Whitepaper Internal Control for Fixed Assets
Real Asset Management
White Paper: Internal Control for Fixed Assets
Real Asset Management
Internal Control for Fixed Assets Following the financial disasters at Enron, WorldCom and many others, Congress mandated in the Sarbanes-Oxley Act (SOX) that all publicly traded companies have a system of Internal Controls. Further, companies must evaluate them at least once a year and a report must then be provided to shareholders. An additional requirement is for the independent auditor to report on its evaluations of those Internal Controls. A typical Internal Control report, as filed with the SEC, reads:
Under Section 404 of the Sarbanes-Oxley Act of 2002, management is required to assess the effectiveness of the Company’s internal control over financial reporting as of the end of each fiscal year and report, based on that assessment, whether the Company’s internal control over financial reporting is effective. Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is designed to provide reasonable assurance as to the reliability of the Company’s financial reporting and the preparation of external financial statements in accordance with generally accepted accounting principles. Internal controls over financial reporting, no matter how well designed, have inherent limitations. Therefore, internal control over financial reporting determined to be effective can provide only reasonable assurance with respect to financial statement preparation and may not prevent or detect all misstatements. Moreover, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. The Company’s management has assessed the effectiveness of the Company’s internal control over financial reporting as of December 28, 2008. In making this assessment, the Company used the criteria established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control-Integrated Framework.” These criteria are in the areas of control environment, risk assessment, control activities, information and communication, and monitoring. The Company’s assessment included extensive documenting, evaluating and testing the design and operating effectiveness of its internal controls over financial reporting. Based on the Company’s processes and assessment, as described above, management has concluded that, as of ________ , the Company’s internal control over financial reporting was effective. The effectiveness of the Company’s internal control over financial reporting as of __________ has been audited by an independent registered public accounting firm, as stated in their report, which appears herein. This SOX mandate incorporates all financial aspects of a company’s business, including revenue recognition, valuation of securities, provision of adequate reserves, and so on. Many companies have spent literally millions of dollars to be in compliance with SOX. Further, the annual testing of these Internal Controls is a major responsibility of top management, which must personally sign a compliance statement with serious potential consequences if the report is in error. There is, however, for many businesses one operating area that may not be in ‘Control’, at least as far as the word is defined in SOX. By definition, the directive requires that control totals (the property record detail and totals) accurately reflect the underlying physical assets.
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White Paper: Internal Control for Fixed Assets
Real Asset Management
Many companies have significant discrepancies between what is shown in their property record system and actual assets physically present. This White Paper discusses Internal Control required by SOX with specific reference to Fixed Assets.
ELEMENTS OF INTERNAL CONTROL OVER FIXED ASSETS Fixed Assets are sometimes referred to as Property, Plant and Equipment (PP&E) and the terms are used interchangeably. In many companies the following elements of Internal Control over PP&E are considered and performed according to standard guidelines: 99
Approval process for Capital Expenditures (Capex)
99
Determination whether planned expenditure is capitalized or expensed
99
Purchasing and Accounts Payable systems are correctly applied
99
If capitalized, appropriate useful life and salvage value determined
99
Correct depreciation expense is calculated and applied each period
99
Property tax reports filed with tax jurisdictions
99
Insurance coverage relates directly to asset exposure
However, there is one critical element of Internal Control that often is missed. This involves periodically checking that the information shown in the property record system corresponds to the actual assets reported to be there. To put this into perspective, a company may have a very good system of invoicing and accounts receivable, but it is still necessary to confirm the outstanding balances as part of the required annual audit. One well known aspect of this is the verification of ageing debts in the A/R ledger to confirm their collectability. Similarly, with inventory (raw material, work in process and finished goods), for the past 70 years companies have been required to perform a physical count and valuation at least once a year. Further, auditors are required to monitor closely the inventory taking and pricing. In the case of perpetual inventory systems, periodic sample testing is required, again with external auditor input. After the reconciliation of receivables and inventory, adjusting entries must be made to bring the accounting records into agreement with the underlying assets. It is equally necessary that the same kind of reconciliation of reported balances to actual physical assets is in place because for many companies, PP&E may represent 35% or more of total assets. Without a periodic reconciliation, the property record system will lose accuracy as items are scrapped or enhanced. If a reconciliation is performed and adjusting entries made, however, the resultant asset category totals have been verified. Management can then sign with confidence the Section 404 certification - its assertion that there is a system of Internal Controls and that the system is working properly.
THE MISSING ELEMENT IN PP&E CONTROLS Very few companies systematically reconcile the assets shown on their property records with actual physical assets being utilized by the organization. Progressive and responsible companies undertake regular physical audits, reconciling what is there with what is supposed to be there (per the property record system). It is a high risk strategy for company management to sign a Section 404 certification if such an inventory of Fixed Assets has not been taken. Yet many companies are asserting each year their Internal Control systems are working without such checks. How is this possible? Independent audit firms have driven the SOX implementation in most organizations. For many companies, compliance with SOX began with their auditors or consultants initially suggesting what had to be done. Outside consultants were probably brought in to help establish and test the controls. Then the company’s independent auditors tested the controls that were put in place so the audit firm could affirm
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White Paper: Internal Control for Fixed Assets
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management’s assertions as stated in Section 404. The missing link was that the audit firm overlooked the physical inventory and reconciliation function for fixed assets. In effect, they told management that as long as they had a functioning fixed asset software system, had controls on the acquisition and capitalization of assets and properly calculated depreciation, they were OK. Further, the Public Company Accounting Oversight Board (PCAOB), while stating that controls over PP&E were necessary, actually did not put emphasis on fixed assets in their reviews of auditor work papers. However, it has been reported that the PCAOB is planning to start a crackdown on what is effectively malpractice. In the past, where the PCAOB did not follow this up, then the independent auditors, with limited time budgets, did not check that the assets shown on their clients’ property records were actually there. This lack of emphasis on the physical reconciliation of company property records is about to change as the PCAOB puts PP&E higher on its priority list. The PCAOB inspectors will find that some independent audit firms have done little work on asset reconciliation and, if firms are written up for this ‘deficiency’, they will very quickly start scrutinizing their clients’ practices in physical reconciliation of PP&E. When gaps are identified they will have to be plugged, inevitably delaying publication of the final accounts and adding considerable internal and external cost to the audit process.
WHY PP&E RECORDS ARE NOT TESTED WITH A PHYSICAL INVENTORY There is one unique aspect of property accounting that may be the cause of inattention to verifying or validating the records. The very nature of depreciation expense, calculated periodically for financial statements, is that sooner or later the net book value of every asset will be written down to salvage value or to zero. Assume for a minute that a particular asset is missing, perhaps it was traded in for a piece of new equipment and that information was never entered into the property record. As soon as this is discovered, the company should write the asset down to zero and take a charge to earnings, to correct the inaccuracy of the records. But what if no entry is made? Then each year a depreciation charge will be taken to expense for the missing asset. After a certain number of years, the book value will automatically have been written down to zero. Whilst this has little impact for a single, low value asset, it can seriously affect profit statements when a larger number of more costly items are involved. In the past, management as well as some auditors, were guilty of looking at one year’s expense total and comparing it to the previous year’s. Under the scenario where an asset should be written off, but isn’t, the reported operating expenses year to year will be comparable (assuming the company is using straight-line depreciation). This thought process, analyzing the Internal Control of Fixed Assets by comparing one year’s depreciation expense to the next, provides a false sense of assurance. As long as the PCAOB is not reviewing audit firm work on PP&E and audit firms are not reviewing PP&E reconciliations of their clients, then the simplistic analysis that the two years depreciation totals are the same obviates challenge. The only way of assuring that the property record system is correct and accurate is to reconcile the records with the actual PP&E physically present. In short, one has to take and reconcile a fixed asset inventory, just as is done annually with finished goods inventory.
PHYSICAL RECONCILIATION OF PP&E RECORDS Using spreadsheets and antiquated systems is time-consuming and requires the active involvement of management personnel. A good fixed asset management system that utilizes barcode technologies will speed up physical audits, making them both fast and efficient.
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White Paper: Internal Control for Fixed Assets
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The procedure is a simple one that involves downloading information from the asset register onto an inexpensive, handheld device. The operator then scans the barcode labels for all assets, automatically recording where they are located and, by exception, noting assets that are not found. The data is then uploaded into the fixed asset system and management is presented with a change report for final authorization before the data is processed against the asset register. It is outside the scope of this White Paper to lay out a detailed management approach to an appropriate physical inventory and reconciliation of PP&E. Those interested in pursuing this further should contact Real Asset Management International (RAMI) at 617-3427291 for a no-obligation consultation.
SUMMARY AND CONCLUSION The PCAOB, and independent auditors, have already started the process of reviewing Internal Controls on Fixed Assets. The best property record system in the world does not represent true Internal Control. The only way to assure that the property record is correct, and that the record truly reflects actual conditions, is to take a physical inventory of PP&E and then reconcile the results. It is highly likely that there will be some significant discrepancies, due to a multitude of causes. Correcting these discrepancies, in turn, may involve material accounting entries. Whether it is possible to offset discrepancies, assets present but not on the books (zombie assets), with assets on the books that cannot be found (ghost assets) is a matter for each company and its auditors. In many cases these can be considered corrections of prior accounting errors. In other cases, a charge to expense may be required. Once such an inventory is taken and reconciled, then management can sign the Section 404 assertions with confidence. Right now, it is safe to say, many such 404 assertions are made but without underlying support, at least in the case of Fixed Assets.
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White Paper: Internal Control for Fixed Assets
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GLOSSARY OF TERMS Internal Control Internal control is required to keep an organization’s revenue goals in place and to minimize unplanned financial events. They enable management to deal with changing economic environments, priorities, and future growth plans. Internal controls help to promote efficiency, reduce risk of asset loss, and help ensure the accuracy of financial statements and compliance with laws and regulations.
Sarbanes-Oxley (SOX) The Sarbanes-Oxley Act of 2002, commonly referred to as SOX or S-Ox, is a United States federal law enacted in response to several major corporate accounting scandals. This legislation establishes enhanced standards for all U.S. public company boards, management and public accounting firms. The Act requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law. In summary, SOX covers issues such as auditor independence, corporate governance, internal control assessment and increased financial disclosure.
Capital Expenditures (Capex) Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory.
Public Company Accounting Oversight Board (PCAOB) A private, nonprofit corporation created by the Sarbanes-Oxley Act of 2002 to oversee the auditors of public companies. The PCAOB was created to protect investors and the public interest by promoting informative, fair, and independent audit reports.Furthermore, after completing its latest physical audit, ABC Company was unable to locate 10 percent of its assets; refer to the company facts above.
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