Considerable confusing discussion has occurred for years on the subject of valuing property, plant, and equipment. Much of the confusion comes about as a result of the many different procedures there are for the valuation of property, plant, and equipment and the reasons for each. The purpose that the value is to be used for requires a different methodology for arriving at value. Generally Accepted Accounting Principles (GAAP) require that the book value of an asset appears on the balance sheet; but there are many different values for the same object. This post provides brief description of the following values: Historical cost—the book value as GAAP defines it, original cost—the purchase price of the item, replacement cost new or insurance value—the cost to purchase the same capability today, current market value—the amount a willing buyer will pay for it today, fair market value—the price that would be paid for the item in a condemnation proceeding, assessed value—the basis on which it will be taxed and a bit about “valuation techniques of property, plant and equipment assets“.
Let’s start it from the historical cost. Read on…
Historical Cost Of Property, Plant and Equipments
Each of the many values will be different. The reason, of course, is they have different purposes and, therefore, different procedures for establishing them. These values must be determined with care and deliberation. Historical cost, or book value, is the cost of purchasing and putting an object into use.
Historical land value, once established, rarely changes and then only because of specific occurrences. Events that will change historical land value are limited to:
- Adding an item of significant value
- Extraordinary modifications or repairs that increase the value, extend the life, or increase the capability of the asset
- Impairment by catastrophe
- Sale for less than land value, if the asset is part of an operating business and is sold as a whole.
Values used for other purposes will change over time. For example: when an object is first acquired and put into service, its insurance value or replacement cost is the same as book value. However, after a period of time, these values will vary. Some items, such as: vehicles, machinery, and computers, will probably decrease in market value, but may well increase in replacement cost. Buildings, on the other hand, will probably increase in both market value and replacement cost. Therefore, the value recorded for insurance purposes must be reviewed periodically, a new determination made, and records updated appropriately.
The procedures needed to determine other values are subject to interpretation. Most companies will periodically secure the services of an appraiser to establish these values. Insurance companies may provide advice and guidance to their customers.
It is important to recognize, though, that using wrong value procedures can lead to disaster for a business. Insurance rates are based on a percentage of the value at which the property is insured. Insurance values greater than replacement cost increase the premiums, but will not provide a greater return in case of destruction. On the other hand, insurance values below replacement cost will mean serious problems if the property is damaged or lost. Insurance companies pay the maximum of replacement cost or insured value, whichever is less. Most insurance policies pay replacement cost only if the insured value is greater than 80 percent of the replacement cost at the time of the casualty. When insured cost is less than 80 percent, the companies pay on replacement cost, less depreciation. The loss of buildings can be seen as the worst disaster, since the replacement cost is likely to have gone up in spite of the building’s age and use.
Other types of problems with using the correct valuation for the purpose exist. For example: in a not-for-profit trade association, the county tax assessor requested an inventory of business property for the purposes of establishing the personal property tax. The organization’s bookkeeper had just received an insurance company assessment of replacement costs of its few assets. Because these are insured at replacement cost, that figure was much higher than current market value. This assessment was supplied to the tax assessor. There was no property record, and the organization did not depreciate its equipment, in accordance with fund accounting principles. The tax assessor for a subsequent ten-year period did not request, nor did the association submit, revised equipment values. The assessment process was to add 5 percent per year to the original values it received in lieu of a new report. Therefore, the current tax assessment was based on a 50 percent increase on an originally inflated replacement cost.
In reality, the business property tax procedures call for market value of the property as the assessed value. The association still had most of the same property at the end of the ten-year period. Its market value was very low. Therefore, when correct reports were filed and reassessment occurred, the tax was reduced by 95 percent.
Uses Of Values
Historical cost, or book value, is used to allocate costs to the periods used. It is accumulated as the purchase or invoice cost plus the cost to prepare the item for service. This cost is then depreciated over the periods of usefulness. Other purposes are to establish the future value of an asset. That value will vary due to many different factors.
Insurance valuation will be based on the agreed upon actual cash or replacement value at the time the policy is issued. The premiums paid will be based on a percentage of that value. When a claim is made, that value normally represents the maximum that can be expected.
There are a number of problems involved in establishing that value and correcting it over the life of the item. Construction costs are rising, which means that buildings and machinery will likely have a higher replacement cost. New technology may mean that replacement will not even occur on the same basis. Examples are construction techniques for older buildings made of brick or rock. These types of buildings, if damaged in an earthquake, may not be replaceable in the same style. Computer equipment more than a few years old may not be replaceable. Production line equipment, printing presses, and other machinery may dictate a number of different replacement possibilities.
Insurance policies can be written with many different types of coverage. This is not intended as an insurance analysis; however, the asset accountant should be aware of the replacement cost prior to establishing the insurance coverage. At the time of loss, it will be necessary to provide proof of loss. Property records that substantiate the existence and location are needed. It is also important to have recorded and maintained the record of the asset values. An assessment of deferred maintenance, as well as a record of maintenance expenditures on major items, will support that proof of loss. This also points out the need for security and redundancy or backup for asset records. If a building is destroyed, the accounting records should be available at another location.
Collateral For A Loan
The price at which an asset can be sold to a willing buyer without undue pressure on either party is referred to as market, or fair market, value. When property is used as collateral for a loan, the lending institution will provide a loan at only a percentage of that value. If a foreclosure is necessary, the property must be sold quickly and probably in a distress sale. The carrying costs for the finance company can quickly reduce its value.
In considering options for financing, businesses must consider the resale values of their property. Financing can occur as specific mortgages on real estate and buildings. Banks or other financing sources also may want a general mortgage on the property involved. Existence of a well-maintained and documented property record can enhance financing opportunities for both general credit lines and those taking specific assets as collateral. Therefore, the collateral value is enhanced by good accounting and property record systems.
Purchase Or Sale Of A Complete Business
In purchasing an operating business, the sales price is likely to be different from the book value of the property, plant, and equipment. Future sales value will enter into the price determination. When a price in excess of the book value is paid, that excess is recorded as goodwill on the purchasing company’s books. If the purchase price is less than the book value, it is necessary to readjust the book value of property, plant, and equipment downward to reflect its purchase price. This is one of the few times that book value can be reduced on a still usable asset. Considerable discussion is currently focused on the concept of accounting for impairments in fixed assets. There is not yet consensus as to the appropriateness of reductions based on an impairment in U.S. accounting practices.
TIPS: First Creation Of Property Record
When called upon to create a property record for the first time, additional difficulties may be encountered. Many businesses have not maintained property records in the past. Such records have not been required of cities and other government agencies. Even where property records were established, many organizations have not accurately maintained them. Retirements and losses may not have been reflected in the record. Where location is a function of the property record, it may not be current.
A significant task is required to create a property record for the first time in an operating business:
- Review of the existing process establishing the proper property record and maintenance procedures is the first step.
- It will be necessary to do a physical review or inventory of the property remaining.
- Make an assessment of its current condition and if the original cost and date of purchase are not present in the property record, then it will be necessary to make an estimate of these items. From those figures, book costs can be established in a manner similar to that done when acquiring a new business.
Valuation Techniques In Brief
Current market values are established by considering three methods:
- Present value of future cash flows is one value determinant. By making an assessment of the future inflows and outflows of cash, the net income for future periods can be reduced to current value utilizing current value analysis.
- Comparable sales can be used to establish a second cost comparison figure. Where a current market exists for similar items, such as automobiles, airplanes, computers, and some production equipment, looking at recent comparable sales provides a good estimate of current market value. Real estate, land, and buildings are always appraised based on comparable sales. They must be within the same geographical area. Comparable real estate sales, even within the same town, may be considerably different if not in close proximity to one another.
- Historical cost, less deterioration, plus improvements (less costs of disposal) is the third value determinant. Taking the original purchase price and reducing it based on observed wear and tear and obsolescence, then adding the improvements, provides a third benchmark for comparison of value purposes. Care must be taken that items that will have a negative value are also considered. Toxic chemical spills or presence of other negatives must be assessed as part of the depreciation. Also, the cost of disposition at some future date is appropriate to consider.
Using these three measures of market value can provide the appraiser with sufficient information to arrive at an estimate of property value. Land is always valued based on comparable sales. There is an established market for real estate, and present value of current cash flows or historical costs less depreciation should not influence the appraisal value.
Management Information For Property, Plant and Equipment Valuation
Management must understand the various values to make correct decisions. Using the wrong value in making a decision can have serious consequences.
Return on investment is a required external analysis. The published financial reports are based on book value and that investment base is used for the analysis. However, for internal management purposes, it may be appropriate to use market values. When attempting to evaluate the effectiveness of an old plant with very low book value to a modern new plant with a high book value, there are problems. Return on investment using book value would indicate the older plant has a higher return. For internal management purposes, it may be appropriate to normalize in some fashion the value of the investments being compared. Using current market value of both, or simply recognizing that this comparison is invalid, is important to the management process.
The high rate of inflation has caused many incorrect management decisions in the past few years. Leveraged buyouts used to finance hostile takeovers have been one result. These have occurred in many cases because management was not aware of the actual market value of the component parts. Potential purchasers recognized that the market value of the individual components of a business were worth more than the current return on them. As a result, they purchased stock sufficient to take over the company and financed their purchase with debt secured by the inflated asset value of the firm. In many cases, they then liquidated the assets to reduce or eliminate the debt. Numerous businesses have been totally closed and sold off in pieces with the sale of individual assets bringing back significant profits to the purchaser.
Management must be aware of, and periodically consider, alternative uses of their assets. An old asset having substantial current market value may be a good candidate for sale and replacement with new technology. It may also be appropriate to discontinue a business line that is not providing an adequate return on the current market value. Either changing to a different product line or selling off the individual assets themselves to enter a new business line may be a better decision.
If management personnel have the information needed, they can make correct decisions. Knowing the various asset values will allow them to manage the assets for the best use. They can also make correct decisions and carry adequate insurance. Insurance premiums should not be greater than necessary for adequate coverage, however. Assessment of the state of deferred maintenance will allow the company to manage the asset as opposed to using it up. The manager responsible for the assets needs to know all of the values concerning that asset. Market value is just one.
Periodic Assessment Of Value
Because the values of property, plant, and equipment change over time, a periodic assessment of those values is necessary. This assessment can be done with a firm’s own employees if they have the skills and time necessary to accomplish it. It can be done on a periodic basis, such as annually. Alternatively, it can be done when there is a reassignment of responsible manager or departmental custodian. Normally, an assessment of deferred maintenance should be done when verification of the assets’ existence occurs.
Assessment of other values is probably necessary about every five years. This depends on the rate of inflation and its impact on an individual company’s property, plant, and equipment. There are appraisal companies and consultants available to do all of these tasks. Contracting with an appraisal firm can bring an expert into the process. There are many appraisal firms, both local and national. Numerous public accounting and consulting firms also provide this service. The selection of an outside appraisal firm is also an important decision. The past savings and loan problems were caused in many cases by inflated appraisals on real estate and buildings. There has not been a requirement for appraisers to be certified. Effective January 1, 1992, the federal government has required certification of appraisers who assess the value of property financed or guaranteed by any federal program.
These certification processes have been put into place by the various state governments, and vary from grandfathering those professionals who have been appraising for a number of years to individual testing of all candidates. It is appropriate, therefore, neither to accept the lowest offer for your appraisal contract nor to assume that the certification of the appraisers is adequate protection. As a minimum, the firm must have adequate certified appraisers to accomplish the task.
In addition, look beyond the certification. For what other companies in your industry has the firm provided service? Are these certified appraisers members of professional societies? Within the numerous professional societies are conflict of interest rules and codes of ethics to which their members voluntarily subscribe.
It is important to be assured that the appraisers assigned will have adequate specialization in your industry and type of equipment. Real estate appraisers may have no knowledge of your manufacturing process or the markets for your type of machinery.
Not reappraising periodically may be appropriate for your business; however, management should do an analysis and make a decision on a conscious basis. It is important for the asset accountant to periodically review a sample of assets in the current market. The asset accountant should be responsible for bringing to management’s attention any discrepancies between insurance values, replacement costs, and current market values of their assets.