When Tangible Assets Lose Their Value

By Thomas M. Brown

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Today’s market demands lower-priced alternatives to arrive at the value of tangible personal property. Two practices in use within the appraisal profession that have responded to this demand are 1) net book value (NBV) equals fair market value (FMV) and 2) trend and depreciate historical property records. The question is whether these lower-cost practices can still provide a reasonable grasp of the asset values in question.

Net Book Value Equals Fair Market Value

The provisions of both SFAS 141, Business Combinations, and 142, Goodwill and Other Intangible Assets, have led to an acceptance of the reported NBV as evidence of the FMV of the tangible assets.

NBV is the net result of a variety of accounting decisions related to whether expenditures are capitalized or expensed. NBV is a function of the property classification of the asset, the application of a depreciable life and method, the recognition of a salvage value, and the application of a depreciation convention. NBV is further influenced by the accounting system’s ability to keep up with asset transfers and partial or complete retirement of the asset itself. In addition, there is the impact of fully reserved assets that have zero NBV or that may even be removed from the record when they become fully reserved.

The presence of reported goodwill is the result of a company’s having applied purchase accounting to an acquisition sometime in its past. Thus, the NBV of tangible assets is further subject to SFAS 141 purchase price allocation treatment and the application of depreciable lives and methods to what is essentially a collection of used assets.

FMV is dependent upon the cost of new assets, the market prices of similar assets being bought and sold in the used market, and the impact of age, wear, technology, and market conditions as they may be quantified in physical, functional, and economic obsolescence.

What is the likelihood that NBV will equal FMV? Mathematically, it can and does happen. But those incidents are far fewer than proponents suggest. The following are some of the events that drive FMV to be different than NBV.

The existence of fully depreciated assets on the books and in use with NBV equal to zero. For example, consider the valuation of a large developer of computer software for an SFAS 141 allocation. The company used an 18-month life for depreciation of its computer equipment. Thus, all computer equipment more than 18 months old had zero NBV. The company, however, had tens of millions of dollars of computer equipment more than 18 months old that was still in use. The equipment represented millions of dollars to the buyer of the business that would not be recognized if it were assumed that NBV equals FMV.

The capital-versus-expense policy may influence the magnitude of the difference between NBV and FMV. Many companies have high dollar cutoffs, meaning some longer-lived assets below the dollar cutoff may not be reported on the books at all. Other companies capitalize large expenditures because of the magnitude of the expenditure, but the result may not be a long-lived asset with value. Such costs include relocating equipment, repairs, cleaning, and painting. The effects of the capital-versus-expense policy can be compounded over time. The company may be more aggressive in expense treatment in good years, while capitalizing costs more in bad years.

NBV is based on the historical property record. Most companies’ historical property records lack the communication and policies to capture and reflect all asset retirements. Many companies’ property records have one or more “group” entries, such as “1997 equipment, $2,749,635” or “1998 improvements, $44,898,000,” that do not describe any specific assets. Rarely are partial retirements made to group entries as components of these asset records are retired. Over time, the cost (and NBV) remain on the books, but assets are gone and thus have zero FMV.

Trend and Depreciate

Under the trend-and-depreciate approach, price adjustment factors are developed to trend the original costs reported in the property record to estimates of cost of reproduction-new (CRN) as of the purchase date. Then, depreciation factors are applied to the CRN to arrive at an estimate of FMV. The accuracy of the resulting value opinion is often dubious due to a variety of factors, some of which are explored below.

Trend factors must be developed for the specific type and age of the equipment. The type of equipment makes a difference, since the price changes of equipment vary over time. For example, prices of computer equipment may decrease while general machine tool prices increase over the same period. Thus, the property record must reflect sufficient detail to develop trend factors to reflect a company’s unique mix of asset types. Examples of records that would not be specific enough to be trended might include plant addition, machinery and equipment, warehouse equipment, and addition to the printing line. Such records lack the specific nature of the asset to properly develop a trend factor.

The application of trend-and-depreciation factors depends upon the asset records reflecting the acquisition date and cost when purchased new. Property records that reflect prior purchase accounting have the acquisition dates reset to the date of the business purchase, and cost is allocated. An allocated record is not a proper base for trending and depreciation. Trend factors are developed based on price changes of the asset type over time. The base is always the cost of the asset when new in its year of manufacture. When either piece of information is lost through purchase accounting, trend-and-depreciate methodology cannot be applied. NBV will equal FMV only by accident.

The trend-and-depreciate exercise largely depends upon the quality of the historical property record. If asset retirements have not been properly removed from the record over the years, costs will be overstated and the resulting value will be too high. If the record is missing costs due to capitalization issues or write-offs of fully reserved assets, the value indicated by trending will understate the true asset value.

Alternative Means for Efficient Valuation

The standard service outlined earlier is the best means of determining what assets are present, their location, age, condition, and FMV. The standard service is costlier than some other services, but is the best approach when documented and fully supportable values are needed for the IRS, an accounting review, or the courtroom.

In the name of cost savings there are many abuses in the application of the NBV-equals-FMV theory and the trend-and-depreciate routine. Consumers of valuation services should be aware of other cost-effective means to determine FMV when records are suspect. Through the use of trained and experienced machinery and equipment valuation experts, valuation consultants are able to opine on supportable values in a cost-effective manner. Some of these alternatives include the following:

• If there are multiple properties that are similar in nature, such as retail stores, the appraiser can inspect and model typical facilities. Value indications of base models can then be applied to the universe of properties.
• If the requirements are simply to have values without much documentation, the experienced machinery and equipment appraiser can do a walk-through on a facility. Equipped with years of experience and knowledge of machinery and equipment values, the appraiser can create a short-form, line-item listing of what physically exists in the facility and its respective value.
• The trend-and-depreciate method can be combined with on-site verification. During the on-site verification, the appraiser can accomplish a number of things to enhance the reliability of the value conclusion. First, the appraiser can verify the existence of major assets and remove recorded assets which are no longer in existence. The appraiser can also spot major assets that may not be on the existing record, value them, and include them in the conclusion. By being on site, the appraiser can also note the use of assets and maintenance policies to develop depreciation factors representative of the actual property.
• Sometimes the sheer size of a project intimidates the parties. An acquisition may include tens or even hundreds of domestic locations and a similar number of international properties. The fear of large appraisal fees may influence the appraisal decision, resulting in minimal valuation work and unreliable value conclusions. One alternative is to stratify the project into modules; a valuation plan can be developed for each module depending on the size, relative value, and location of owned property. Depending upon the company’s needs, major facilities may have walk-throughs and other locations may be trended, while some minor locations default to NBV. The result will be more supportable than a valuation based solely on trending or NBV equals FMV.

The Costs of Inaccurate Appraisals

What are the implications of asset valuations that are completed hastily and result in poor and perhaps unsupportable values? First, overstating asset values will overstate property tax bills for years to come. When records are used for insurance placement, overstating values means paying excessive insurance premiums. Understating values exposes the company to inadequate coverage in the event of disaster. In addition, there is the excessive cost of labor to try and track and report the investment in fixed assets while using an asset record that is inaccurate and unreliable.

The most important reason, however, is that management and boards of directors have an ethical, legal, and fiduciary responsibility to properly maintain records that accurately report a company’s financial position. Management and directors have an obligation to shareholders, the SEC, the IRS, taxing authorities, and others relying on their financial statements to supply records that fairly reflect reported assets.