCUSSED in this chapter, most company Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) are signing an annual certification with the Securities and Exchange Commission (SEC). The certification states that they are complying with the applicable requirements of the Sarbanes-Oxley Act (SOX). What may not be known is that those requirements actually include a mandatory physical inventory of Property, Plant, and Equipment (PP&E) and a reconciliation of that inventory to the books of account, with any changes having to be recorded properly.

INTERNAL CONTROLS OVER PROPERTY, PLANT, AND EQUIPMENT-MANDATORY BUT WEAK

It is a rare company indeed that has recently taken a physical inventory of its PP&E, reconciled that inventory to the books of account, and then adjusted the books for ghost¹ and zombie assets. Unless this task is completed, it is hard to see how a CEO and CFO can honestly sign the required SOX certification. A real-life CEO certification in a Form 10-K sent to the SEC goes something like this:

"SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of ___ Inc. (the Company) on Form 10-K for the period ending September 27, 20xx, as filed with the Securities and Exchange Commission on the date hereof (the Report), I, ___, as the Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of my knowledge:

(1) The Report fully complies with the requirements of section 13 (a) or 15(d) of the Securities Exchange Act of 1934

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company

In turn, this requirement in 18 U.S.C. (United States Code) 1350 reads:

"Sec. 1350. Failure of corporate officers to certify financial reports

(a) CERTIFICATION OF PERIODIC FINANCIAL REPORTS-Each periodic report containing financial statements filed by an issuer with the Securities Exchange Commission pursuant to section 13 (a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)) shall be accompanied by a written statement by the chief executive officer and chief financial officer (or equivalent thereof) of the issuer.

(b) CONTENT-The statement required under subsection (a) shall certify that the periodic report containing the financial statements fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C 78m(a) or 78o(d)) and that information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer."

The applicable law referenced above reads:

(a) Reports by issuer of security; contents:

(1) Every issuer of a security registered pursuant to section 781 of this title shall file with the Commission, ...

(2) Such annual reports (and such copies thereof), certified if required by the rules and regulations of the Commission by independent public accountants, ...

(b) Form of report; books, records, and internal accounting; directives . . .

(2) Every issuer which has a class of securities registered pursuant to section 78l of this title and every issuer which is required to file reports pursuant to section 78o(d) of this title shall—

(A) Make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer

(B) Devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that—

(i) Transactions are executed in accordance with management’s general or specific authorization

(ii) Transactions are recorded as necessary

(I) To permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements

(II) To maintain accountability for assets

(iii) Access to assets is permitted only in accordance with management’s general or specific authorization

(iv) The recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences

Cutting through all the legalese, these laws and regulations, certified by the CEO and CFO of every publicly traded company, appear to require just what we are writing about in this book. Companies must take a periodic physical inventory of PP&E and then have a reconciliation of that inventory to the books of account. Yet very few companies are actually doing this.

Virtually every company that owns fixed assets, sometimes referred to as Property, Plant, and Equipment, does have a computerized property record system. There are a number of such fixed-asset or property record software systems on the market and most of them do a reasonable job of (1) recording newly acquired assets, (2) computing depreciation expense for books and taxes, and (3) allowing for additions and deletions over time.

The programs have provision for adjustments based on physical inventories, but such capabilities are rarely used. Our professional experience when we actually try and locate assets from the property record system is that up to 15% of the assets cannot be located! Offsetting these ghost assets are what we refer to as zombie assets, which are physically present but not on the property record system.

It would be hard to argue that a record, which is 15% off from economic reality represents internal control that complies with the SOX requirements stated above.

But it is not all bad news. Once a company gets into compliance with an accurate record, one that can and will be maintained properly in the future, there are a number of benefits.

As will be discussed in this chapter and throughout the book, a typical property record system probably meets the needs of the accounting department, which is the requirement for periodic calculation of depreciation expense. Most companies however, at least in the author’s experience, do not fully use their property records for many of the following additional tasks:

• Internal Control

• Internal Audit of Capital Expenditures

• Maintenance and Condition

• Insurance

• Property Tax

• Return on Investment

• Transfers between departments and plants

Further, while the accounting department is usually the custodian of the records, as well as the principal user, many other departments can and should be involved, as shown in the previous listing. The previous listing is not in random order, and the very first item, internal control, is of critical concern for all publicly traded companies and any privately held firm that could be sold to a public firm at some point in the future.

What is internal control over fixed assets? Internal control means far more than just having a printout of assets that you bought and have not yet fully depreciated. Internal control really means having assurance that the assets you think you own are still there, and that they have not gone missing. While it may not immediately come to mind, internal control also means that you do not have assets physically present that are not on your books at all or zombie assets.

Any generalization that companies are not in compliance with the books and records requirements of the Securities and Exchange Commission (SEC), can be disproved for any single company; it must be admitted that certain firms, particularly in the utility and defense industries, do a pretty good job of internal control. But by and large it is a very safe generalization that most companies have poor, or even nonexistent, controls over PP&E.

Before looking at internal controls over PP&E, let us take a look at an area where virtually all companies do have good internal control systems, that is, working capital.

INTERNAL CONTROLS OVER WORKING CAPITAL

Companies every year send out confirmations to their customers, asking them to verify that the receivables on the books of account represent real liabilities by the customer to the company. Auditors usually carry out this confirmation project, and attempt to reconcile any differences which are uncovered. Certainly when a customer is willing to acknowledge that it owes money this is an indication that the company’s control over receivables complies with all applicable internal control requirements.

Any differences in receivables reported by customers or clients then become the basis for further analysis. The reasons that companies do not pay, or withhold payment from their suppliers, are as varied as the human imagination can develop. These excuses for nonpayment are an integral part of the business model of suppliers to retail firms. Yet nonpayment does not indicate a lack of control. It does suggest that there are some problems between the two firms that must be resolved. This is not a responsibility of the auditor, but rather between marketing and production relative to what the customers received, as contrasted to what they thought they would receive. Only on the rare occasion where there is actual fraud do receivables appear to be out of control.

Internal control over inventories is somewhat more difficult, at least in terms of pricing out the items, and assessing whether some of the items on hand are surplus or obsolete. Nonetheless, companies either have a perpetual inventory system that is constantly being tested for accuracy, or they take an annual physical inventory. After pricing out the items on hand, and comparing the total to the book balances, inventory shrinkage charges often must be made. Retailers usually budget for such losses, while other manufacturing and wholesale companies attempt to keep writedowns to an absolute minimum. The reason is clear: Adjustments directly hit the profit and loss (P&L) accounts, and reported earnings are going to be reduced.

Pricing out an inventory, depending on the type of company, may involve significant judgment. It is the application of this judgment that auditors review, after assuring themselves that the reported physical quantities are accurate. Two examples of the type of judgment that is required are (1) if the company is on LIFO (last in, first out) and (2) if the merchandise is seasonal and may be unsalable at list price. Valuing inventory is an integral responsibility of every company and it is safe to say that the job is either done properly, or the firm itself is going to be in financial difficulty.

Thus when signing an SOX certification there is little downside risk for the CEO and CFO with respect to working capital. The SOX requirements for internal control obviously go way beyond working capital, particularly for valuing financial instruments and for developing accurate revenue recognition. Such functions are outside the scope of this book. We do cover working capital because all the issues in valuing receivables and inventory are involved in PP&E, as will be discussed in this book.

SECURITIES AND EXCHANGE COMMISSION AND PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD SCRUTINY OF FINANCIAL STATEMENTS

Similarly, we do not devote effort here to the valuation problems of intangible assets and the determination of whether any of them are impaired or not. Valuation of intangibles is high on the audit requirements of most auditing firms, because of Public Company Accounting Oversight Board (PCAOB) scrutiny; consequently this scrutiny drives management effort. If management did not review intangibles at least once a year, there would be a real threat that the auditing firm could not and would not issue its opinion. Since every company filing with the SEC has to have an auditor’s attestation, what gets scrutinized by regulators gets done.

The PCAOB’s review of auditing workpapers drives auditing firms to be responsive to what the PCAOB review team checks in their annual review. Knowing the PCAOB will be looking at financial instrument valuation, and revenue recognition puts these functions near the top of an auditor’s to-do list in the annual audit. Knowing that auditors are going to review financial instruments and intangibles, as well as revenue recognition, means in turn that a company’s financial management devotes resources to these tasks. Thus, the signing of the SOX certification for these aspects of internal control does not cause any sleepless nights for CEOs and CFOs.

When it comes to scrutiny over fixed assets, however, the PCAOB so far has not had this very high on its list of things to review in auditor work papers. If the PCAOB is not worrying about something, then with limited time and fee, most auditors will not devote undue resources to client controls over PP&E. If the auditors are not looking at something then company management tends to put any such effort at a very low level.

In short, what gets measured gets done.

WHY DO AUDITORS NOT SPEND MORE TIME ON PROPERTY, PLANT, AND EQUIPMENT?

The standard audit certificate states:

In our opinion, the financial statements present fairly, in all material respects, the consolidated financial position of ___ and the consolidated results of operations and its cash flows, in conformity with U.S. generally accepted accounting principles.

Now, generally accepted accounting principles (GAAP) do not deal directly with internal control. The auditor’s review of a client’s internal control may be performed in conjunction with the financial statement audit, but is actually a quite separate review.

What auditors look for in reviewing annual financial statements of a client involves an understanding of what is going on in the business. Are there any unusual occurrences this year that might mean the client’s accounting could be off? Auditors look at this year’s P&L and balance sheet, and compare them with the corresponding statements of the prior year and the current year’s budget. As long as there is a consistent pattern, the no news is good news thought governs their actions.

Now, let us look at the property record system. When a new asset is listed, at a minimum the information recorded is the cost, the salvage value if any, the depreciation method (straight line, declining balance, etc.), and the expected life. From that point on the computer will calculate depreciation expense every month (or every quarter) until the original cost has been written down to zero or to the estimated salvage value.

The calculation of depreciation expense can, and will, go on irrespective of whether or not the asset is actually on hand. Suppose the asset is traded five years later, and the original life estimate was 12 years. If not written off at that time, then for the following seven years the company would continue to record depreciation expense until a zero balance was obtained.

Any audit tests comparing this year’s results with last year’s, or this year’s results with the budget will show a 100% correlation. Even if both years and the budget are wrong, the inexorable march until the asset is fully depreciated will continue. The error, which will never be caught absent a physical inventory, is that the asset is not in use, and should not be recorded as an asset belonging to the company. But on a comparative basis, year to year, there