The Scary Truth about Ghost Assets

Marshall & Stevens excels at providing accurate, timely, and supportable valuations for a wide range of debt instruments.

Many people cannot resist a good ghost story. However, while a good ghost story is harmless, ghost assets are not. The term “ghost assets” refers to physical assets that are accounted for on a company’s fixed asset listing (“FAL”), but that do not physically exist at the manufacturing plant or other locations. FAL discrepancies arise for a variety of reasons, including the sale, decommission or cannibalization of machinery, equipment, and other assets. In capital-intensive industries such as manufacturing and wholesale distribution, there is great potential for such discrepancies, which can lead to either an over- or under-reporting of assets.

The Benefits of Eliminating Ghost Assets:

By conducting periodic appraisals of their assets, which includes physical counts of assets, manufacturers and distributors may be able to reduce and/or eliminate their ghost assets. Potential benefits of an appraisal include:

• Possible reduction in personal property taxes in applicable taxing jurisdictions;
• Adequate insurance coverage of the assets;
• Streamlined and cost-effective annual updates;
• Accurate accounting of assets for financial reporting, and;
• Improved budgeting for future capital expenditures.

The Haunting

Manufacturers and wholesale distribution companies often allow themselves to be unwittingly haunted by ghost assets in a few ways. For example, companies could be paying personal property taxes on nonexistent property. There is also the potential for undervaluing — and therefore underinsuring — physical assets. Companies making an acquisition may be unpleasantly surprised to find that the acquired assets were miscounted or did not exist, and the fair market value was therefore miscalculated. Since fixed assets often represent the largest items on a manufacturer’s or distributor’s balance sheet, inaccurate accounting can lead to significant financial reporting misstatements, which can damage management’s credibility with shareholders, lenders, and suppliers.

Provided below are several scenarios where an appraisal would be beneficial:

Acquisitions – Purchase Price Allocations: In a business combination there may be some assets that are duplicated, disposed of, cannibalized for extra parts or may have been retired or upgraded. As a result, this can affect the fair value of the assets. Problems can occur when the lists of assets are initially merged. The buyer can be certain that the assets purchased exist by having an appraiser conduct a physical count of the assets and prepare an appraisal that accurately reflects the duplicated, disposed, retired, and upgraded assets.

Insurance: Appraisals are required to establish a replacement cost new (“RCN”) for insurance coverage to indemnify the insured against loss. Thus, the insurable value of assets is obviously of concern to owners, lessors, lessees, insurers, agents, and brokers. If a manufacturer or distributor does not perform a routine inventory of its assets to remove ghost assets from its FAL, it runs the risk of insuring assets that do not exist, resulting in unnecessarily high insurance premiums. Conversely, if significant upgrades to a production line have been performed and not properly accounted for, the company could be underinsuring its assets and increasing its exposure. Consideration should be given to the level of exposure related to customized assets such as automated distribution centers, filling machines in bottling plants, etc. These assets are typically designed and built for a specific company for a specific purpose. By properly identifying and valuing these customized assets, a company can mitigate its level of exposure and be certain that its insurance company is aware of the one-of-a-kind nature of the assets and that appropriate measures have been taken to mitigate risk.

Personal Property Tax: Many states levy personal property taxes on machinery and equipment. Typically, these taxes are levied based on “self-reporting,” with the company providing a copy of its FAL to the assessor, who then calculates the personal property tax liability. Without an accurate inventory, ghost assets can linger on the FAL, resulting in the company paying personal property taxes on assets that no longer exist. As illustrated in the table below, the company realized a tax savings of $180,000 in the first year following the appraisal. Some states allow business owners to amend their personal property taxes for up to three years, so the savings can be significant.

Income Tax: One of the most common income tax-related reasons for an appraisal is for the purchase price allocation in a transaction (as per the IRS Asset Acquisition Statement Under Form 10601). The IRS’s standard of value is fair market value; therefore, the removal of ghost assets results in more accurate calculations of fair market value, with the purchase price being allocated to the assets that physically exist. As shown in Table 1 below, ghost assets totaling $7,000,000 were identified and removed from the fair market value allocation. Using an estimated 38% federal tax rate, the seller could realize a potential savings of $2,660,000 ($7,000,000 x .38). This would cause a reallocation of purchase price and potentially prompt the buyer to rethink the consideration paid.

Condemnation (Eminent Domain): When a public agency needs to acquire private property for conversion to public use, it exercises the power of eminent domain. If the property in question is industrial or commercial in character, it probably contains a considerable amount of machinery and equipment that would be costly to relocate. By having a professional appraisal performed, a company can better demonstrate its losses attributed to equipment that is either difficult to remove or relocate, which aids in its negotiations for just compensation.

How the Appraisal Process Works

Marshall & Stevens recommends having appraisals performed by an accredited appraiser (see sidebar) because, in addition to offering independence and objectivity, they possess significant expertise in valuing machinery and equipment. When conducting an appraisal, an appraiser typically:

• Identifies assets that do not physically exist but are recorded in the FAL as well as assets that physically exist but are not recorded in the FAL
• Considers the three approaches to value: 1) cost, 2) sales comparison, and 3) income;
• Corrects the classification of assets as necessary;
• Calculates the reproduction / replacement cost new;
• Determines the normal useful lives of assets;
• Calculates physical deterioration;
• Identifies and develops functional and economic obsolescence penalties (if applicable); and
• Performs research in the secondary market of comparable assets (if applicable).

The appraisal process typically involves four steps:

At the outset of an appraisal, an appraiser will request a copy of the current FAL. The appraiser then evaluates the FAL with the purpose of identifying inconsistencies such as assets that may have been disposed, retired, sold or transferred but still appear on the FAL and therefore are reported in financial statements. These inconsistencies are investigated during the on-site visit when a physical inventory is carried out. Following the on-site visit, the appraiser updates the FAL, removing assets that do not physically exist and adding those that were not reported. Finally, the appraiser calculates the fair market value, providing the business owner with a clean and final FAL.