Net book value is not the same as fair value

First let us define several important terms and develop a clear understanding of their place when contemplating the application of NBV as a proxy of fair value for assets.

Net Book Value

“The capitalized cost of an asset less the accounting depreciation taken for financial reporting.” – American Society of Appraisers (ASA), Machinery and Technical Specialties Committee, in “Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets” (Fourth Edition)

Fair Market Value (IRS)

“The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” – IRS Revenue Ruling 59-60

Fair Value (Financial Accounting Standards Board, FASB)

“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – Accounting Standards Codification (ASC) Topic 820, “Fair Value Measurement”

ASC 805 (“Business Combinations”) further explains: “A fair value measurement assumes the highest and best use of the asset by market participants, considering the use of the asset that is physically possible, legally permissible, and financially feasible at the measurement date. In broad terms, highest and best use refers to the use of an asset by market participants that would maximize the value of the asset or the group of assets within which the asset would be used. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different.”

For this article we will assume that “fair market value” is synonymous with “fair value” because they are defined similarly, and both contemplate similar economic circumstances in the development of a measure of market value.

Normal Useful Life

“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.” – ASA Machinery and Technical Specialties Committee, in “Valuing Machinery and Equipment”

NBV and fair value are distinctly different concepts. NBV is an accounting exercise: original (unadjusted) cost less a depreciation amount set by a tax or book depreciation curve. Accounting depreciation does not consider the following:

• Current reproduction/replacement costs
• Physical condition of the assets
• Improvements or partial retirements made to the assets
• Current utilization of the assets
• Changes in the effective age of the assets
• Functional or economic obsolescence factors
• Salvage value (not in all, but in many cases)

The following three examples related to tax accounting, GAAP accounting, and valuation demonstrate the differences between NBV vs. fair value.

Example 1: Tax Accounting Perspective

In tax accounting, NBV (referred to as the adjusted tax basis) is the original cost minus tax depreciation. Each year, a taxpayer calculates the annual depreciation, which causes the adjusted tax basis to decrease over time. At the end of the asset’s tax recovery period (useful life), the asset will be fully depreciated and the NBV will be zero. Accordingly, there will no longer be a depreciation tax benefit to the taxpayer going forward.

The IRS publishes tax recovery periods for U.S. federal income tax purposes. Generally, assets are depreciated using the Modified Accelerated Cost Recovery System (MACRS). Absent the requirement to use or an election to use the Alternative Depreciation Method (ADS), MACRS applies either a “double-declining balance” method or “150% declining balance” method to most non-building assets. These non-straight-line MACRS depreciation methods result in tax depreciation being front-loaded into earlier years. In fact, if a taxpayer takes advantage of additional first-year depreciation (“bonus depreciation”), the taxpayer may be able to fully recover the cost basis of a tax asset in the year in which it is placed in service, resulting in a $0 NBV by the end of the year in which the asset is placed in service.

Further, for property placed in service in taxable years beginning after Dec. 31, 2017, the taxpayer may elect to include the following improvements (as listed by the IRS) made to nonresidential real property after the date when the property was first placed in service as Section 179 property eligible for Year 1 bonus depreciation:

• “Qualified improvement property, which means any improvement to a building’s interior. However, improvements do not qualify if they are attributable to:
  • The enlargement of the building,
  • Any elevator or escalator, or
  • The internal structural framework of the building.
• “Roofs, HVAC, fire protection systems, alarm systems, and security systems.”

The following is a general overview of MACRS lives.

Suppose a vehicle was acquired at an original cost of $30,000 in 2013 and used in the operation of a business as a delivery van, and the owner elects to apply the MACRS schedule as opposed to Year 1 bonus depreciation. The appropriate MACRS life for tax purposes would be five years. For federal tax purposes, a “five-year asset” is actually depreciated over a six-year period with a half-year of depreciation in the first and last years of the recovery period; so for U.S. federal income tax purposes, a five-year asset would be recovered as follows: 20% in Year 1; 32% in Year 2; 19.2% in Year 3; 11.53% in each of years 4 and 5; and 5.76% in Year 6. Accordingly, the tax NBV of the asset would be $0 by the end of the sixth year.

Example 2: GAAP Accounting Perspective

From a U.S. GAAP accounting perspective, the NBV is typically calculated as “the capitalized cost of an asset less the accounting depreciation taken for financial reporting,” to quote the ASA’s “Valuing Machinery and Equipment” guide. The overall principle is similar to the tax accounting example in the sense that original unadjusted cost is applied to a depreciation curve, and a normal useful life is identified, in this case by utilizing accounting lives determined by the business owner.

For this example we will assume that the business owner has chosen a residual value of $0 for GAAP accounting purposes, which is observed to be common in practice. Once the asset age has reached its normal useful life, the NBV will be equal to zero in our example, regardless of whether the asset is still in use and generating income.

INITIAL OBSERVATIONS

In examples 1 and 2, two different normal useful lives have been applied: Five years in the tax accounting example, and eight years for U.S. GAAP reporting. But both examples show an end result of NBV to be zero because the asset age reached or exceeded both the tax recovery period and the book life. However, the asset still exists and is contributing to producing income for the business. 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 3: VALUATION 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: The Income Approach, the Cost Approach, and the Sales Comparison Approach (also known as the “market” or “comparative transactions” approach). Table 1 provides a simplified valuation analysis to estimate the fair value of the asset; the underlying valuation methodology is outlined underneath.

Table 1 Footnotes:

^{(a)             The cost to the original owner when the asset was first placed in service.}

^{(b)             Used in the indirect cost approach method to adjust for changing price levels to estimate current year cost new.}

^{(c)              = (a) x (b)}

^{(d)             Determined by market research for cost new. Consider dealer quotes for cost new, MSRP, new asset listings on Kelley Blue Book, and Edmunds.}

^{(e)             Consider reproduction cost new and replacement cost new estimates.}

^{(f)              Based on published industry sources, appraiser experience, and input from Management on typical useful lives for similar assets operating in the same setting.}

^{(g)             Start with historical age (Current year - Year Placed in Service) and make adjustments up or down for effective age based on observation and analysis.}

^{(h)             = Effective Age - Normal Useful Life. Also, the appraiser could estimate the remaining useful life of the asset as of the Valuation Date.}

^{(i)               = Effective Age / Normal Useful Life.}

^{(j)               Salvage value estimated based on industry experience and/or review of Salvage Factors published by Marshall Valuation Service by industry.}

^{(k)              See discussion below.}

^{(l)               = (e) * (1 - min( i , j ))}

^{(m)            Determined by market research for cost new. Consider dealer quotes for cost new, MSRP, new asset listings on Kelley Blue Book, and Edmunds.}

^{(n)             The appraiser considers and reconciles the three approaches to value to determine a Fair Value estimate of the asset.}

Appraisers consider the cost, market, and income approaches to value when performing an appraisal or valuation. In comparison, the calculation of net book value is an accounting function that does not consider all factors affecting value, and does not necessarily provide an accurate 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 could be much more substantial, showing a significant deviation between NBV and fair value. When estimates of fair value are needed, it is important to have a professional machinery and equipment specialist – someone who understands the many factors affecting fair value – perform the valuation of the assets. A professional valuation specialist will consider the relevant factors in estimating the fair value, helping to ensure that an accurate representation of the asset has been considered and applied in the final conclusion of fair value.

This article was adapted from an article originally written by CohnReznick for the American Society of Appraisers.

Steven Munson, Director, Valuation Advisory Services

646.601.7731

Richard Shevak, Principal, National Tax Services

862.245.5029