Property Record-Keeping and Section 404 Certification

By Thomas M. Brown and Gerald J. Mehm

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JULY 2005 - Recent corporate disclosures have exposed schemes involving companies’ fixed-asset accounting records that have been used as a conduit to hide questionable accounting practices. Section 404 of the Sarbanes-Oxley Act (SOA) is a response to these accounting issues, and states that CEOs and CFOs of SEC registrants must report on the completeness and accuracy of the information contained in reports as well as the effectiveness of underlying controls. SOA is broader than GAAP in that it requires a company’s financial statements to be transparent by fairly presenting the company’s financial condition, results of operations, and cash flow. The CEO and CFO must certify the above, as well as give assurance that adequate disclosure controls and procedures are maintained.

For capital-intensive companies, the fixed-asset investment is often the largest portion of the asset side of the balance sheet. The income and cash flow statements are impacted by the annual depreciation charges for the tangible assets.

For companies that have grown through acquisitions, particularly acquisitions of high-tech and service businesses, a significant portion of their asset base will be the intellectual property, intangible assets, and goodwill resulting from the allocation of the purchase price paid in excess of the fair value of the tangible assets acquired. Here also, the income and cash flow statements are impacted by the annual amortization charges for the intangible assets with determinable useful lives.

Businesses spend millions of dollars on computer systems, hardware, and staff to maintain property accounting records. Yet this does not mean that everything is in order when it comes to the reporting of assets on the books of many SEC registrants. When most CEOs and CFOs certify their company’s financial statements under SOA section 404, they are acting in good faith on information that has been provided to them regarding the condition of the fixed-asset records and amortization schedules for intangibles carried on the company’s books. In some cases, however, corporate fixed-asset records and intangible-asset amortization schedules are not complete and accurate, or do not fairly represent costs and annual depreciation and amortization charges.

There are a number of pitfalls that can easily raise questions for a CEO/CFO certification. The following are just some of the common issues a CEO or CFO should be aware of.

Purchase Allocation (SFAS 141)

At times, an acquiring company views the intangible assets within a purchase as the key assets, assessing that the tangible assets are not significant. The expedient action then is to carry these assets over at net book value. After three or four acquisitions, all following similar tangible-asset treatment, these seemingly insignificant assets suddenly become material. The practice of booking assets at net book value, as opposed to the fair value measure of SFAS 141, will lead to this result. The assets are correctly reflected on the company’s books only by chance. The practice fails to recognize that land values and, in many cases, buildings, for a period of their life, may actually appreciate and be worth more than net book value. Personal property may have been subject to various capitalization or expensing policies over time in the seller’s hands. The seller’s asset record may reflect substantial “ghost assets” if a practice is not in place to capture asset retirements. Conversely, older assets still contributing to the operations may no longer be on the books if the seller has a practice of removing them from the books once they are fully depreciated.

In addition, in an effort to control costs, many buyers elect to have assets valued using “desk-top” methods, wherein the appraiser never actually sees the assets. Without visual confirmation of the existence and condition of the assets, the appraiser has to accept the property records provided as evidence of the assets’ existence, and assume a normal condition of the assets. Given the historical record-keeping issues of many companies, and variances in maintenance policies, such an approach will not necessarily result in a factually correct value for the assets as if they were to be inspected, inventoried, and valued based on their observed condition.

In accordance with SFAS 141, FASB concluded that identifiability is the characteristic that distinguishes other intangibles from goodwill. FASB proposed that intangible assets that are identifiable and reliably measurable should be recognized as assets apart from goodwill if they meet the asset recognition criteria in Concepts Statement 5, and if either of the following apply:

  • Control over future economic benefits of the asset results from contractual or other legal rights (the contractual/legal
    criterion), or
  • The intangible asset is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged, either separately or as part of a group (the separability criterion).

Compliance with SFAS 141 requires a careful analysis of the value of the intangible assets held by an acquired business.

Perhaps the most common example of misstatement is the practice of assigning depreciable lives for tangible property. To simplify, imagine that a company’s practice for new acquisitions is to depreciate buildings over a 45-year life and tangible personal property over a 12-year life.

The company buys a competitor with similar asset holding with intent to fold that operation into its own. The acquired assets are valued, the purchase price allocated, and the annual depreciation calculated according to the rules above. How will the depreciation expenses for a portfolio of “used” assets reasonably reflect actual loss of value when the lives assigned are the same as the lives considered appropriate for “new” assets? This practice should certainly be a concern for the CEO and the CFO certifying a company’s financial statements.

In accordance with SFAS 142, the useful life of an intangible asset is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of the entity. In each reporting period after the initial establishment of the useful life of an amortizable asset, an entity must evaluate the remaining useful life to determine whether events and circumstances warrant a revision to the remaining period of amortization. In accordance with SFAS 144, amortizable intangibles must be tested for recoverability whenever events or changes in circumstance indicate that the carrying amount may not be recoverable. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. An impairment charge is recorded equal to the amount by which the carrying value of the asset exceeds its fair value.

If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an intangible asset, the useful life is considered to be indefinite. An intangible asset that is not subject to amortization must be tested for impairment annually, or more frequently if events or changes in circumstance indicate that the asset might be impaired. An impairment loss will be recognized in an amount equal to the amount by which the carrying value of the asset exceeds its fair value.

Goodwill is another consideration. It is not amortized, but it is tested for impairment under the two-step procedure promulgated in SFAS 142. Step one entails a determination of the fair value of the net assets of a reporting unit, which is compared to its carrying value. If the carrying value exceeds the fair value, the underlying tangible and intangible assets, both recognized and unrecognized, are valued. The fair value of the reporting unit is then allocated among the assets as if they were purchased for fair value in a business combination. The goodwill impairment charge is recognized in an amount equal to the amount by which the carrying value of the goodwill exceeds its implied fair value.

Property Records

Businesses often find themselves in a position where their records have gotten out of step with their physical assets. The common problems are as outlined above. Physical-asset retirements aren’t reflected in the property record, so costs become overstated. Transfers made over the years have not been entered in the property record. Physical assets are no longer in the plants, buildings, floors, and departments as the record reports them. Variances in the capitalization policy over time means similar assets may have been capitalized one year and expensed in another. Record structures of large, group entries prevent even the most conscientious property accountant from being able to track transfers and retirements of the components that make up the group.

Most companies have some level of ghost assets on the books, usually due to a lack of communication. Most companies are very good about tracking the costs of a new project into the capital record. But similar lines of communication do not always exist or function well when assets are junked, traded in, razed to make way for new ones, sold, cannibalized for parts, or even stolen. This author has observed that an average of 10% to 15% of a company’s reported building costs no longer actually exist. Historically, a range of 15% to 25% of tangible personal property costs need to be removed from the property record in order to expunge ghost assets.

When the CEO and the CFO sign the certification, they should be aware of the condition of the company’s fixed-asset accounting records, and should ask the following: When was the last time the physical properties were verified against the property record? What were the results? How have business combinations been booked? Are the depreciable and amortizable lives reasonable for the asset costs being written off? Has the company now or at any time in the past exercised practices that would cause the fixed-asset record to incorrectly represent the physical assets employed in the business? Any response that reveals innaccuracy in the property records should be cause for concern. The property record should then be investigated and corrected.

Property Management

Finally, certification requires that adequate controls and procedures be in place to ensure the property accounting function. The common record-keeping problems noted above are most often the result of a lack of formalized procedures, staff training, and follow-up. In the property accounting area, companies should have written procedures to deal with decisions about—

  • project management for construction in process;
  • what expenditures are capitalized versus expensed;
  • depreciation policies for book and tax purposes;
  • accounting controls, with regard to general ledger accounts, tax reporting (including IRC section 1245 and 1250 segregation), special handling for property tax considerations, and department or cost-center controls;
  • physical controls, including plants, buildings, and floors;
  • level of descriptive data to be recorded, including tag number where applicable; and
  • various procedures, controls, forms, routing, and communications re transfers and retirements.

In addition to establishing procedures, there should be staff training and periodic follow-ups and checks in place to ensure that the intended practices are actually being followed. Again, CEOs and CFOs that cannot be sure of what the company is doing regarding the procedures for fixed-asset accounting should be concerned about the section 404 certification.

Being Prepared for Certification

Given the SOA certification requirement, CEOs and CFOs can no longer take for granted that their fixed-asset accounting practices are in order. Fixed-asset records can be used as a vehicle to hide accounting abuses, from capitalizing what should be operating expenses to creating phantom records used to offset phantom sales. Similarly, CEOs and CFOs must be satisfied that the carrying values of their intangible assets and goodwill have been adequately tested for impairment.

Before certifying property accounting records and practices, senior management would be well advised to ask tough questions and be prepared to take corrective actions whenever the answers suggest that property records or depreciation and amortization expenses may not fairly present the company’s financial condition.

Thomas M. Brown is a senior vice president–national director for the industrial valuation group, and Gerald J. Mehm is a senior vice president and managing principal, both of American Appraisal Associates, Inc.




















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