Question

Which components of the internal asset audit are the most valuable? Why? PROVIDE A REFERENCE

Answer 1

Internal Asset Audit (Fixed Asset) Controls and Reporting

Being a unit of fraud and financial misstatement, fixed assets are not relevant for audit purpose, a myth.

Although they are considered as low risk by auditors, fixed assets need attention to ensure that the organization’s records are accurate and its controls provide effective view of this area. As with other asset classes, best practices enhance proper accounting, valuations and financial reporting.

Fixed assets represent the long-term tangible assets an organization uses to generate and deliver its products or services, and manage its operations. In many capital-intensive business such as manufacturing, healthcare and power generation , fixed assets represent the largest item on the balance sheet. Historically, fixed assets have received little audit scrutiny and, as a result, major financial frauds have been performed through significant misstatements of fixed asset balances in the financial statements of public companies.

When inquired if fixed assets are represented accurately at the end of financial statements, most organizations will answer with “yes.” However, audits may present a different output. Although many organizations do not perform an inventory of current fixed assets and a corresponding reconciliation, these steps provide an essential internal control for the financial reporting of fixed assets.

Typical Audit Approach

Fixed assets are probably one of the and most repetitive areas of accounting. Before the passage of the Sarbanes-Oxley Act, auditors viewed fixed assets as having the appropriate internal controls and, therefore, deemed them a low-risk area. Audits of fixed assets were allocated little time and usually assigned to an entry-level staff auditor.

Fixed asset audit measures were typically limited to:

- Reviewing a roll-forward analysis for the cost and depreciation of account balances

- Vouching of current-year purchases

- Reasonableness testing of current-year depreciation expense calculations

- Performing very limited reconciliation procedures

This approach was well-understood by external auditors, their clients’ accounting managers, corporate controllers and chief financial officers.

Changes made

One of SOX’s central components is the increased testing of internal controls. Another noteworthy requirement is that publicly owned companies maintain an internal audit process. This increased testing of internal controls, with the required role of internal auditors, has led to increased scrutiny of fixed assets.

Controls Over Fixed Assets

Fixed asset transactions typically represent the acquisition and disposal of assets and the allocation of relevant costs to reporting periods through depreciation expense. The internal controls over the acquisition of fixed assets are straightforward, easy to test and include the following points:

- Issuance and approval of a purchase order

- Receipt of assets and preparation of a receiving report

- Receipt of an invoice from a vendor

- Reconciliation of the vendor invoice to the related receiving report and purchase order

- Authorization of the payment of the vendor invoice

- Issuance of a check for payment of the vendor invoice

- Posting of the entry in the equipment sub-ledger

- Posting of the equipment subledger activity to the related general ledger control accounts

- Reconciliation of the general ledger control accounts to the equipment subledger.

However, for other fixed-asset transactions, internal controls are not typically marked.

Resulting missteps often include:

- Inadequate asset descriptions including missing manufacturer, model and serial number information

- Least or no use of property identification tags   

- Inconsistent application of the capitalization threshold

- Improper segregation of construction-in-progress projects into building and equipment accounts   

- Poor documentation of asset movement

- Assignment of unreasonable lives for depreciation calculations

- Infrequent or no periodic physical inventory/reconciliation

Not as Low-Risk as Anticipated

The fixed assets represent the largest item on the balance sheet. Therefore, deficient fixed asset records can lead to inaccurate financial reporting and inaccurate financial reporting can lead to a qualified audit opinion, which in turn can damage management’s credibility with shareholders, lenders and suppliers.

Depending on the city and state in which it operates, a company can be subject to personal property tax. Tax assessments are based on the organization’s fixed asset accounting records, with rates applied to the assessed value.

Each state differs in how personal property tax rates are set. In this example, a state that assesses personal property tax at 1/3 of the fair market value is used.

Fixed asset accounting records are used to determine the replacement cost of personal property for insurance placement purposes. When it comes to insurable values, accuracy is important — if a loss has occurred.

Organizations routinely use the net book value of existing fixed-asset accounting records to assist in negotiations when acquiring entities. The net book value of the fixed assets may serve as a proxy for the final purchase price.

Therefore, it is critical for the acquiring entity to employ the appropriate due diligence to make sure it is getting the assets it is paying for.

The ability to maintain accurate records can be very challenging for organizations, especially those that are large, capital-intensive and decentralized. Two solutions are: diagnostic consulting, and fixed asset inventory and reconciliation.

Best-practice components:

• Conduct an inventory every five years

• The inventory team should be independent and not have a vested interest in the results

• Consistently apply the capitalization threshold of the organization while conducting the inventory

• Complete the inventory as quickly as possible to minimize asset movement

• Record all descriptive and locational information possible

• Affix property tags to all untagged assets.

Effectiveness of Controls

Organizations typically maintain written policies and procedures for purchasing capital assets. In many cases, the same procedures have been in place for years and have not been updated to reflect changes in the business, regulations and economy. Sometimes, the procedures have been updated, but they are not practiced as effectively as they should be.

Regardless of the type of business, it is important to have effective policies and to review them periodically to ensure their continued effectiveness and practicality. Equally important is following policy. Few organizations that have concerns in this area can engage an external consultant to perform an assessment and recommend improvements.

Such a consulting engagement begins with a in-depth analysis of existing policies and procedures as well as interviews of staff members responsible for asset life cycles. Recommendations are made to senior management regarding identified weaknesses, and the implicated policies and procedures can be modified or rewritten. The result will be a best-practice approach to asset management.

Even an organization has good procedures in place, equipment tends to be moved, transferred and disposed of without proper documentation. Therefore, it’s important to conduct a periodic fixed-asset inventory.

An important step is reconciling the inventory to the fixed-asset accounting records. Many organizations attempt to perform this in-house, which leads to challenges. Lack of experience, poor descriptions on the accounting records and allocating the appropriate amount of time are just a few of the challenges.

In-house inventories are conducted by the custodians of the equipment, who may be afraid of reporting retirements. Independence and objectivity are common casualties of an in-house inventory and reconciliation.

Reconciliation Process

If the right steps are followed, a comprehensive inventory can be done simply and effectively.

The reconciliation process will identify the following:

1) Matched assets – items found during the inventory process and traced to the fixed asset accounting records   

2) Unrecorded additions – items found during the inventory process but not found in the fixed asset accounting records   

3) Unrecorded retirements – items found in the fixed asset accounting records but not found during the inventory process

Several approaches of reconciliation broken into three categories are: tag number match, hybrid reconciliation and comprehensive line-by-line reconciliation.

Depending on the approach, the number of assets and the associated historical cost of the matches, retirements and additions will vary significantly.

(I) Tag Number

By definition, the tag number match is the comparison of existing tag numbers to those found in the fixed asset accounts. The tag number is the first mechanism for identifying a fixed asset. In many cases, this approach can result in a 50 percent or lower match rate, and the auditors will have difficulty accepting the credibility of the inventory process because of the large variances.

(II) Hybrid

In this approach an additional effort is made to address matches by description, manufacturer, model and serial number that appear in the rest of the record. If the quality of the fixed asset accounting records is very good, this approach may yield acceptable results. However, many organizations’ fixed asset accounting records are of poor quality, and this approach may not yield completely acceptable results.

(III) Line by Line

A comprehensive line-by-line reconciliation is considered a best-practice approach. This approach address each asset until it is verified as a match, retirement or addition. It involves the following steps:

- Tag number matches are addressed first

- Manufacturers and models are compared

- Additional description, location and department numbers are taken into consideration   

- Fiscal year additions are analyzed against estimated acquisition dates from the inventory   

- Bulk entries and grouped purchases are allocated to the individual assets (computer equipment, furniture, etc.)

- Follow-up visits with departments are conducted to verify any residual assets.

Regardless of which approach is used, a consistent audit trail should be used to link the reconciled inventory file with the existing fixed asset accounting records. It is important to assign a transaction code to establish an audit trail on each item. The transaction code identifies the actual disposition of each asset. Simple transaction codes are:

"A” – Unrecorded addition   

“M” – Matched asset   

“R” – Unrecorded retirement

Each line item on the fixed-asset accounting record will receive a transaction code to link it to the reconciled inventory file.

Independence and objectivity are critical in any audit, so it is desirable to hire a consultant to assist with this process. Organizations should only consider consulting firms with specific industry expertise and those who work extensively with the Big Four and other public accounting firms. Consultants should be able to provide appropriate references. They should also use the latest technology, including accounting software, so proper depreciation calculations are made.

Conclusion:

Fixed-asset inventory and reconciliation procedures can help an organization to increase the level of fixed-asset scrutiny. For many organizations, fixed assets represent the largest item on the balance sheet. To ensure the proper valuation of these assets and accurate financial reporting, organizations need to confirm the proper handling of these transactions.