There is a direct correlation between the costs of running a fixed-asset system, and the number of assets one is trying to control with that system. This correlation is not totally linear—a 15% drop in cost for a 15% reduction in assets would be linear—but most financial managers would agree that total costs will go down if you control fewer assets. Similarly, if one adds assets to the system it is realistic for him/her to assume some increase in costs.
In fact, many controllers, in developing budgets, tend to assume that most selling, general, and administrative (SG&A) costs are fixed during periods of growth and should be variable on the downside. Reality is that costs tend to go up more or less proportionately with volume and are perceived to be fixed in nature only in a downturn.
This discussion on costs leads to a critical point: ‘‘Reduce the costs of internal control by controlling fewer assets,’’ am I right? But then, the natural question is ‘‘How do you control fewer assets?’’ Through this post I am going to discuss about why fixed asset capitalization levels matter to internal control. But before that, let’s do a quick “capitalization theory” overview—one won’t go anywhere on capitalization until he/she understand the theory behind it.
Theory behind the Capitalization
The basic accounting theory supporting the capitalization of fixed assets—often referred to as ‘Property, Plant, and Equipment’ (PP&E)—is that assets which have a useful life longer than a year should have the initial cost spread over the ‘‘useful life.’’ By definition, for fixed assets the useful life always is longer than a year. And, by capitalizing the initial cost, and spreading the depreciation over subsequent years, a company is considered to be ‘‘matching’’ costs and revenues.
It just takes a minute to realize if all capital costs were expensed in the year of acquisition, reported net income would be essentially wiped out during years of expansion. Then if a company reached a steady-state, or were even declining, the absence of expense charges for assets used in the business would tend to ‘‘overstate’’ income.
Accounting folks, allover the world (including me) were taught, in our early accounting classes, the importance of: matching income and expense; revenues and costs—that is we use accrual accounting and not cash-based accounting. For many years accrual accounting, which matches inflows and outflows to measure operating profitability, was the basis of virtually all accounting efforts. And, to a great extent, the system worked reasonably well, with a few anomalies that were usually overlooked!
The Financial Accounting Standards Board (FASB), in the mid-1970s, started to review the fundamental concepts of accounting. One of the first results of this review was essentially an abandonment of the matching concepts in favor of so-called “asset-and-liability approach.”
The ‘asset-and-liability-approach’ puts primacy on the accuracy of a company’s balance sheet, and asserted that, at least in theory: net income for a period was the difference between beginning and ending net assets. So, put another way, net income was the difference between ‘beginning’ and ‘ending’ net worth, adjusted for stock sales, redemptions, and dividends.
In turn this balance sheet approach focused attention on how assets and liabilities were valued. Simply carrying over original historical cost, particularly in periods of rapid technological change and/or inflation, was felt to distort the financial statements. It was deemed to be far better to show the current fair value of the assets and liabilities as contrasted with the original costs. By doing this, readers of a company’s financial statements would have a better idea as to what a company as a whole was ‘really worth.
A further advantage of carrying assets and liabilities at fair value would be to preclude potential manipulation by management. Many firms, when under pressure to report higher net income, would carefully sell those assets whose current value was in excess of its original depreciated cost. Such ‘‘cherry picking’’ was both common and criticized by security analysts, journalists, and accounting professors.
Regardless of the theoretical benefit of having companies show all assets and liabilities at fair value, the FASB and Securities and Exchange Commission (SEC) moved very slowly. As this is written only financial instruments, in the broadest sense, are being shown at fair value, while other long-lived assets and intangible assets continue to be shown on the balance sheet at depreciated original cost. However, in a business combination, the buyer must put all acquired assets of the target company on its balance sheet at the fair value current at the date of purchase.
Many financial reporting participants, particularly security analysts and academics, have urged the FASB to require the use of fair value on more assets and liabilities, including self-developed intangibles. The preparer community, company financial officers, has argued strongly for not making the change and the FASB has so far listened to such arguments.
If the security analysts and academics have been unsuccessful in persuading the FASB to expand the use of fair value, there has been a parallel push that appears to be gaining traction, that is, a requirement for greater disclosures of cash flows. One of the required statements companies have to prepare every time they publicly release financial information is a Statement of Cash Flows often referred to in the past as a statement on the Sources and Uses of Funds.
While somewhat technical in nature, there has been persistent criticism as to how companies prepare and disseminate their cash flow information. Pressure has been building for companies to adopt, in essence, a parallel reporting system of actual direct cash flows based on a three-part breakdown into operations, financing, and investment.
How does this digression into accounting theory tie into fixed asset? Very simply: the lower the capitalization level, the more that expenditures for fixed asset will show up in the investment category with fewer outlay dollars in the operating segment. Greater attention is paid by analysts to cash flow from operations, so companies have an incentive to maximize reported capital expenditures, minimize reported operating expenses, and maximize reported operating income.
Accountants, today, still urge clients to match revenues and expenditures. In turn this suggests to companies that the more fixed asset expenditures that they capitalize, the higher will be the reported cash flow from operations, offset by higher expenditures for investment. Financial analysts place a premium on maximizing cash flow. Under the matching approach, the fair value approach, and the cash flow approach, auditors continue to urge companies to properly account for capital expenditures. This essentially encourages firms to set, and retain, quite low capitalization thresholds.
To sum up at this point, the lower the capitalization level, the more expenditures will be capitalized and the less they will be reported as operating expenses. Of course, subsequent depreciation expense, on an annual basis, will be higher. But since many analysts disregard depreciation expense, assuming it is a ‘non-cash’ charge—companies think they will put themselves in the best possible light by maximizing capitalization.
Fixed Asset Capitalization Levels Does Matter
Companies have limited resources. Demands for efficiency and productivity continue. This is not to mention trying to beat this year’s budget and forecasting even better results for next year. But both human ingenuity and time available are limited. At some point managers have to face up to reality.
As a manager, if employment cannot increase, one may have to reduce the workload—some tasks simply may not get done. An excellent place to start is with the resources devoted to the control over fixed assets. Put in fewer resources, and then ask the staff to do less!
Back in to the question mentioned on the preface: “reduce the costs of internal control by controlling fewer assets, but how do you control fewer assets?’’
The simplest, and least controversial, way is to raise the minimum level at which asset acquisitions are capitalized, as opposed to charging them directly to expense.
If you raise the minimum capitalization limit from $500 to $1,500, as an example, you might reduce by 15 to 20% the total number of asset lines in the fixed-asset ledger. A further increase, to $3,500, could reduce the number of asset lines by a further 30 to 40%.
There is a very simple way to test this hypothesis in your own company:
- Sort the existing asset ledger in descending order by original asset cost.
- Determine how many assets are shown with an original cost less than $1,500 and by less than $3,500.
- Then determine the dollar value of the assets less than $1,500 and less than $3,500.
The Pareto principle undoubtedly will hold true and a disproportionately large number of the asset listings will account for a relatively small portion of the overall dollar value. By adopting a $3,500 minimum capitalization level, a company can dramatically reduce its workload in controlling fixed assets.
In term of physical control of fixed asset—the taking of a physical inventory and reconciliation of that inventory to the current ledger, if you have fewer assets to inventory and reconcile, it obviously will take less time and resources, perhaps by more than 50%.
Another way of looking at this issue of internal control is this. Most companies have not reconciled in a long time what is physically there with what the books of account assume is there. A major reason for postponing such reconciliation is the sheer magnitude of the project.
In fact, most companies have literally thousands of line items in their property ledger. Trying to find and then tie out thousands of individual assets is a monumental task, one that is all too easily postponed “until we have time for it.” Of course such time never arrives and the reconciliation remains an item on the “to-do” list until the next “we have time for it”—keep rolling to the next book periods at worst.
In short, the task of demonstrating that there is in fact good control over fixed assets has to become manageable. It is unmanageable to try and find every desk, chair, and filing cabinet in the office, or every tool and die in a manufacturing plant.
If it is unmanageable to locate and reconcile thousands of smaller assets, then why set them up in the first place? The real issue for most companies is this: ‘‘Is it better to control 70 to 80% of my assets, or not control 100% of my assets?’’
Note that the law and SEC certification requirements do not say anything about minimum capitalization levels. All they require is that you be able to demonstrate that whatever has been capitalized is physically there, or the books themselves have been adjusted. Put a different way, there is nothing in the concept of internal control that mandates a specific minimum capitalization level.