ASSET INVENTORY AUDITS Benefits of an Automated Approach

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1 ASSET INVENTORY AUDITS ALDEN SNYDER, PRESIDENT AND FOUNDER, ASSET SYSTEMS, INC >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> White Paper

2 Introduction When you consider a company s internal controls, audits of fixed assets are perhaps the most routinely avoided. Audits of fixed assets are both infrequent and cumbersome. The quality of the underlying data is often out of date and, for audit purposes, difficult to use. As a result, the fieldwork becomes tedious and the reconciliation process inaccurate. Often the results are viewed with suspicion. Not a pretty picture. The process of auditing a company s fixed assets can, however, be easily improved. Actions taken by the accounting department and the auditor can dramatically change how audits of fixed assets are conducted and greatly reduce the tedium associated with them. The following will explore the present state of audits of fixed assets, as well as what changes can be made to improve the process. The Requirement Most organizations have a standard requirement for conducting inventories of their fixed assets on a regular basis. This obligation is derived from a number of formal requirements. Generally Accepted Accounting Principles (GAAP) require audits. As formalized under FASB ASC 360, Property, Plant and Equipment, GAAP requires all fixed assets to be fairly valued and any downward valuations be recorded. Once the value of an asset has become impaired, the company must reduce the recorded book value of the asset and recognize the loss in the current period. Clearly, a business cannot test for impairment losses on assets unless it has performed a physical inventory. Whether or not a company s financial statements are in compliance with GAAP must be determined by the auditor in order to meet the requirements of SAS No. 1, Adherence to Generally Accepted Accounting Principles, AU Section 410. Furthermore, an expression of opinion regarding the financial statements (or an assertion to the effect that an opinion cannot be expressed) must be included, consistent with SAS No. 26, Association with Financial Statements, AU Section 504. To accomplish this, it is essential that the auditor confirms that the balance sheet PP&E account accurately reflects the actual property, plant, and equipment owned by the company. The regulatory requirements of Sarbanes-Oxley (Sarbox) raised the standards for all U.S. public companies to follow. Public companies must now identify which risks are likely to result in a misstatement of their financial statements. This requires the testing of the company s internal controls that are related to their accounting systems. In order to reduce such risks for the management of a company s fixed assets, it is necessary to ensure that their property, plant, and equipment is properly capitalized and depreciated, that impairment losses are recorded as necessary for financial reporting, and that assets are removed from the financial statements in the correct reporting periods. Section 404 of Sarbox requires public companies to include an assessment of the effectiveness of their internal controls when they issue their annual statements. This is the area that most affects a company s fixed assets since internal controls must oversee the management of its fixed assets. Section 404 has been broadly interpreted to mean that a company cannot properly account for its fixed assets if they are not secure and properly inventoried. Finally, depreciation of qualifying assets is required for income tax reporting purposes due to the allowed-or-allowable basis reduction rule under Internal Revenue Code Section 1016(a) (2). Under this IRS Code section, a company is required to depreciate its fixed assets or it will lose the deduction. This is because the basis of all depreciable assets must be reduced by depreciation when they are disposed, regardless of whether or not they were actually depreciated. In order to maximize tax deductions, you must be able to ascertain the existence of all depreciable assets so that the full amount of depreciation may be claimed. 2

3 Given all of these formal mandates, the need for regular audits of a company s fixed assets is undeniable. The Environment Taking an accurate inventory of fixed assets is a challenge faced by most businesses. Records of fixed assets often suffer from systemically weak maintenance as the information given to the accounting department and the physical presence of the assets bear little consistency. The organization may have a large number of geographically dispersed locations. Sometimes acquisitions have occurred since the last audit or capitalization limits have changed and the person in charge of fixed assets management was not informed. This further limits the value of the information available at the beginning of the audit. Changes in the company s policies, practices, personnel, or a significant amount of time between audits may all affect performance. Many times, the poor condition of the asset data presents the biggest obstacle. In some cases, entries may have been made based on groups of assets and this, in turn, can make the matching process difficult or impossible. If the tagging of assets has not been consistently applied or the manufacturer s serial number has not been recorded, direct identification of the assets may be difficult to determine. In other cases, significant variation in the number and cost of the assets makes meaningful sampling extremely difficult. Traditional Approaches Nonetheless, audit we must. Several techniques have been employed to bridge these disconnects. Most popular is the local management approach. An asset report is printed at each location. Local management is then asked to review the asset list and confirm the presence of the assets included in the report. If this is not viable, a similar effort can be conducted by the organization s central audit area. Both of these approaches have the attraction of a low incremental cost; however, both assume that a useable report can be produced and that those charged with the task of performing the inventory will have the time and the knowledge to properly verify the assets. The low cost appeal may prove elusive because comparatively high cost managers may be the ones conducting the audit rather than lower cost staff. Furthermore, using this approach, it is virtually impossible to confirm that the inventory has actually been properly performed as opposed to being rushed, not completely and carefully taken, or even having someone simply signing the audit report without doing the actual inventory. Despite these shortcomings, many organizations still rely on this approach as their primary audit tool for fixed assets, mistakenly believing that it always produces sound results. To improve the objectivity of the audit, some organizations resort to a statistics-based approach. They simply identify a statistically significant sampling of assets, confirm their existence, and extrapolate from there. To achieve a level of comfort, a sampling often focuses on the net book values rather than the absolute number of assets. A better approach is to combine the two to make certain that the sampling is truly significant. Unfortunately, this approach can easily be undone if the quality of the underlying data is poor. For example, if the ledgers contain entries of aggregate purchases, it may be difficult to determine which assets should be included in the sample. Moreover, such an approach may overlook older assets with little book value that clutter the ledger but have long since been disposed. These assets, known as ghost assets, can often account for 30% or more of the entries in the PP&E account and can significantly inflate data that is critical to personal property tax returns. 3

4 Electronic-Based Audit Approach While the need for the audit does not change with automation, the method certainly does. In planning for the audit, the same factors are considered: partial or complete, certain categories of assets, materiality, and so forth. Once an organization s strategy has been identified, its application may vary. For example, a traditional approach may define asset categories based on net book value. An automated approach may audit all assets at a single location because it is much faster and can be performed by a lower level staff member. Another advantage for the electronic-based approach is that once the migration to the electronic-based audit technique is complete, the fieldwork can easily be conducted by simply scanning the appropriate asset tags. Data is then transferred to the host and reports are printed and checked for quality. Specific Asset Identification Ultimately, the best hope for a successful audit of a company s fixed assets starts with accurate asset identification and tracking, long before the audit is required. Experts generally agree that the most reliable technique to track assets is a pre-assigned identifier that appears on the physical asset. Most accounting systems will assign an asset identifier when a new asset is added but its use is purely administrative and not for asset identification. A popular method of identification is to record the manufacturer s serial number as an ad hoc asset identifier. While this data is often readily available and removes the need for the organization to label assets independently, it has several shortcomings. A major drawback is that manufacturers will often use serial numbers in ways that suit their needs, varying the size, length and placement at a whim with seemingly little regard for the ultimate user. In fact, serial numbers are often placed in locations that are difficult to read. For example, the serial number of a cell phone is often found inside the battery compartment. Sometimes the data provided in invoices or purchasing documents is only partial, requiring a best-guess scenario. In summary, using serial numbers may be convenient but often falls short of the mark. The optimal approach involves the methodic application of labels on assets at the time they are placed in service. This is important because the receiving process gives an organization a perfect opportunity to properly identify and tag the asset, as well as to record much of the necessary asset data. It is imperative that this be performed in the field, upon receipt of the asset, and before the asset has been moved, making it more difficult to locate. Finally, it is important that all asset labels support electronic identification. The overwhelming choice for this is bar coding but the use of RFID (radio-frequency identification) is becoming increasingly popular. The importance of labeling cannot be overstated. First, it enhances accuracy. By scanning a label, the users can correctly identify the asset virtually every time. No longer is it necessary to physically identify and record the asset information simply scan the label and the task is completed with near-perfect accuracy. Second, scanning assets is fast. With bar coding, the user simply locates and scans the label; with RFID, the user simply activates the reader within proximity of the scanned item. This electronic enhancement to the audit process means that the results are far more reliable and both audit time and costs are significantly reduced. The ultimate step is to integrate the identification data into the fixed assets ledger. Once complete, the reconciliation of the field inventory to the fixed assets ledger is simply a matter of printing the appropriate report. If assets have been tagged properly, it is literally that simple. 4

5 Reconciliation The last step in both the traditional and electronic-based asset inventory audit processes is to reconcile the field inventory results with the fixed assets ledger. Reconciliation involves matching the field data to the schedule of fixed assets on a line-by-line basis. Depending upon the condition of the fixed assets ledgers, using one of the traditional manual approaches can be very time consuming, often taking longer than the field inventory itself. Even if the descriptions and granularity of the asset records are sound, an asset recorded in the wrong location can take hours to find and extensive guesswork to match. This is the single most important reason that fixed assets audit hours exceed budget. With the electronic-based approach, a manual reconciliation effort may be virtually eliminated. The data is electronically transferred to the host systems and reconciliation reports made readily available. This approach typically results in considerable time savings. Return on Investment The ability to use an electronic audit technique assumes that an asset inventory system is in place. This, in turn, requires a commitment and an investment in hardware, software, and asset tagging. The returns on this investment go far beyond a significant reduction in audit costs. Other important factors to consider include the following: Income tax overpayments occur when fixed assets are not properly recorded and depreciation deductions are lost. Property tax overpayments occur when property taxes are paid on assets that are no longer owned by the organization. Insurance overpayments occur when assets that are no longer owned by the organization are still being insured. Underinsurance risks occur when assets owned by the organization are not recorded and, therefore, are not insured. Reduced labor costs occur when the maintenance of the fixed assets ledgers is automated. Theft losses of fixed assets occur when losses are not claimed, as the assets were never recorded when acquired. Each of these elements supports the argument that proper management of a company s fixed assets provides a worthwhile return on investment. Conclusion Our goal has been to examine how the audits of fixed assets are presently being conducted and identify areas where improvements can be made. Clearly, automating the asset inventory process reduces the difficulty of the audit, improves the speed, saves costs, increases accuracy, and all but eliminates the need to manually reconcile the results. Although an additional investment in technology is required to achieve these improvements, the justification can be based on broad savings throughout the organization. At the outset, we identified the requirement for conducting an inventory of fixed assets. That requirement has not changed. What can change is how a company conducts an audit and the level of commitment it has to reducing risk and making the process more accurate and cost effective. 5

6 BNA Asset Inventory BNA Asset Inventory helps you track assets such as furniture, fixtures, IT software and hardware, plant assets, machinery, equipment, tools, and more from receipt of the asset through to retirement. Using bar codes or RFID, BNA Asset Inventory streamlines the management of all of your physical fixed assets, providing you with: More accurate asset inventory management, Documentation with a detailed history and audit trail, Reduced risk of theft, Less effort and fewer errors by eliminating duplicate entry of assets, Improved visibility of all assets, potentially reducing your property taxes, income taxes, and insurance costs, and Better internal controls for regulatory compliance. With BNA Asset Inventory, you can efficiently perform an accurate asset inventory, as well as validate and reconcile data with existing asset data on the books. With asset labels you can also track the physical location of assets for accurate payment of personal property taxes and insurance payments just point and scan for accurate inventory tracking. Plus, it provides the reporting capabilities and documentation you need to validate that financial data on the books ties directly to assets on the floor. BNA Asset Inventory integrates with BNA Fixed Assets depreciation software for a total asset management solution. BNA Fixed Assets With BNA Fixed Assets from Bloomberg BNA, it s easy, efficient, and cost-effective for companies of any size to manage the complete fixed assets lifecycle from purchase to retirement saving you time and money while ensuring accuracy. Bloomberg BNA s renowned tax expertise is built right into the software it s like having a tax expert at your side, providing the most up-to-date, comprehensive insight into the latest accounting rules and regulations. Our unique validation engine enforces compliance with tax regulations and GAAP rules, automatically ensuring accuracy. Even novice users can correctly and easily use the software without compromising accuracy. BNA Fixed Assets delivers all the capabilities of a robust fixed assets management system and grows with you as your business matures. Whether your company has tens, hundreds, or thousands of fixed assets, there s a BNA Fixed Assets solution designed to meet your needs and budget: Desktop Designed for a single user, it s powerful, but easy-to-use Server For multiple users within the same company Web-hosted Powerful, secure, anytime, anywhere access with no software to install or maintain 6

7 About Alden Snyder Alden Snyder founded Asset Systems, Inc. (ASI) with the specific goal of bringing asset management to the contract furniture industry. Over the years, every major manufacturer endorsed the company s solutions for their customers and dealers. Leveraging that achievement, ASI broadened its distribution to other industries including banking, information technology, government, healthcare, consumer products, and not-for-profits. Considered an industry expert, Alden is a frequent speaker at various trade association meetings and is involved in several industry initiatives relating to systems interoperability. An industry veteran with over 35 year s experience, he holds undergraduate and MBA degrees from Roosevelt University. About Bloomberg BNA s Software Products Bloomberg BNA offers expert software products for tax and accounting professionals. With category-leading software and top-rated technical support, we are the solution of choice for professional firms and corporations of every size. More than 70,000 customers, including the IRS, depend upon Bloomberg BNA s software products for the highest degree of tax, regulatory, and compliance expertise available in the market. About Bloomberg BNA Bloomberg BNA, a wholly owned subsidiary of Bloomberg, is a leading source of legal, regulatory, and business information for professionals. Its network of more than 2,500 reporters, correspondents, and leading practitioners delivers expert analysis, news, practice tools, and guidance the information that matters most to professionals. Bloomberg BNA s authoritative coverage spans the full range of legal practice areas, including tax & accounting, labor & employment, intellectual property, banking & securities, employee benefits, health care, privacy & data security, human resources, and environment, health & safety. Though intended to provide accurate and authoritative information, this publication is provided with the understanding that it does not constitute tax, legal, accounting, or other professional advice or service. This publication may not be reproduced, stored in a retrieval system, or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of Bloomberg BNA. For more information call , contact your local Bloomberg BNA Representative, or visit South Bell Street, Arlington, VA, BNA Software, a division of Tax Management Inc.. All rights reserved. AI002-WH rc 7