Internal Control of Fixed Assets

A Controller and Auditor's Guide

Alfred M. King

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118028360
• Edition: 1
• Topic: Business
• Subtopic: Managerial Accounting
• Index: Business

For many companies, fixed assets represent the largest single aspect of their financial statement, yet rarely do they command time proportionate to the magnitude of the investment. This is the first book to show how to implement internal controls for fixed assets. It is a step-by-step guide for developing and maintaining a functioning internal control system that will withstand the closest scrutiny from independent public accountants and the PCAOB. With up-to-the-minute discussion of IFRS and GAAP, this is a must-have guide for controllers, auditors, and CFOs.

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...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Preface
• CHAPTER ONE.1 - Internal Control, Sarbanes-Oxley, and the Public Company ...
• CHAPTER TWO 2 - Capitalization versus Expense
• CHAPTER THREE 3 - Asset Life Cycle—Controls and Software
• CHAPTER FOUR 4 - Depreciation and Amortization for Books and Taxes
• CHAPTER FIVE 5 - Impairment Testing
• CHAPTER SIX 6 - Physical Control of Property, Plant, and Equipment
• CHAPTER SEVEN 7 - Taking a Physical Inventory
• CHAPTER EIGHT 8 - Reconciliation of Physical Inventory to Accounting Records
• CHAPTER NINE 9 - Fixed Assets in a Business Combination
• CHAPTER TEN 10 - Insurance for Fixed Assets
• CHAPTER ELEVEN 11 - Property Taxes—Personal Property and Real Estate
• CHAPTER TWELVE 12 - Developing the Fair Value of Fixed Assets
• CHAPTER THIRTEEN 13 - Control of Fixed Assets under International Financial ...
• CHAPTER FOURTEEN 14 - Component Depreciation for Buildings
• APPENDIX - Excerpt of Internal Revenue Service Cost Segregation Audit Guide
• About the Author
• Index