Don’t Bank on Book Value
Borrowers often pledge fixed assets — such as real estate and equipment — as loan collateral. But there could be many reasons that the book values reported on a customer’s balance sheets are greater than their current market values.
In today’s volatile marketplace, it’s imperative to keep a close watch on fixed assets because they represent the largest category of investments for capital-intensive borrowers. Here are some potential problems and areas for improvement relevant to your borrower’s property, plant and equipment (PPE).
Looking for Hidden Impairment
Your borrowers customarily record fixed assets at historic cost and then depreciate them over their useful lives. But sometimes a fixed asset’s book value (historic cost less accumulated depreciation) overstates its fair value, which is “the price that would be received to sell an asset … in an orderly transaction between market participants at the measurement date,” according to Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements.
If the value of a fixed asset is “impaired,” the borrower should report the impairment loss as part of the income from continuing operations, per FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Impairment losses also reduce the carrying value of the impaired asset on the borrower’s balance sheet. Once impairment happens, FASB prohibits the upward revaluation of fixed assets in periods that follow.
FASB Statement 144 doesn’t require companies to test for impairment every accounting period. Rather, testing frequency should occur on a consistent basis — say, every three to five years. Possible reasons for interim testing include changing market conditions, inaccurate useful lives or overpaying for an acquisition.
Unfortunately, there are many reasons borrowers delay, or deny, impairment. First, no one wants to disappoint or worry lenders. An impairment loss lowers earnings and the value of fixed assets and, therefore, raises a red flag. Second, impairment testing is based on subjective internal assumptions about the asset’s projected cash flows. To some extent, management can massage estimates to avoid booking an impairment loss.
Additionally, impairment testing may be outside the comfort zones of some internal accounting personnel.
Searching Beyond Impairment
Beyond asset impairment, a borrower’s balance sheet may be “off” if management fails to maintain an accurate fixed asset ledger. The company may no longer physically possess an asset that’s been stolen or misappropriated by an employee. Or fixed assets may be idle, damaged or obsolete. Some companies also capitalize repairs or smaller items — such as tools or supplies — that should be expensed in the current accounting period.
Moreover, some PPE may be underused, thanks to the recession. Divestitures are one way to free up cash flow if a company owns too many fixed assets, but other inventive alternatives abound.
For example, a tool and die manufacturer had excess plant and warehouse space after it lost a major customer. To bridge the gap until productivity rebounded, the owner subleased space to his brother’s tool and die shop. Now they’re also sharing overhead costs, including secretarial, maintenance and accounting personnel.
Reining in Fixed Assets
Economic uncertainty compromises the value of your collateral, including PPE. You can achieve peace of mind by retaining an objective outsider to inventory fixed assets and reconcile any material inconsistencies. A CPA can test for impairment and economic obsolescence, as well as recommend creative solutions to off-kilter fixed assets.
For more information on how we can help your community bank, please contact Sonny MacArthur at email@example.com or 404-420-5631.