The Risks of Long-Term Asset Valuation

Impairment has been a hotly debated issue as of late. Much of the discussion has focused on intangible assets, specifically debating the merits of impairment, depreciation, and amortization when recording the value of long-term intangible assets.

The valuation of intangible assets can involve subjective estimates, uncertainty, and rely on significant management judgment. In some industries, intangible assets are the largest item on the balance sheet and, for these companies, changes in the valuation of these assets can have significant effects on securing financing and attracting investors. These factors increase the amount of risk associated with these accounts and have led many to wonder if there is a better way.

Though less discussed, long-term tangible assets can carry a high amount of risk and can just as significantly affect an entity and its shareholders.

In a recent study, Audit Risks Associated with Long-Lived Tangible Asset Intensity, Age, and Impairment, David Zhang [Texas A&M University – Corpus Christi], Keval Amin [Stony Brook University], and Donald Deis [Texas A&M – Corpus Christi] examined the link between audit fees and the intensity (relative concentration of long-term intangible assets), average age, and impairment of long-term tangible assets at a given entity.

Long-term tangible assets are often the largest item on the balance sheet particularly in manufacturing, power generation, healthcare, and other capital-intensive industries. Though often considered a low-risk area, errors in in the valuation of tangible assets have resulted in cataclysmic effects.

The risks that long-term tangible assets carry has been documented in past studies. Alali and Romero’s 2013 study, Benford’s Law: Analyzing a Decade of Financial Data, found “likely manipulations across different analyses” for several accounts, including net PP&E when looking at large U.S. public company restatements over a 10-year period. The work of Zhang et. al. adds to this discussion by contributing several unique insights.

Using the Audit Analytics fee database, Zhang et al. found that entities with a higher PP&E intensity were charged significantly lower audit fees. Multiple studies have shown that audit fees are reflective of auditor’s risk assessment and the level of audit effort, and this fee correlation suggests that auditors exert less effort on testing PP&E than other accounts and consider long-term assets to carry less risk.

This phenomenon was less pronounced for first year auditors but is reasonable considering new auditors must verify the beginning balances of long-term assets. The more extensive testing to verify these balances likely contributes to the decrease in audit fees and effort associated with these accounts after this initial year, as auditors leverage these amounts and reduce the extent of test work in future years.

At a certain point however, the researchers found that long-term assets present higher amounts of risk, particularly for aged PP&E balances and asset impairments. Entities holding older PP&E might replace equipment and fail to remove these assets from company books, inflating PP&E balances, and losses incurred upon the disposal. Long-term assets must be tested for impairment, and as these assets age, the potential for impairment also increases. Impairment assessments “are subjective and may vary across managers over similar assets,” and this uncertainty increases the level of risk and effort required by auditors to provide assurance over the value of these balances. 

Celadon Group Inc.   

Recent events at Celadon Group, Inc., a truckload freight company, emphasize the necessity of recognizing the risks long-term tangible assets potentially bring.

In April 2019, the SEC charged Celadon with accounting fraud after the company engaged in activities to materially misstate PP&E accounts. According to the SEC report, Celadon held trucks on its books at much higher values than what the assets could receive on the open market. Through colluding with external parties, Celadon sold these used trucks at inflated values and, in exchange, bought used trucks at inflated prices, sometimes resulting in the book value of the asset being recorded at twice their open market value.

Celadon then entered a joint venture that the Company transferred money and equipment to, in exchange for an ownership interest. Many of these used trucks were transferred to this joint venture and recorded on Celadon’s books at an even higher value than the company paid third parties to acquire them.

As a result of this fraudulent activity, the company avoided recognizing at least $20M in impairment charges and losses, nearly two-thirds of 2016’s income before taxes, and resulted in material misstatement of income before taxes, net income, and earnings per share in public filings in 2016 and 2017.

Further, as a result of the costs of the multi-year investigation, restatements, and debt obligations, Celadon was unable to continue operations.

On December 9, 2019, the company filed for chapter 11 bankruptcy, putting nearly 4,000 employees out of work and leaving more than 3,000 drivers jobless and, in some cases, stranded across the U.S. after their corporate gas cards were cancelled.

The Celadon case illustrates the extent to which companies can act to perpetrate fraudulent long-term asset reporting and demonstrates the devastating effects these activities can have on an entity’s stakeholders. Zhang et al.’s research indicates that while long-term assets might generally be considered low risk, several factors can influence auditor’s risk assessment.

Auditors seem to respond to the inherent risks associated with high concentrations of aging long-term assets and corporate asset impairments with higher audit fees. The correlation between audit fees and auditor effort indicate that auditors are responding to the complexity associated with these risks with additional testing to reduce these risks to an acceptably low level. Cases like Celadon are notable because the auditors did not identify the fraudulent activity associated with these high risk account, but this research indicates that auditors are generally responsive to these risks.

While fraudulent manipulation of long-term assets is not novel, the frequency at which this occurs may be curbed by these preemptive efforts. More research is needed to better understand the effectiveness of the current risk analysis auditors employ when approaching long-term tangible assets, but the work of Zhang et al. provides notable contributions to the overall discussion, as well as a significant foundation upon which future inquiries can be based.

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