REVALUATION OF PLANT & MACHINERY ASSETS IN ACCORDANCE WITH FRS15 & IAS16 Every year companies state a value for plant and machinery in their end of year accounts and in most cases this will be the Current Net Book Value but is this an accurate reflection of the true value of the assets of a company? The National and International Financial Reporting Standards allows for an alternative treatment for stating the value of tangible fixed assets at a “Current Value” or “Fair Value” rather than the usual net book value. In the United Kingdom the details of this approach are covered by FRS 15 and Internationally it is covered by IAS 16

What is Fair Value and how is it calculated? The Fair Value equates to the current Market Value of an asset. Unfortunately the market value is not a single absolute figure but a range of values that will depend on the circumstances surrounding the sale. For example the market value of assets sold as part of the sale of a profitable business is likely to be completely different to the market value of the same assets if sold for piecemeal removal from site following insolvency. The Royal Institution of Chartered Surveyors RICS issues guidelines for the accurate assessment of value of assets of an existing business where the following assumptions apply. a) The plant and equipment will continue in its present use in the business b) There is adequate potential profitability of the business, or continuing viability of the undertaking, both having due regard to the value of the total assets employed and the nature of the operation. c) That the transfer is part of an arm’s length sale of the business wherein both parties acted knowledgeably, prudently and without compulsion. Even though this approach assumes that there is a buyer for the business it provides a mechanism for assessing the value of the assets where there is no intention of selling the business. The values are based on the amount that a theoretical buyer would pay to acquire the assets. If reliable market evidence is available this will be based on direct market comparables. However, when considering the total assets of a company there is usually insufficient reliable market evidence, so the Fair Value is usually calculated using a depreciated replacement cost approach. In order to produce a reliable value the depreciation profile used should mirror as closely as possible the value that would be achievable in cases where market evidence exists. For this reason it is usual to adopt a reducing balance depreciation profile when calculating Fair Values rather than the straight line approach used to calculate Net Book Values. The effect of this is that the Fair Value will fall more dramatically in the early years of an assets life and then tend to level out as the asset gets older. The mechanism for calculating the Fair Value of an asset requires the assessment of a number of variables for each asset. These being the current new replacement cost, the total economic life of an asset, the remaining economic life and the residual value at the end of an asset’s anticipated economic life. When considering asset revaluation it is important to re-value all assets in a class. Failure to do this not only does not comply with the terms of the various Financial Reporting Standards but is

also likely to provide an inaccurate value. We have been involved with a number valuation exercises that have concentrated on a fairly limited number of assets with relatively high book values. The reality of this approach often means that we have to walk past dozens of assets that would have a cumulative value many times that of the selected sample. For the majority of businesses the older assets that have been written off in the books will provide a far larger pool of unrecognised value than the newer assets with a relatively high Net Book Value. What are the rules governing the revaluation of assets? The rules governing the revaluation of plant and machinery assets are outlined in the Financial Reporting Standards, published by the Accounting Standards Board and the International Financial Reporting Standards. FRS 15 and IAS 16 deal with the revaluation of plant and machinery assets. There are differences between the Financial Reporting Standards and the International Accounting Standards but the governing principals concerning the valuation of assets are broadly similar and can be summarised as follows.     

Asset Revaluation permitted but not required Should be consistently applied to all assets in the same class but not necessarily to all classes of assets Revaluation should be at market value or Depreciated Replacement Cost Valuation must be carried out or reviewed by an external valuer Should be kept up to date with regular revaluations.

Why is Net Book Value a Poor indicator of the true value of assets? One of the major problems with Net Book Value is that there is often a single depreciation rate used for all plant & machinery assets. This can result in say a piece of high tech electronic test equipment being given the same life as a heavy duty power press. In reality the item of test equipment is likely to remain in service for approximately 10 years but the power press may well still be in productive service 30 or 40 years after it was purchased. Obviously adopting long lives for depreciating assets can in itself create problems with unrealistically large right offs. However, when carrying out a valuation of assets we need to allow for the age and condition of equipment at the date of valuation, so if there is a 30 year old machine we still need to make a judgement as to the remaining economic life of that asset. Because the Fair Value is a snapshot of value at a particular date we are able to assess the age and condition of all equipment employed in the business and it is not uncommon for the economic lives that we use to be longer than the life over which the asset is depreciated in the company books. The Net Book Value also fails to make allowance for events that happen during an assets life. Major overhauls or upgrades may be recorded as capital expenditure but the routine maintenance of equipment is almost certainly treated as revenue costs. If it is regularly maintained, most plant and machinery can be kept in service for many years beyond its’ original life expectancy. It is often only retired once the maintenance costs become prohibitively high or there are technological advances in the process or operation in which it is employed that render it obsolete. The third major problem with The Net Book Value is that it allows assets to have either a zero value or nominal value. Clearly if an asset continues to be usefully employed in a business it will always have some value when measured in terms of tangible worth. When calculating the Fair Value we need to recognise this concept of residual value.

Is there a relationship between Fair Value and net Book Value? The term Net Book Value is in itself misleading because the word value implies some measure of tangible worth. In reality the Net Book Value is the residue of the purchase price that has still to be depreciated and any similarity between the Net Book Value and Fair Value is largely coincidental. However, there is some correlation between the two particularly in the earlier years of an assets life. During the first few years following the acquisition of an asset the Net Book Value will give a fair indication of the Fair Value of assets and if anything will be slightly higher. However, as time passes the Book Value will start to fall below the Fair Value. As time progresses a value based solely on the historic cost of an asset becomes increasingly inaccurate and meaningless.

Is it possible to determine when Net Book Value ceases to reflect the Fair Value? It is difficult to quantify the difference between the Net Book Value and the Fair Value because there are many factors that cloud the picture The following graph contrasts the Net Book Value and Fair Value for an asset costing £100,000 in the year 2000 and depreciated over 12 years assuming an annual inflation rate of 3.5%. in the cost of new equipment. The chart shows that there is reasonable correlation between the Net Book Value and the Fair Value for the first six or seven years of the assets life. However, by 2011 the Net Book Value is less than half of the Fair Value.

Obviously just looking at a single asset simplifies the picture. The assumption of a uniform 3.5% inflation in new machinery prices assumes a fairly benign economic landscape and when we have seen a 20% fluctuation in exchange rates between the pound and most major currencies this is by no means a safe assumption. However, as a general rule a company that makes a significant investment in new plant & machinery each year is likely to be making a fairly accurate statement of true asset value by using the Net Book Value. On the other hand, a company with a high proportion of older machinery; which has possibly been written off in the books; is likely to be seriously under stating the Fair Value of the assets. It is hard to predict the exact point where the Net Book Value becomes an unreliable measure of Fair value but as a guide I would say that if the Net Book Value is less than 50% of the historic cost then a company is probably starting to understate the value of its assets. The degree of understatement will increase the lower the Net Book Value falls below this benchmark.

What are the benefits of asset revaluation? The principal benefits of an asset revaluation are       

Greater accuracy when stating asset values Strengthens balance sheet value Less personal liability for company director’s resulting from inaccurate asset values Less scope for under valuation of companies assets in takeover negotiations Capital allowance tax benefits following merger or acquisition Reduction of goodwill element of acquisition costs Greater transparency for shareholders re asset value

If a company chooses to adopt a revaluation policy then the gains and losses on valuation are normally taken to the revaluation reserve via the statement of total recognised gains & losses and would not be shown in the profit and loss account. However, Valuation losses resulting from the impairment of assets can be shown in the profit & loss account. Although there is no obligation for companies to accurately state the Fair Value of their assets there is a mood for greater transparency in financial statements. I have worked in over 25 countries throughout the world and have found that the awareness of the true value of plant and machinery assets in the United Kingdom is about as low as anywhere. Philip Davies FRICS Hickman – Shearer Ltd 7 Buttermarket, Thame, OX9 3EW