This is not a trivial issue. Simply saying “because we have always done it this way” is not a substitute for serious analysis. In some ways the entire process of internal control of fixed assets depends on the initial decision as to when expensing stops and capitalization starts.

The actual range that different companies use is far wider than might be imagined. In today’s environment it is unusual to find anyone capitalizing purchases of less than $500 per item, although there are firms with lower levels. Yet a significant number of companies have a policy of capitalizing all fixed assets acquired in excess of $500. At the other extreme, one large construction and engineering firm expenses everything under $25,000.

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.

Many readers of this book were taught, in their early accounting classes, the importance of matching income and expense, revenues and costs. That is why 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.

In the mid-1970s the Financial Accounting Standards Board (FASB) 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 what is often called an “asset and liability approach.”

The asset and liability approach put 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 PP&E? Very simply. The lower the capitalization level, the more that expenditures for PP&E 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 PP&E 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 “noncash” charge, companies think they will put themselves in the best possible light by maximizing capitalization.

As a manager, if employment cannot increase, you 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!

There is a direct correlation between the costs of running a fixed-asset system, and the number of assets you are trying to control with that system. Now 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 you add assets to the system it is realistic to assume some increase in costs. 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 our critical point: “Reduce the costs of internal control by controlling fewer assets.”

Then the natural question is “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 principle¹ 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 Chapters 6 through 8 there is a discussion of the physical control of PP&E, 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. 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.

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.

But what they do not want for companies to do on their own volition, the IRS is more than willing to do if it will raise revenue. Look at the current inventory capitalization rules. A number of years ago the IRS required companies to capitalize more overhead expenses in calculating the “cost” of inventory.

An increase in the overhead being capitalized is equivalent to reducing current period operating expenses and increasing taxable income. Any such change, however, works for only a period of a few years. Let us say that inventory turns over once a year, at least for this discussion. If companies have $10 million of sales and $6 million of inventory, then there will also be direct production costs for goods sold of that $6 million, and gross profit is obviously $4 million. If total SG&A expenses were $2.5 million then taxable income for the year would be reported at $1.5 million.

But if the IRS said you had to put $500,000 of your SG&A into inventory (reducing SG&A to $2 million) then at the end of the year you would have $6.5 million carrying value (physical quantities are being held constant) and $2 million of taxable income.

But look at the second year. Now you have the same $10 million of sales; $6.5 million comes out of inventory into cost of goods sold so gross profit is $3.5 million. Subtracting the now current $2 million of SG&A leaves you with $1.5 million of taxable income, the exact same amount as before the required capitalization.

What this means is that changing an amount from expense to capitalization in a particular year has only a one-time impact; after that everything reverts to the same as with the prior accounting. By changing the inventory capitalization rules, the IRS forced companies to show a one-time increase in taxable income in the year of change. This change also had the effect of considerably increasing the cost of maintaining the new accounting-the rules as to just what expenses should and should not be capitalized were often not as clear as they could have been. The accounting work went up forever, and the government received only a small one-year boost in the corporate income taxes it collected.

Now the same principle applies to the concepts enunciated here, where we recommend that companies increase the minimum capitalization level. This will have the impact of increasing expense in the year of change, reducing taxable income for a brief period. But over a three or four year period the impact zeroes out as future depreciation is reduced as a consequence of fewer assets being capitalized. This makes the reasonable assumption that low-cost items previously capitalized also had short lives. If, to the contrary, a company has a sizable file of low-cost items on its property record with long lives, the sheer increase in accounting cost over that time period has to be considered as truly non-value-added work for the accounting staff and the tax department.

It is hard to come up with a single rule of thumb that says changing minimum capitalization will balance out in a specific number of years. You can make a rough calculation by looking to see what total depreciation expense is as a percentage of depreciable assets. If assets turn over in eight years, then at the end of the fourth year the financial impact of any change will pretty much be absorbed, particularly if the company is not making significant annual increases in capital expenditures (capex).

We know of no firm that has explicitly asked the IRS for “permission” to change its capitalization level, although certainly in history there has to have been at least one firm. What the IRS response might have been, or actually was, is not known to this author. Common sense, however, suggests that a gradual increase over a period of years should not have a major impact on overall taxable income.

So if a company currently has a $500 capitalization level and wants to go to $2,500, it might be advisable to increase the dollar amount $500 per year for four years. It should be remembered that IRS audits of many corporate income tax returns are done only once every few years, with the revenue agent looking at two, three, or even four years in one examination.

As stated, any change in accounting of say $500 a year is going to be pretty small initially (how many items are being bought between $501 and $999 each year?) and then the offset of future lower depreciation expense will start kicking in.

There is a further argument in favor of this approach. A change from a $500 level to a $2,500 level, carried out over a four to five year period, essentially will reflect only the impact of offsetting the inflation that has actually occurred over the past 15, 20, or 25 years. Look at it this way, if $500 was correct 25 years ago then $2,500 today has the same financial impact in relation to prices paid for capex items.

This is similar to LIFO (last in, first out) where higher and higher current costs go into cost of sales each year reducing the dollar amount of inventory on the books of accounts. In subsequent chapters we discuss adjusting asset costs for inflation in response to insurance requirements, which should be on the basis of current replacement costs, not original costs. So there are really two reasons, which can explain for tax purposes what is proposed here. You are offsetting inflation, and the net difference is a one-time only reduction in income or a decrease in taxes paid.

Finally, in this discussion of taxes let us look briefly at property taxes. Most tax jurisdictions rely initially on self-reporting by the taxpayer of new capital additions. While technically a company probably could report differently to the local assessor amounts that differ from internal accounting records, it is our observation that simply to simplify the reporting process virtually all firms use the same amounts.

Thus, by increasing the capitalization limit and reducing the dollars reported each year to the local assessors, ultimately there should be a small, yet meaningful, reduction in property taxes paid.

Consequently, there is no way around this. Changing capitalization levels will have a small but positive impact on taxes and an offsetting negative impact on reported income.

How often does a company make an investment with short-term negative consequences in order to obtain a greater long-term gain? This is not the place to argue about an over-emphasis on short-term earnings. Those who “poohpooh” the importance of earnings have never been responsible to shareholders and security analysts. Having said that, management is paid to make that kind of decision, trading off near-term pain for long-term gain.

There is no doubt that better internal control can be obtained if limited resources are not spread so widely that nothing ever is completed. The basic principle has to be: “It is better to really control 80% of your PP&E than to pretend that you are controlling 100% of PP&E, while failing at it.”

If in order to accomplish this goal you have to take a short-term “hit” to reported earnings (in fact a favorable impact on cash flow because of tax savings), that is the kind of judgment that CFOs (Chief Financial Officers) are paid to make.

Obviously if items are charged to expense when acquired, there is no issue of possible impairment. However, it is totally feasible to have a record of assets that were purchased, and for which physical presence is important, without having them show up as an asset in the property ledger. As an example, take personal computers, which is the asset most frequently brought up in these discussions.

There are software systems that will record each personal computer the company owns, what software, and what versions of that software the user has access to. One can keep track of operating problems, parts replacement, expected life, and so forth in a separate file. The point is that one can maintain control over assets, without capitalizing them for the balance sheet.

Put a different way, a company should not give up control over IT assets, even items as small as a Blackberry. But if the individual items are under the minimum capitalization level, and hence charged to expense when acquired, it is still possible to assign responsibility to those entrusted with the assets.

If this approach is followed then a company’s IT department can and should have the overall authority for IT assets. Company policies can be set up, enforced, and monitored for all IT assets. It is just that in terms of internal control, for SOX compliance, there will be many fewer assets that a company has to reconcile to its books of account.

As discussed in subsequent chapters, it is imperative that companies have a regular policy, one that is adhered to and enforced, verifying that assets are where they are supposed to be and reconciling any differences. For IT assets already charged to expense when bought, one can verify that they are actively being used by the employee(s) to whom they were assigned. But if, for example, a terminated employee “walks off” with a $700 computer, this will not show up as a reconciling item on the profit and loss (P&L) statement. If that did happen frequently it might suggest better coordination between Human Resources and IT, but in terms of the formal internal control system mandated by SOX, for which the CEO (Chief Executive Officer) and CFO have to sign annually, keeping track of low-dollar amount IT assets is not required.

Now, as discussed previously, if a company currently has a $500 limit, it would probably be unwise suddenly to increase this tenfold. A $500 or $1,000 increase per year, until the $5,000 limit is reached, is supportable as a sound operating policy and will minimize any distortions to P&L and probably obviate any serious IRS concerns.

It should be stated here, at least for the record, that there is no requirement for companies to use the same capitalization limit for financial statements (internal control) and for IRS requirements. Almost all companies do use the same limits, to minimize the work in entering the asset into the property record system.

Virtually all personal computer-based fixed-asset software systems have provisions for different costs or bases for books and for taxes. Many companies use different depreciation methods for books and taxes, so conceptually once you are running two parallel systems it does not add materially to the workload to start with different initial asset costs.

The disadvantage of having separate records and depreciation methods for books and taxes is that when this occurs, GAAP requires deferred tax accounting. There certainly is something positive to say about minimizing or even eliminating such differences. But there is absolutely no requirement in GAAP, or IRS regulations, that the same dollar amount and depreciation methods must be used. It is only in LIFO accounting that there is a mandatory use for financial statements if a company is going to use LIFO for taxes. Fixed-asset accounting can be separate without violating any known requirements.

In fact, some companies will even use different asset cost figures for submission to county tax assessors than they use for internal control purposes and capitalization and a third cost or basis for income taxes. This will be discussed in more detail in Chapter 3; here it only further supports our recommendation that capitalization levels be as high as possible for financial statements and internal control so as to minimize the physical inventory and concurrent reconciliations.

Many company policies and controls date back before the availability of easy-to-use personal computer-based software. Without dating myself, the author saw manual records in many firms, the information kept on separate ledger cards, with depreciation being calculated manually.

Then came mainframe computer software systems. Such systems could be programmed to do anything management could want or imagine. But the programming effort had to be made by the IT department, and in most companies resources never seemed to be available to “tweak” the software. Most companies simply used the existing built-in capabilities of the mainframe software and gave up trying to make it more “user-friendly.”

It has only been with the advent of powerful personal computers and specially designed software systems for use on personal computers that companies now have a degree of flexibility they never had before. A good personal computer-based fixed-asset system can do ten times more today than the most advanced mainframe systems could in the 1980s. What has not changed in many companies however is a lack of desire to utilize the full capabilities of today’s sophisticated software. Many CFOs and controllers really give very little thought to PP&E, and the lower-level employee tasked with maintaining the records often takes the path of least resistance and that is to continue doing things “the way we always have.”

Most companies dread the thought of taking an inventory of their PP&E for two reasons. It is time consuming and expensive, as well as being almost impossible to reconcile to the actual records. If there are major discrepancies, it may be necessary to book an impairment charge. We have yet to meet a CFO or controller who views an impairment charge as any less painful than a root canal. In practice it has been easier to do nothing, than to undertake an inventory that will be costly in several dimensions.

But to the extent that the PCAOB (public company accounting oversight board) and SEC, in the future, start to put pressure on companies and their auditors, to verify and validate internal control over PP&E, it is highly desirable to get “ahead of the curve” before there is too much scrutiny. The first step is to set a reasonable minimum capitalization limit, if necessary, getting to the chosen amount over a period of years.

During the period of change there may be some incremental expense during the years of conversion, and there is always a chance the IRS will come in and object. If companies really are worried about such an occurrence then today’s personal computer-based software can easily handle book and tax differences.