Economic Obsolescence Is a Type of Depreciation That Results from Excess Costs

Economic obsolescence is a type of depreciation that results from excess costs. This occurs when an asset's value decreases due to increased costs associated with its maintenance, operation, or replacement.

Excess costs can arise from various factors, including technological advancements that make older assets outdated. For instance, a company may have invested in a new manufacturing process that renders its existing equipment obsolete.

The excess costs associated with economic obsolescence can be substantial, leading to a significant decrease in an asset's value. In some cases, the costs may even outweigh the asset's remaining useful life.

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Economic obsolescence is a type of depreciation that results from external factors affecting a business or its assets. This can include industry economics, regulatory changes, or loss of resources.

Industry economics can significantly impact a business, making it difficult to remain profitable. For example, if a company produces a product that becomes outdated due to market dominance, it can lead to reduced demand and earnings.

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Regulatory changes, such as tariffs, can also impose additional costs on goods and materials. This can make it challenging for businesses to pass on these costs to customers, leading to reduced profit margins.

A business's ability to adapt to these external factors can greatly impact its success. If a company can't adjust to changes in the market or regulatory environment, it may be subject to economic obsolescence.

Here are some examples of external factors that can lead to economic obsolescence:

These factors can affect a business's profitability and the value of its assets, making it essential to understand and adapt to external obsolescence.

Calculating the level of economic obsolescence requires input from valuation experts skilled in business and fixed asset valuation. Several iterations of value calculations are needed to identify which assets are subject to external obsolescence and to what degree.

Economic obsolescence is often encountered in valuation work performed for financial reporting purposes, bankruptcy emergence, and other practice areas. Identifying, measuring, and applying the adjustment for EO can be a complex and iterative process.

The process involves multiple valuation disciplines, including real property, personal property, business valuation, and intangible asset valuation. Calculating obsolescence is a crucial step in determining the true value of assets.

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Calculating the level of economic obsolescence requires input from valuation experts skilled in business and fixed asset valuation.

Several iterations of value calculations are necessary to identify which assets are subject to external obsolescence and to what degree.

Valuation experts use their expertise to measure economic obsolescence, making it a complex and nuanced process.

In the context of business combinations, economic obsolescence is often related to fixed assets, which need to be valued for financial reporting purposes.

The sum of the fair value of assets that comprise the subject company is ideally less than the purchase price, where goodwill will be residual.

Goodwill can sometimes be negative, but this may be due to economic obsolescence rather than a bargain purchase, especially in fixed asset-heavy industries.

The underlying economics of the assets drive the economics of the business, making economic obsolescence a crucial factor to consider.

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Calculating obsolescence due to excess costs is a crucial aspect of determining the value of a property. Excess operating expenses can lead to functional obsolescence, which is a significant penalty for the existing property.

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A modern plant can have lower operating expenses compared to an older property. This can be measured by the present value of the excess operating expenses from continued operation of the existing property compared to the modern plant.

Excess operating costs can be a symptom of functional obsolescence, indicating that the property is not operating efficiently. For example, a paper mill with an inefficient design may have higher operating expenses than a newer mill producing similar products.

A comparison of production cost per ton can help confirm the presence of functional obsolescence due to excess operating costs. This calculation can be based on the amount of increased operating expenses.

Here are some examples of excess operating costs that can lead to functional obsolescence:

Calculating obsolescence can be a complex task, but one key factor to consider is curable functional/economic obsolescence due to necessary capital expenditures.

These costs are typically required by the government to keep the property in operation, making them a necessary expense to ensure the asset remains functional.

If a property requires upgrades to its computer numeric controls (CNC) to increase its capacity, the cost of the necessary upgrade can be identified, making it easier to quantify.

The cost of replacing necessary components can be a significant factor in determining the overall value of an asset, and can be a major consideration when calculating obsolescence.

In some cases, upgrading or replacing necessary components can increase the value of an asset, making it a worthwhile investment for buyers or sellers.

Economic obsolescence is a type of depreciation that results from unfavorable conditions external to the property. This can be caused by a local economy that's struggling, making it difficult to sell or rent the property.

Availability of financing for the type of assets being valued is a significant factor, as it can become scarce and make it hard to maintain or improve the property.

Unfavorable economic conditions can lead to a decline in value, making it essential to consider external factors when valuing a property.

Changes in ordinances can also lead to economic obsolescence, as new regulations may make it difficult to operate or maintain the property.

Loss of material and labor sources can cause economic obsolescence, as it becomes harder to find the resources needed to maintain or improve the property.

Shifting of business centers can lead to economic obsolescence, as the area becomes less desirable and the property's value declines.

Encroachment of objectionable enterprises can also cause economic obsolescence, as the presence of unwanted businesses can negatively impact the property's value.

Measuring economic obsolescence requires a thorough understanding of the asset's value. This involves considering various approaches used to value the assets, such as the market approach, income approach, and cost approach.

The market approach includes the effects of economic obsolescence because it reflects the willing buyer and seller's negotiations. The income approach also incorporates the expected economic circumstances, providing a value indication that fully reflects internal and external obsolescence factors.

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To determine economic obsolescence, asset values are compared to the enterprise value or purchase price of the business. If the asset value is less than or equal to the enterprise value or purchase price, it may indicate that a reasonable valuation for the fixed assets has been calculated.

Factors that cause economic obsolescence include industry economics, loss of resources, new legislation, increased cost of inputs, reduced demand, increased competition, and reduced earnings or margins. These factors can lead to a loss of value that is outside the owner's influence or control.

Economic obsolescence can be measured using various methods, including the income approach, cost approach, and market approach. The income approach, for example, calculates the expected economic circumstances and incorporates them into the value estimate.

Here are some common factors that contribute to economic obsolescence:

Measuring economic obsolescence involves determining the impact of external factors on an asset's value. This is done by comparing the asset's value to its floor value, which is typically based on the net orderly liquidation value (NOLV) or salvage value.

To calculate economic obsolescence, you need to consider the asset's physical and functional depreciation, as well as external factors that affect its value. These external factors can include changes in market conditions, technological advancements, or shifts in consumer behavior.

Economic obsolescence can be measured using an income approach, which takes into account the projected profitability of the asset and incorporates expected economic circumstances. This approach provides a value indication that fully reflects internal and external obsolescence factors.

In some cases, economic obsolescence may not be applicable to all assets, such as land, where comparables are used to determine value. The assignment of economic obsolescence may also not be evenly allocated across all assets, taking into consideration their floor values.

To determine the level of economic obsolescence, you may need to use discounted cash flow models to allocate enterprise value to various components of the business. This allows you to determine the level of economic obsolescence operable in each business unit, which may vary significantly.

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Fixed assets are initially valued assuming an in-use premise, which means their utility is compared to their rated capacity. This capacity is usually around 85% to 95% of full operation, as most facilities have some normal downtime for maintenance.

To determine the actual utility of an asset, you need to calculate depreciation, including physical and functional obsolescence. If an asset is less than fully utilized, an economic obsolescence (EO) adjustment is applied directly to the asset to establish fair value.

The floor value of fixed assets subject to external obsolescence should also be estimated. This is typically based on the net orderly liquidation value (NOLV) or salvage value of the assets. Determining the floor value helps ensure that economic obsolescence is not overestimated.

For real property, the property must be assessed to determine if economic obsolescence is applicable. The determination of economic obsolescence in real estate differs because land and structure values are based on comparable sales. External obsolescence in real estate often refers to the desirability of the location.

Here are some key considerations for fixed asset valuations:

Functional obsolescence can manifest in various ways, and one key indicator is a lack of functional utility. This occurs when a property cannot perform its intended function efficiently or effectively.

Excess operating costs are another symptom of functional obsolescence. This can be due to outdated equipment or inefficient systems that increase energy consumption and maintenance needs.

Inadequate design or construction can also lead to functional obsolescence, making a property less useful than a newer or more modern alternative. For example, a building with limited natural light or outdated ventilation systems may struggle to provide a healthy and productive environment for occupants.

Functional obsolescence can result in significant losses in value, making it essential to identify and address these issues promptly.

Fixed assets are initially valued assuming an in-use premise, with all other forms of depreciation calculated to compare the asset's utility to its rated capacity.

The full productive capacity of an asset is typically assumed to be in the range of 85%–95%, as most operations have downtime for maintenance.

If an asset is less than fully utilized, an economic obsolescence adjustment is applied to establish fair value. This adjustment helps to ensure that the asset's value is not overestimated.

Economic obsolescence can be caused by various factors, including industry, business, or economic factors, which can lead to a loss of value in an asset.

In cases where economic obsolescence is initially suspected, it's essential to estimate the floor value of the fixed assets subject to external obsolescence. This floor value is typically based on the salvage value or net orderly liquidation value of the assets.

To determine the level of economic obsolescence, the collective value of all identified assets is compared to the overall, enterprise value of the business. If the value of all assets (except goodwill) and working capital is less than or equal to enterprise value or purchase price, it's an indication that a reasonable valuation for the fixed assets has been calculated.

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However, if the sum of asset values exceeds the purchase price or enterprise value, further review of the fixed assets is necessary to determine the level of economic obsolescence.

In some cases, economic obsolescence may not be applicable to the value of land, where comparables are used to determine value. But in other cases, it may be necessary to disaggregate enterprise or reporting unit value among groups of assets to determine if economic obsolescence applies to the company as a whole or is applicable only to certain assets.

Here are some common factors that may cause economic obsolescence:

Economic obsolescence is a type of depreciation that results from external economic factors, and it's essential to consider it when valuing assets. This can lead to a mismatch between the purchase price or enterprise value of a company and the collective value of its assets.

The enterprise value or purchase price of a company determines economic obsolescence. If the purchase price is lower than the collective fair value of acquired assets, it may indicate negative goodwill. However, if the fixed assets have lost value due to external factors, additional calculations are necessary to account for the economic obsolescence of specific assets.

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Economic obsolescence can be caused by various factors, including the economics of an industry, loss of resources, new legislation and ordinances, increased cost of inputs, reduced demand, increased competition, and reduced earnings or margins.

To determine the level of economic obsolescence, it's crucial to compare the collective value of all identified assets to the overall enterprise value of the business. This can be done by using discounted cash flow models to allocate enterprise value to various components of the business.

The assignment of economic obsolescence may not be evenly allocated across all assets, as it may not be applicable to the value of land, where comparables are used to determine value. It's also essential to consider the floor values of individual assets when assigning economic obsolescence.

Here are some common factors that may cause economic obsolescence:

Economic obsolescence can manifest itself in the profit margin of a business, making it essential to consider it when valuing assets.

Economic obsolescence is typically calculated by comparing the asset's actual utility to its rated capacity, which is the physical productive capacity of the facility at full operation.

The income/earnings shortfall method is another approach to quantify EO, which compares the indication of value from the cost approach to the indication of value from the income approach.

The difference between the two approaches is EO, and this method can be used to quantify all forms of EO in the cost approach.

In some cases, the income shortfall method may be considered a good method, but it's suggested to be used with other supporting analyses of EO.

The income shortfall method resulted in an economic obsolescence penalty of $122,300,000 in one case, supporting a quantification of EO at 75%.

To determine the correct percentage of EO to apply, consider the specific circumstances of the assets being valued, such as their utilization rates and industry trends.

A table to consider when quantifying EO:

Note: The EO adjustment values and percentages are examples and may vary depending on the specific circumstances of the assets being valued.