Asset audits will help keep books in order

By Adam Bernstein, Monday 01 October 2018

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Every business has assets. From land and buildings, to equipment, goodwill, brands and intellectual property (IP), there is value in everything. But the question for the businessman on Clapham omnibus is how to understand the true value of those assets?

assets

Legal principles

David Bunker, assistant managing director at Close Brothers (Banking Division), outlines the principles and what the Companies Act 2006 demands. He says that the starting point is that a business’s accounts must show a fair and reasonable value of the cost of an asset at the outset and also throughout its life. But showing this isn’t simple: “Assets are used in different ways. A press, for example, which is run on a light shift will be worth more over time than a press run 24/7 and the accounting principles allow for a business to reflect this in their accounts.”

In terms of the legal responsibility for the valuation process, Mark Nelson, director, Compass Business Finance, says this rests with the company and its directors: “Accountants will never be involved unless the depreciation policy of the business is consistently out of kilter with the market – that is, they always make significant profits or losses on sale of assets.”

From an auditor’s perspective, Michael Bridge, manager – Financial Reporting Advisory Group, Grant Thornton UK, says that however the process is approached, the value attributed to the asset must be consistent with the likely economic benefit that will be derived from use of that asset. He says cash generating assets may be valued on future cashflows; whereas investment assets may be valued on what they might return when sold.

As to what is an asset and how they’re treated, Paul Holohan, chief executive of Richmond Capital Partners, says that “they can be tangible (such as presses) or intangible (such as goodwill or IP); directors are asked to be ‘prudent’ and ‘consistent’ in setting depreciation or amortisation rates.” He adds that whatever rates of depreciation are used must be shown in the accounts. 

Bunker expands on this. He says procedurally directors must detail fixed tangible assets at cost less depreciation at rates calculated to write off the cost less estimated residual value of the asset over its useful expected life. For print he says these rates are normally set between 10%-25% per annum – “but the business would review this with their accountant.”

On top of this Nelson says values should be recorded on a worst-case scenario basis with the only exception being freehold property.

The need to revalue

So why would a business ever want to revalue their assets? 

One major reason, according to Nelson, is the need to understand the equity and risk position a business has against the debt owed on those assets: “It may be the company is looking to restructure their debts in order to manage monthly cashflow, release equity so they can better utilise that cash for another purpose, or understand where their personal risk would be.” He also says that it is common for any equity within the assets of a business to be used during a merger or acquisition, so knowing this information would be critical. 

Bunker’s experience has taught him that property is the main asset class that gets revalued. “In the main, leasehold land and buildings are depreciated over time at 2%, but if property has gone up in value the directors will need, and indeed, may want to reflect the increase to the correct figure.”

And Holohan agrees. He says that it’s “somewhat unusual for fixed assets such as machinery, computer equipment or motor vehicles” to be revalued for obvious reasons – “it is far more common for land and buildings”.

As for the spur, a gut reaction might start the process reckons Bunker. Another push might, as Holohan says, come from the need to strengthen the balance sheet to demonstrate that the business is worth more in shareholders’ funds than is currently shown. But he says that “it is rarely done for those seeking to sell. It is more common to show an ‘adjusted balance sheet’ to interested parties with evidence to support the claim.”

In his view, there are rarely good reasons for revaluing assets but it can be justified where depreciation rates have been aggressive or overtly prudent. He offers a note of caution though: “We would rarely advise [on a revaluation] unless there is a good reason as it is easy to see through a move, for example, to make an insolvent business look solvent.”

However, Bridge says that accounting standard IAS 36 – Impairment of Assets requires an entity to review their assets for impairment at least annually, “at which time the current value of the asset per the balance sheet will be compared to the recoverable amount”. He carries on: “If this indicates that the asset book value is too high then it will be written down to the appropriate amount – the value that the entity will actually derive from the intended realisation of the asset.” 

He notes that firms can revalue more frequently, such as listed companies that produce quarterly statements and those ceasing business.

Failing duties

Running a business carries numerous duties especially legal compliance. By extension, failing to keep assets properly valued – whether over or under – is a breach of the law and as Bunker comments, the company and directors could find themselves in serious difficulties.

For Holohan, there are other risks associated with failing to keep values accurate, not least of which is access to borrowing: “If assets are not valued properly it can lead to errors of judgement on credit ratings and perceptions of the business in the eyes of suppliers.” 

Another trouble spot that Bunker’s seen involves machines not being used as hard as expected: “This may mean that instead of using 15%-20% depreciation per annum against machinery the directors expect just 10%. Alternatively, it may be that contracts and shifts change and assets get worked harder and if the directors don’t change the rate of depreciation to reflect this then the accounts will be misleading and when the asset is finally sold this will create a loss on disposal.”

Nelson has witnessed the same when significant errors on the depreciation policy of the business appear. Where this happens, “a company could be showing much higher (or lower, although less likely) profits, than the true performance of the business”.

The key, according to Holohan, is to see what auditors agree to: “Where assets are over-valued, directors will rarely reduce the balance sheet and auditors will rarely insist that this is done. This is why the acid test is if the auditor will sign off the accounts with a ‘true and fair view’ opinion.”

Material changes in asset value

As to what causes fluctuations in asset values, there are countless causes. This might be an exchange rate – many machines are sold outside the UK and dealers will reflect this in their offers as worldwide demand has changed values. 

Bridge suggests that the value of an investment asset will be linked to the performance of an underlying investment, for example an investment in a printing firm could be impaired if the trading has deteriorated such that the business is now sustaining losses and the fair value is less than the current carrying value of the investment. He also looks at the outputs – “if an entity is carrying inventory that it can no longer sell at a profit, the value of the inventory should be written down to the actual value that they will derive through sale (if at all) of the items.” 

And small things, says Nelson, can also affect values. He points to the condition of equipment, access to premises, and changes in market perception of the make and model of the equipment in question. This is something that Bunker echoes – “the housekeeping of a factory can drive value – I would say anecdotally that the difference in values between a well-kept B1 press and one not could be as much as £50,000-£100,000.”

The impact of technology on the industry where some new areas of technology might appear to enhance values can make equipment difficult to sell. “Some digital machines,” says Bunker, “have been good examples of this but this may be because businesses are depreciating over a long period of time when actually the useful life may be much less.” It’s for this reason that he cautions printers that some machines just cannot be sold on so it’s important to ensure they are written off over time. 

And the list can go on. Holohan includes asbestos that needs remediation, a lack of spares, or a change in an intangible such as IP. In fact, it’s the intangibles that he sees increasing when “large firms value their brand on the balance sheet.” His view is that “in a vacuum stakeholders make assumptions. This can be dangerous.”

Impaired assets

It’s all well and good having assets that increase in value, but what if the asset is impaired – is it worth less than the book value? 

From an accounting viewpoint, Bridge says that if an asset is impaired it will impact on both the profit and loss and the balance sheet: “An impairment will reduce the net asset value of the balance sheet and the profit recorded for that period, which will impact on the distributable reserves for the entity and could restrict their ability to pay any dividends... this could influence investor’s decisions and also result in the breach of any applicable covenants.” 

But in practical term, Bunker thinks that most will have in inkling of the problem from watching market values, market demands, technological changes, economic drivers and accepted obsolescence or damage.

To cOnclude

The valuation of assets is not a science, but instead, more of an art. One thing is clear though, firms that ignore the statutory requirements are heading for trouble – especially if they hit the buffers. Directors have duties and the authorities will investigate those that give incorrect information to stakeholders. 

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