Internal Controls – Fixed Assets
Internal control is a subset of the accounting system to aid in proper reporting of existing assets and liabilities. Internal controls over fixed assets alleviate two distinct risks. The primary risk is physical in nature and relates to the asset getting lost, stolen or damaged thereby affecting the value as reported on the financial statements. The second risk is financial in nature related to errors in determining cost basis, useful life, and depreciation assigned; all of which can affect value.
Each risk uses a separate set of controls to minimize or eliminate the exposure and reduce management’s concern that the financial value as reported is incorrect. This article explains the standard set of controls for each risk group.
The goals of physical control are to verify existence, condition and custody of the respective asset.
Historically fixed assets were considered low risk for any type of financial defalcation (incorrect financial value, theft, misappropriation or unrecorded damage). This is mostly due to the difficulty in stealing an asset as most fixed assets have a title to them. Or another way of stating this: how can you steal the building? Furthermore, fixed assets are ranked in groups on the balance sheet and the most valuable is the land and building. So the bulk of the financial value resides in an asset that is pretty much immovable. After the real estate based assets are your production equipment such as specialized manufacturing equipment or large pieces of heavy equipment. Again, title exists making it impossible for the person stealing the asset to sell the asset. In addition, heavy equipment is highly specialized and therefore a limited if any market exists. For example, who is going to steal a 90’ long extruder specifically designed to create disposable cups?
Next in line are the pieces of equipment that are more likely to be stolen or misappropriated and this includes vehicles, trailers and tools. These types of fixed assets require more physical control to ensure proper use. For most small business, the final group of assets is the more common value found on the balance sheet – office equipment. This is mostly technology based equipment specifically computers and laptops. These fixed assets are the easiest to steal or misappropriate and therefore more scrutiny over them should be exercised by the management team.
The best tool for this type of equipment is an assignment statement whereby a particular asset is assigned to an employee and this employee’s acknowledges responsibility by signing a statement. The term used in accounting is ‘Custody’ over the equipment.
Remember the primary purpose of physical controls is to be able to verify existence of the asset.
Key physical controls include:
- Is there a fixed assets ledger identifying the particular asset, date of purchase, model number, serial number, acquisition cost, expected life and assignment to any debt instrument?
- Are the assets accounted for at least annually?
- Is a physical inspection made of those assets that have a high exposure to damage like vehicles, site development equipment and tools to identify any possible valuation adjustments?
- For assets that are used by multiple employees, is there a check-in and check-out log?
- Does management review periodically the insurance policies related to the particular assets that have exposure to damage and loss?
- Are high risk small mobile and valuable objects locked are have some form of tracking device like a GPS installed? Examples include cell phones, tablets, laptops, pneumatic tools, medical equipment, electronic testing equipment etc.
It is one thing to verify existence which is the easiest of the physical controls to implement it is another to have actual control over the asset. As small businesses grow, often the physical assets are used by employees for personal purposes. The best examples are the vehicles and technology equipment. Naturally in small business the management team also owns the company. These owners want to use the fixed assets for business and personal purposes. There is nothing wrong with this. I know some of you are looking at this and saying this can’t be right. Well, it is true. Let me put it to you in a different way by asking you a question. How can someone steal from himself?
Let’s use the typical scenario. The company is owned by one individual and this owner uses a company vehicle to go to and from work each day. In the larger publicly traded operations, this is not acceptable unless it is a part of the employment agreement or allowed as a policy for certain employees. But in small business, who owns the vehicle? Well, the company owns the vehicle. Who owns the company? By substitution, the owner owns the vehicle and quite honestly he can use the vehicle anyway he desires. And yes the costs are deductible on the financial statements. They may not be deductible for tax purposes but that is a different matter.
My point here is that in general management will use the company assets for personal purposes. The goal of accounting is to separate the associated costs for the personal use and the business use for tax purposes. It is when the non-owners use assets for personal purposes that we have a problem that needs controls to prevent. For vehicles there are several different physical controls that one can implement to prevent misappropriation:
- GPS Monitoring
- Vehicles are stored at the site premises at night.
- Key Logs
- Selective assignment of vehicles to certain employees
Similar controls can be used for computer equipment and expensive mobile equipment. All of these physical controls help to establish custody over the assets.
The final area of physical control addresses conditions of the assets to prevent or properly control the asset value related to damage. The absolute best physical control for this is custody of the asset. When the asset is assigned or checked out, the asset’s condition is assessed and the employee is expected to bring the asset back in the same condition except for typical wear and tear.
Another physical control to identify damage is periodic inspection of the assets by someone independent in relationship to the assets. Have somebody from the parts department inspect the physical assets for the service department and so on. Actually the accountant can simply have a pattern of inspection to confirm existence and condition of the physical assets of the company.
Physical controls prevent theft and monitor issues related to value. But with any value change you must make sure this information is recorded to the books of record and this is done via financial controls.
The goal of financial controls is to ensure that the fixed asset value as reported on the balance sheet is accurate.
For those of you not familiar with the fixed assets section of the balance sheet, I encourage you to read the two following articles so that you may understand more and relate to the balance of this section:
The two drivers of the value as reported on the balance sheet for fixed assets are the initial acquisition cost and the depreciation method used. If acquisition cost is improperly recorded the value as reported will be affected. The easiest tool to manage this particular issue is a policy stating how acquisition cost is calculated. In general, accountants use the initial purchase price, modification costs, delivery, installation and testing as the value for acquisition.
For most small businesses the value is basically the purchase price. But in some cases it is a bit more as the following example illustrates:
In my state when a vehicle is purchased by a business the total costs of the vehicle include the following:
- Initial purchase price
- Delivery fee
- Sales tax
- Title fee
- Registration fee
- Tag Fee
For the purposes of the balance sheet the fixed asset acquisition cost includes the initial purchase price, the delivery fee, sales tax and title fee. The two remaining items are annual fees and therefore are expensed to the profit and loss statement as the fees are only good for one year. The balance is spread over the expected life of the asset.
The best financial control is a policy that defines acquisition cost for most of the typical assets this type of business will purchase. This is then used by the accounting staff to record the purchase appropriately. In addition to defining the acquisition cost there should also be a policy that defines ‘WHO’ determines the expenditure of funds for the asset. Basically the policy should limit the decision model to the owners for smaller operations and to some form of a committee or a method of requesting the funding of an asset for capital expenditures.
Once the asset is recorded to the books now a depreciation method needs to be assigned to the respective asset. For those you not familiar with depreciation I have written the following articles to help you understand more:
- Depreciation – This is Weird Accounting
- The Various Forms of Depreciation
- Accelerated Depreciation – An Explanation
- Small Business Tax Depreciation – Section 179
You should choose a method of depreciation that most closely resembles the expected value adjustment for the particular asset. If you select a method that decreases the value too quickly the financial statement will display a lower value for the fixed assets; too little and the fixed assets may be overstated in value. The key is to be reasonable in your selection for the respective method of depreciation for the respective asset. Remember you may have a method for each respective fixed asset on the balance sheet or for a similar group of assets. The following are appropriate examples:
- Commercial Buildings – 40 years (matches the tax code)
- Manufacturing Equipment – 7 to 10 years
- Animals – about 75% of their expected life
- Vehicles – five to seven years depending on the respective use
- Technology Equipment – three years
The all too common error made by small business management is to accelerate the depreciation on the books and this drives down the value on the balance sheet. Remember the goal of accounting is to paint an appropriate value for all the assets on the balance sheet and identify the actual profit made for the company. The desire to accelerate depreciation is driven by the constant drumming of tax accountants to take as much expense as possible to reduce the overall tax liability for the small business owner. Great if you are only interested in saving taxes in the short-term; but business isn’t about saving taxes, it is about maximizing value to the owners. Besides, a small business may use tax depreciation for tax preparation purposes and use an appropriate depreciation method for the financial records.
This is why most small businesses keep two sets of accounting books – one accrual based and the other is tax based. The tax return has a section that reconciles the two sets of books. By doing this you get the best of both worlds. Your financial statements are reported on the accrual basis using the proper depreciation method and the tax set allows for more deprecation and a corresponding tax savings.
The two key financial controls are proper acquisition cost calculation with recording; and the second is the selection of the appropriate depreciation method to properly determine asset value over time.
There are other financial controls but these have less impact on the value as recorded on the financial statements. The following are the basic set of financial controls:
- Do the owners initiate and/or approve of requests for fixed asset purchases?
- Is there a policy in place that sets the requirements for capitalization of an asset, i.e. minimum dollar amount and life expectancy?
- Is there a policy and a corresponding set of procedures to follow to determine the depreciation formula and the frequency of journal entries related to depreciation?
- Is there an inventory conducted of all fixed assets (see physical controls above) on a maximum of an annual basis?
- Are disposals of assets approved by management and then properly recorded to the books of record?
- Are fixed asset ledgers reviewed regularly to confirm segregation of non-fixed asset purchases to the fixed assets account? The most common error is construction in process expenses being recorded to the fixed assets account.
Overall there are two groups of financial controls; physical and financial. Both are instrumental in ensuring the proper value as reported on the balance sheet. Physical controls are designed to verify existence, condition and custody of the respective asset. Financial controls are designed to record the values to the books of record using a reasonable basis of determining value. The two most important financial controls relate to proper recording of acquisition cost and using the appropriate depreciation method to match the asset’s life or use. Act on Knowledge.
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