Why Net Book Value does not equal Fair Value
This article was originally published by American Society of Appraisers.
In valuing assets for financial reporting purposes, it is critical to understand that Net Book Value (“NBV”) is NOT an appropriate measure of fair value for machinery & equipment (“M&E” or “Asset”) related to financial reporting.
To begin this discussion, it is important to define several important terms and have a clear understanding of their place when debating the application of NBV as an appropriate measure of fair value for assets.
Net Book Value1
“The cost of an asset (the amount that was paid for it) minus accumulated depreciation for financial reporting purposes.”
Fair Value (ASC 805)2
“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. (This statement also explains that a fair value measurement of an asset assumes its highest and best use by market participants. Such use would maximize the value of the asset or group of assets within which the asset would be used, regardless of the intended use of the asset by the reporting entity.”
Normal Useful Life3
“The physical life, usually estimated in terms of years that a new property will actually be used before it is retired from service. A property’s normal useful life relates to how long similar properties actually tend to be used, as opposed to the more theoretical economic life calculation of how long a property can profitably be used.”
As previously mentioned, NBV and fair value are two very different concepts. NBV is the result of a depreciated asset minus its original cost. Accounting depreciation does not consider the following:
• Physical condition of the assets
• Improvements or partial retirements made to the assets
• Changes in the effective age of the assets
• Functional or economic obsolescence factors
The following three examples related to tax accounting, GAAP accounting, and valuation demonstrate the differences between NBV vs. Fair Value.
Tax Accounting Perspective
In tax accounting, NBV calculates the annual depreciation of the assets with the purpose of reducing the taxpayer’s tax liability. Once the normal useful life of the asset has been fully depreciated, the NBV goes to zero and, as a result, there is no longer a tax benefit to the taxpayer. In the case of tax accounting, Modified Accelerated Cost Recovery System (“MACRS”) lives, which are published by the IRS, are typically used. MACRS lives are designed to recapture the cost of assets used in the operation of a business at an accelerated pace. This increases cash flow and, as a result, provides opportunities to reinvest the additional cash flow.
MACRS lives are divided into the following categories:
EXAMPLE GAAP Accounting PerspectiveFrom an accounting perspective, the calculation of NBV follows guidelines set forth by US GAAP. The overall principle is the same as in tax accounting in the sense that a normal useful life is identified utilizing either MACRS lives, accounting lives, or lives determined by the business owner. Once the asset has surpassed its normal useful life, the NBV goes to zero - regardless of whether the asset is still in use and generating income.
Table 2 considers the same example as in Table 1, but from an accounting perspective under US GAAP.
INITIAL OBSERVATIONSIn examples 1 and 2, two different normal useful lives have been applied. Five years was applied related to the tax accounting example and eight years was applied for US GAAP reporting. But both examples show an end result of NBV zero. However, the asset still exists and is producing an income. Maintenance expenditures are still being applied to this asset. Is it reasonable to assume that the fair value of the asset is also zero?
EXAMPLE 3Valuation Perspective
In valuation for financial reporting, the purpose is to calculate fair value. In doing this, a valuation specialist must consider the three approaches to value which are the income, cost, and market approach.
Table 3 provides a simplified indirect cost approach to calculate the fair value of the asset.
Historic Cost x Trend Factor = Reproduction Cost New (“RCN”)
RCN x Depreciation = Fair Value.
In performing M&E valuation, there are other factors that can impact the fair value. Factors that can increase the fair value are:
• Upgrading a production line or piece of equipment
• Standard maintenance procedures
• Replacing key components of an asset.
On the flip side, a number of factors can decrease the fair value of an asset. These would be identified through decreases in the effective age, as well as functional or economic obsolescence penalties. Examples of these penalties include, but are not limited to, a poorly maintained asset reflecting a higher rate of physical deterioration than a well-maintained one.
Examples of functional obsolescence would include:
• Excess operating costs
• Excess construction costs
• Lack of utility or similar conditions
Examples of economic obsolescence would include:
• Economics of the industry
• Availability of financing
• Loss of material and/or labor sources
• Passage of new legislation
• Changes in ordinances
• Increased cost of raw materials, labor, or utilities
• Reduced demand for the product
• Increased competition
• Inflation or high interest rates or similar factors
In the application of the cost approach, the three forms of depreciation (physical deterioration, functional obsolescence, and economic obsolescence) should be considered when calculating the fair value of assets.
Additionally, as discussed above, there are many factors that must be considered when performing a valuation, in addition to what is typically expressed within the NBV.
It is important to reinforce that among the three approaches to value, the income approach is rarely applied by M&E appraisers. However, depending on the type of asset, the market approach or a combination of the market and cost approach can be more applicable in determining the fair value of the asset.
APPLICATION OF THE MARKET APPROACHThe market approach is most reliable when there is an active market yielding a sufficient number of sales of comparable properties that can be independently verified through reliable sources. This approach focuses on the actions of real buyers and sellers. In theory, the market approach measures the loss in value from all forms of appraisal depreciation and obsolescence that are inherent in the asset. This is assuming that proper adjustments are made to the comparables reflecting the difference between them and subject assets.
Table 4 compares the NBV versus the fair value of the delivery van mentioned earlier in this article:
If the NBV is zero, does this mean that we now have a delivery van that is eight years old and worthless? Does this mean that we cannot trade this in for a new delivery van? Couldn’t we sell this van to a third party? Using NBV as fair value is not reasonable in this example.
If we were to sell this delivery van after eight years, what may be some selling points to advertise?
• Low miles (adding life – changing the effective age and value)
• Clean interior (adding life – changing the effective age and value)
• Maintenance records available (adding life – changing the effective age and value)
• Original Owner (adding life – changing the effective age and value)
• Never been in an accident (No increased physical deterioration)
In essence, what are we really discussing? This is an attempt to mimic the market’s interpretation of the effective age of the asset and, as a result, potentially increasing the fair value of the asset.
Another factor is the normal useful life used in the calculation of the fair value. Whereas the owners may possibly apply their own normal useful life or use MACRS lives, appraisers use actual service lives. In the case of a delivery van, actual service lives can range from five to eight years. As mentioned in the selling points above, appraisers will also consider adjustments to the effective age.
Appraisers consider the income, cost, and market approaches to value when performing a valuation. Whereas the calculation of net book value is an accounting function, this does not provide a true representation of the fair value of an asset.
The delivery van is a simplified example to illustrate the differences between NBV and fair value. One must consider that, for an asset-intensive business, the differences can be more severe, showing a significant difference between NBV and fair value. It is important to have a professional machinery and equipment specialist - someone who understands the many factors affecting the fair value - perform the valuation of the assets. A professional valuation specialist will calculate the fair value of an asset, ensuring that an accurate representation of the asset has been considered and applied in the final conclusion of fair value.
1Machinery and Technical Specialties Committee of the American Society of Appraisers, Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets, 3rd ed. (Washington DC.: American Society of Appraisers, 2011), page 522
2Machinery and Technical Specialties Committee of the American Society of Appraisers, Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets, 3rd ed. (Washington DC.: American Society of Appraisers, 2011), page 523
4http://data.bls.gov/pdq/SurveyOutputServlet;jsessionid=31E0ABC421E474437BBC05DC3E890879.tc_instance4. Accessed September 20, 2016.
5Machinery and Technical Specialties Committee of the American Society of Appraisers, Estimated Normal Useful Life Study (Herndon, VA: American Society of Appraisers, 2010), page 8 of 94
6Corelogic: Marshall Valuation Service, September 2016 (Los Angeles, CA, 2016), Section 97 Page 26