Equipment Appraisal Blog | Understanding Machinery Appraisals

When equipment you've invested in has become obsolete, it can wreak havoc on your business' accounting, especially when it has not yet been fully depreciated. How do you deal with economic obsolescence in your company? Here's a quick look at what it is and how to best deal with it when it happens in your business.

How equipment appraisal helps you deal with economic obsolescence

I remember the first time I ran into a case of economic obsolescence in a piece of business equipment. Back in 1992, my parents invested in a 286 computer for their business, to run accounting and correspondence. Several years later, I found them a newer computer for the business, so the older desktop came home. Following a number of creative hacks to try to keep the system running for nearly 18 years, my mother finally asked, "That old computer probably isn't good for much more than a boat anchor anymore, is it?" The rejoicing at that point, albeit quietly in my head, was epic.

When equipment is no longer able to be updated to remain useful, it's said to have become obsolete. Economic obsolescence is the point at which it costs more to try to maintain older equipment than to replace it. Unfortunately, this can cause some serious problems with your company's books, especially if the machinery is not yet fully depreciated.

One industry where this regularly happens is IT. Because of the rapid progression of computer technology, it can seem as though every week a faster processor, bigger hard drive or a larger memory stick is coming out. Software from three years ago is no longer being supported by the developer, making it impossible to take care of security issues. When these assets are not yet fully depreciated, they still show value on the books even though they have become completely unusable in daily operations. 

That doesn't mean you won't get any money for it in a sale, but it would require spending time, effort and money to find the right buyer. Some computer companies build their own testing labs by purchasing older systems that may be used by their clients, but these labs are not where the company makes money as much as where they provide customer support and service to ensure the product they're developing will work well on the client's system. Though it has some value for the company, it's not in the profit sector of the company, so is often disregarded in terms of value.

For this reason, an equipment appraisal can help fix this problem. Because a certified equipment appraiser should have experience in the industry in question, they typically have a good grasp of when a technology or piece of equipment is no longer able to remain competitive in the real world. They can help provide a value for the equipment that is realistic, and their appraisal is well documented.

When you have a situation of economic obsolescence in your company, one of the best options to record the loss of machinery value is through an equipment appraisal. When you work with a certified appraiser, they have a good grasp of your industry's rate of progress and understand when certain classes of machinery become obsolete. Because they use standardized methodologies, their appraisal report will stand up well to scrutiny from outside interests, whether it's the legal system, a tax agency, an insurance company or a financial institution.

We've all heard of problems businesses may have due to obsolete equipment. But what many companies don't realize is that there is a big difference between a piece of equipment being economically obsolescent and reaching functional obsolescence. But what's the overall difference between these two major types of obsolescence and what do you do when you have equipment that breaks down or wears out and becomes functionally obsolete? Here's a quick look at how it works out in equipment appraisal.

Used up and worn out: Dealing with functional obsolescence in equipment

Functional obsolescence is defined as the loss of value and usefulness of a piece of equipment which is caused by the machinery's lack of efficiency, inadequacies or high cost of maintenance and repair. In general, it's typically reached when a piece of equipment becomes more expensive to repair or maintain it than to replace it. But how does that work?

As a quick example, consider a vehicle. It's purchased with the understanding that at some point it will need to be replaced. As the years roll by, more repairs are required to keep the vehicle operating reliably. Eventually, the cost of these repairs will exceed the cost of purchasing a newer vehicle.  Another example could entail the need for a more fuel-efficient vehicle. If the current vehicle only gets five miles per gallon and a newer model would get 20 miles per gallon, the cost of operation is the key factor in terms of when to replace the equipment for a more efficient model. 

But what causes machinery to become functionally obsolete? Newer, more efficient technology may gain ground and come down in price, making the cost of acquisition much lower than in the past. This makes it possible to replace the equipment because of the reduced cost of waste. If it's caused by machinery breaking down, that can be caused by operating it in a state of over capacity, which wears the machinery at a faster pace than normal. In general, this is caused by purchasing machinery that is not suited to the task at hand or having to make increased demands on it after the initial investment. If innovations in the market provide new features that become necessary for modern operation practices, this can also make the machinery functionally obsolete.

Unfortunately, when you have a piece of equipment that has become functionally obsolete, it can create problems with your business' accounting and overall financial standing. If the machinery has not yet been fully depreciated, it may be showing a higher value than what it's actually worth at this point. If you have to deal with legal issues, the other side of the case may look at these values and claim that your company has a higher value than is reasonable. Having an equipment appraisal helps you document the machinery's actual value.

Though having equipment reaching functional obsolescence isn't a goal any business tends to make, it's one that many companies end up facing at some point or another. By taking the time to learn how to deal with the issue when it arises, you can make better decisions for your company and your remaining assets. Being able to document the final value of functionally obsolescent machinery can make a huge difference on your accounting and helps provide a more accurate overall picture of your business' financial health.

When we think about depreciation of an asset, we typically think about it based on a percentage, such as is used in tax accounting. But companies that have looked at equipment values over the years realize that a piece of machinery that has been fully depreciated on your taxes still has significant value in your business operation and can cost a lot of money to replace. In equipment appraisals, physical deterioration is a much more commonly used form of depreciation. Here's why:

How physical Deterioration is different than percentage-based depreciation

Because machinery varies so much in terms of lifespan, durability and reliability, it became much easier for the Internal Revenue Service to simply determine a set number of years over which a piece of equipment is appraised. But in reality, equipment that is well cared for may last many years, if not decades, beyond the point that it has been fully depreciated. By having a machinery valuation performed by a qualified equipment appraiser, you have a record of the equipment's actual value instead of what the IRS thinks it's worth.

Why physical Deterioration provides a better estimate of business assets

By comparison, a physical deterioration using the age/life ratio provides you with the best possible documentation that will hold up in financial, legal, insurance and tax office circles. If you  need financing for your latest project, being able to prove the value of all your assets beyond what's listed on your tax return helps you secure it. If you're dealing with a legal headache, you can document the condition of your machinery, proving that its not, in fact, worthless as the other side may contest. If you suffer a serious loss in your business, whether due to a fire, natural disaster or vandalism, you can prove the equipment values of replacing the equipment through your insurance company without any doubt as to the accuracy of the report.

But what about the flip side of the coin? If your equipment is losing value faster than the IRS depreciation tables, a quality machine appraisal provides you with quality evidence that you need to depreciate it more quickly. This can also hold true in terms of property taxes, where you may end up having to appeal your tax assessment because of a high appraisal that was performed based on standardized depreciation rates. A proper equipment valuation provides legal documentation of the equipment's actual value, allowing you to have your taxes lowered based on the lower appraised value and lowering your overhead.

By keeping track of your actual machine values through a quality machine appraisal, it's much easier to document the replacement value when you need it most. If you haven't found a company to perform a quality machinery valuation on your equipment, you could be leaving money on the table when it comes time for insurance policy renewal, financing for a big project or expansion or a property tax appeal.