The value of industrial and commercial tangible personal property is often a controversial issue in bankruptcy disputes. Accordingly, parties-in-interest often rely on appraisals during the bankruptcy process. Such parties include the debtor, the creditors, their legal counsel and the bankruptcy finder of fact. This discussion will summarize (1) the components of a bankruptcy personal property appraisal report and (2) the factors that parties-in-interest should consider when evaluating a bankruptcy personal property appraisal report.

Personal Property Appraisal Report Summary

Exhibit 1 presents an illustrative table of contents (or report outline) for a typical narrative personal property appraisal report. Such an appraisal report would be applicable for bankruptcy purposes. This table of contents is consistent with the Uniform Standards of Professional Appraisal Practice (USPAP) requirements for a self-contained appraisal report, i.e., a report prepared under USPAP Standards Rule 8-2(a).

Personal Property Appraisal Report Content

1. Title Page. The title page should clearly identify the appraisal report subject for all report users. The title page should identify (1) the subject personal property, (2) the location of the personal property, (3) the definition of value concluded and (4) the "as of" valuation date.

2. Letter of Transmittal. The letter of transmittal typically includes the following information:

• date of letter and salutation
• a brief description of the subject personal property
• identification of the subject property ownership interest
• statement that a property inspection and other necessary investigations and analyses were made by the appraiser
• reference that the transmittal letter is an integral component of an accompanying appraisal report
• identification of the type of appraisal and the type of appraisal report
• standard (or definition) of value concluded in the appraisal report
• "as of" date of the appraisal
• opinion of value
• appraiser's signature.

3. Table of Contents. The table of contents typically lists all of the sections of the appraisal report in the order in which they are presented. If there are major divisions with the report, they may also be presented in the table of contents.

4. Certification. The certification is typically presented as a separate page in the introduction section of the appraisal report. However, the certification may be combined with the final value conclusion. In any event, the appraiser(s) will sign and date the certification. If USPAP compliance is applicable to the subject appraisal, the certification will indicate whether the appraiser has personally conducted the appraisal in accordance with USPAP. According to USPAP Standards Rule 8-3, each written personal property appraisal report should contain a signed certification.

5. Summary of Important Conclusions. The summary of important conclusions page, sometimes called the executive summary page, will typically include the following items:

• a brief identification of the subject personal property
• typical ages of the subject personal property
• value indication from the cost approach
• value indication from the income capitalization approach
• value indication from the sales comparison approach
• final estimate of the defined value.

6. Photographs. As a general rule, there cannot be too many photographs in a bankruptcy appraisal report. One of the appraiser's responsibilities is to adequately acquaint the finder of fact with the subject personal property. Photographs help this process.

7. The Plant. This section provides a summary description of the facility in which the subject personal property is located. This description needs to be adequate to provide the finder of fact with an overview of the location and the condition of the subject personal property. Where appropriate, this description can include photographs, engineering drawings, plant diagrams and schematics, etc.

8. The Layout. This section provides a summary description of the layout or configuration of the subject personal property. This description should familiarize the finder of fact with (1) where the major equipment/processes are located within the plant and (2) where the major equipment/processes are located with respect to each other. Again, this description needs to be enough to provide the finder of fact with an overview of the location and condition of the subject personal property. When appropriate, this description can include diagrams, schematics, engineering drawings, process/product flow charts, etc.

9. The Process. This section provides a summary description of the processes by which (1) the major property components operate together and (2) the subject product is converted from raw material to finished goods. This description should explain how the major property components are associated with each other, both physically and functionally. Ideally, this description will allow the finder of fact to mentally "walk through" the plant, following the manufacturing/processing flow, from the raw materials receiving dock to the finished goods shipping dock. Product processing and/or manufacturing flow charts are often included in this section of the appraisal report.

10. The Product. This section provides a summary description of the goods produced by the subject personal property. The subject of the appraisal is the tangible personal property, not the finished goods inventory. However, it is usually helpful for the finder of fact (or any other appraisal report user) to understand the end product produced/ manufactured by the subject personal property. Product photographs, product descriptions and product listings are often included in this section of the appraisal report.

11. Type of Appraisal and Type of Appraisal Report. USPAP defines two alternative types of appraisals: (1) complete appraisal and (2) limited appraisal. These two types of appraisals are defined as follows:

Complete Appraisal: the act or process of developing an opinion of value or an opinion of value developed without invoking the departure rule.
Limited Appraisal: the act or process of developing an opinion of value or an opinion of value developed under and resulting from invoking the departure rule.¹

USPAP also defines the following three types of personal property appraisal reports:

Self-contained Appraisal Report: a written report prepared under Standards Rule 8-2(a).
Summary Appraisal Report: a written report prepared under Standards Rule 8-2(b).
Restricted Use Appraisal Report: a written report prepared under Standards Rule 8-2(c).²

The personal property appraisal report should clearly identify both the type of appraisal performed and the type of appraisal report prepared.

12. Extraordinary Assumptions and Hypothetical Conditions. Hypothetical conditions or extraordinary assumptions that affect the value conclusion may be an important part of a bankruptcy appraisal report. Accordingly, such extraordinary assumptions and hypothetical conditions should be clearly stated. When a personal property value conclusion is subject to an extraordinary assumption or hypothetical condition (such as a pending sale agreement, atypical financing or a known but not-yet-quantified environmental issue), the appraiser should describe the condition in the appraisal report so that its effect on the value conclusion is clear.

13. General Assumptions and Limiting Conditions. USPAP Standards Rule 8-2 lists the three alternative types of personal property appraisal reports as follows:

Each written personal property appraisal report must be prepared under one of the following three options and prominently state which option is used: Self-Contained Appraisal Report, Summary Appraisal Report or Restricted Use Appraisal Report.³

USPAP Standards Rule 8-2 requires the disclosure of assumptions and limiting conditions for all three types of reports (i.e., 8-2(a-viii) for self-contained reports, 8-2(b-iii) for summary reports and 8-2(c-viii) for restricted reports). In fact, many personal property appraisers include a statement of limiting conditions with the initial engagement letter as well as with the appraisal report.

The general assumptions and limiting conditions are an integral part of the appraisal report. The reported conditions establish the framework for what the appraisal does—and does not—include. Particularly in bankruptcy cases, appraisers may obtain legal advice when preparing the statement of general assumptions and limiting conditions.

14. Purpose and Intended Use of the Appraisal. To avoid an unintended (and inappropriate) use of the appraisal report, the intended use and the intended user of the appraisal should be specified in the report. USPAP defines both terms "intended use" and "intended user" as follows:

Intended Use: the use or uses of an appraiser's reported appraisal, appraisal review or appraisal consulting assignment opinions and conclusions, as identified by the appraiser based on communication with the client at the time of the assignment.
Intended User: the client and any other party as identified, by name or type, as users of the appraisal, appraisal review, or appraisal consulting report by the appraiser on the basis of communication with the client at the time of the assignment.⁴

15. Scope of the Appraisal. A clear and accurate description of the scope of the appraisal is useful to all individuals (and particularly to the finder of fact) who may rely on the appraisal. The scope of the appraisal refers to (1) the amount and type of information researched and (2) the analyses performed in the appraisal assignment. Professional standards impose a responsibility on the appraiser to determine the appropriate scope of work in order to conclude the value opinion and prepare the appraisal report.

16. Definition of Value and Date of Value Opinion. The definition of value (also called the standard of value) is the type of value that is estimated in an appraisal report. The premise of value is the hypothetical set of circumstances under which the parties described in the definition of value come together to consummate a transaction. In addition to the definition of value, the applicable premise of value should be defined in the property tax appraisal report. The date of the value opinion (also called the effective date of the appraisal) is the "as of" date to which the value opinion applies.

17. Identification and Description of the Personal Property. This section provides a detailed description of the subject tangible personal property. The personal property may be described by (1) asset type or category, (2) financial accounting account code or category, (3) production process (or location within the total manufacturing process) or (4) physical location within the subject facility. In this section, the appraiser both (1) identifies the specific subject property and (2) describes the condition of the specific subject property. Typically, this report section will refer to (and be supplemented by) detailed asset listings and/or inventories.

18. Ownership and History. The appraisal report should discuss both (1) the current ownership of the subject personal property and (2) the history of recent sales of the subject personal property. Unlike in a real estate appraisal, this discussion is not a USPAP requirement. However, a discussion of the current ownership both documents the personal property appraiser's due diligence investigation and further describes the subject property for the finder of fact.

19. Highest and Best-use Analysis. The analysis of highest and best use is a USPAP requirement for personal property appraisals. The conclusion of highest and best use often influences the appraiser's selection of the appropriate premise of value for the subject appraisal. In a highest-and-best-use analysis, the appraiser determines the use that fulfills the following four tests. The selected personal property highest and best use should be:

1. physically possible
2. legally permitted
3. economically feasible
4. maximally productive.

Each of these four areas of analysis is affected by the others. The amount of income that a particular use could generate is meaningless if legal approval for the use cannot be obtained. Likewise, not every legally permitted use will warrant the expenditure of funds required to bring it about. The appropriate combination of all four factors results in the single use that can be identified as the subject personal property highest and best use.

20. Cost Approach. The cost approach is the most common personal property valuation approach with regard to bankruptcy appraisals. Accordingly, the cost-approach section of the appraisal report should thoroughly explain the particular cost-approach methods and procedures used in the subject appraisal. All appraisal terminology should be identified and explained. For example, the appraiser should not assume that the finder of fact understands the subtle (but important) differences between (1) reproduction cost new less depreciation and (2) replacement cost new less depreciation. In particular, it will confuse the finder of fact if these two terms are used interchangeably in the appraisal report or if these two terms are both abbreviated as RCNLD in the appraisal report.

In its simplest form, the cost approach estimates the current cost (as if new) of the subject property less all forms of depreciation. In the cost approach, the appraiser identifies the subject personal property, develops a current replacement cost new estimate and subtracts all depreciation that makes the property less desirable to own than if it were new. The appraisal report should clarify the cost measure used as the starting point in the cost-approach analysis: (1) replacement cost, (2) reproduction cost or (3) some other defined measure of cost. Valuing Machinery and Equipment defines "replacement cost" and "reproduction cost" as follows:

It is essential that the appraiser understand the difference between replacement cost new and reproduction cost new. Replacement cost is the current cost of a similar new property having the nearest equivalent utility as the property being appraised, whereas reproduction cost is the current cost of reproducing a new replica of the property being appraised using the same, or closely similar, materials. In using the cost approach, the appraiser is comparing to the subject property the property that could actually replace it. The replacement property would be the most economical new property that could replace the service provided by the subject.⁵

A cost-approach analysis starts with either the current replacement cost or current reproduction cost of the subject property and then deducts for the loss in value caused by physical deterioration, functional obsolescence and economic obsolescence. The economic foundation for the cost approach is the principle of substitution: A prudent buyer will not pay more for a property than the cost of acquiring a substitute property of equivalent utility. The principle can be applied either to an individual asset or to an entire facility full of personal property.

The appraisal report should clearly identify (1) the measure (or type) of cost new estimated, (2) the method used to estimate cost new and (3) the data sources used to estimate cost new. Valuing Machinery and Equipment describes the alternative methods for estimating cost new as follows:

There are several methods of determining the current new cost of a property. The major ones are the detail method, trending, cost-to-capacity and other engineering methods.... The detail method, also known as the summation method, requires that a current new cost be assigned to each individual component of an asset or property. The property is itemized or "detailed" so that the sum of the components reflects the cost new of the whole. All normal or typical direct and indirect costs should be included. Direct costs are those material, labor and related expenditures normally and directly incurred in the purchase and installation of an asset, or group of assets, into functional use.... Indirect costs are those expenditures that are normally required to purchase and install a property but which are not usually included in the vendor invoice.⁶ Trending is a method of estimating a property's reproduction cost new (not replacement cost new) in which an index or trend factor is applied to the property's historical cost to convert the known cost into an indication of current cost. Simply put, trending reflects the movement of price over time. As used in this book, historical cost is the cost of a property when it was first placed into service by its first owner. This is to be distinguished from original cost, which is the actual cost of a property when acquired by its present owner, who may not be the first owner and who may have purchased at a price greater or less than the historical cost. Original cost may be the used cost of the property, whereas historical cost can never be a used cost. Obviously historical cost and original cost may be the same.⁷ A third method of estimating cost new is commonly referred to as cost-to-capacity method. This methodology assumes that not all costs vary with size in a straight line.⁸ Several other engineering methods may be used to estimate the cost of entire facilities or components of facilities; most of these methods are best used in chemical or petrochemical processing industries.⁹

There are several methods for estimating the current new cost of personal property. The common methods are the detail method, trending, cost-to-capacity and other engineering methods. Of these four methods, the detail method and the trending method are more commonly used in bankruptcy appraisals. The detail method, also known as the summation method, allows for a current new cost to be assigned to each individual component of a property. The subject personal property is itemized or "detailed" so that the sum of the components reflects the cost new of the whole. The trending method estimates the subject property's reproduction cost new (not replacement cost new). In the trending method, an index or trend factor is applied to the property's historical cost in order to convert (1) the known historical cost into an estimation of (2) current reproduction cost.

21. Physical Deterioration. Valuing Machinery and Equipment describes the types or causes of personal property depreciation as follows:

The three types of causes of appraisal depreciation traditionally recognized by appraisers are physical deterioration, functional obsolescence and economic obsolescence. The traditional definitions of these terms are as follows: Physical deterioration is the loss unit value or usefulness of a property due to the using up or expiration of its useful life caused by wear and tear, deterioration, exposure to various elements, physical stresses and similar factors. Functional obsolescence is the loss in value or usefulness of a property caused by inefficiencies or inadequacies of the property itself, when compared to a more efficient or less-cost replacement property that new technology has developed. Symptoms suggesting the presence of functional obsolescence are excess operating cost, excess construction (excess capital cost), over-capacity, inadequacy, lack of utility, or similar conditions. Economic obsolescence (sometimes called "external obsolescence") is the loss in value or usefulness of a property caused by factors external to the property, such as increased cost of raw materials, labor or utilities (without an offsetting increase in product price); reduced demand for the product; increased competition; environmental or other regulations; inflation or high interest rates; or similar factors.¹⁰

The particular method used to estimate physical deterioration should be identified and defined. The specific procedures used by the appraiser (within the identified method) should be explained. In addition, all significant data sources should be identified. The three common methods for measuring personal property physical deterioration are (1) the physical observation method, (2) the age/life method and (3) the direct dollar measurement method. The appraisal report should adequately describe the method that was used and how it was used in the subject appraisal. All appraisal terminology should be identified and defined. This recommendation is particularly relevant to the age/life method. That depreciation method involves numerous non-intuitive "age" and "life" measures.

Valuing Machinery and Equipment presents the following summary description of these three common methods of estimating personal property physical deterioration:

Three methods of measuring physical deterioration that were discussed are observation, formula/ratio and direct dollar measurement. In the observation method, the appraiser makes a comparison based on the experience he or she has gained by looking at similar properties and comparing them to new properties. In one variation of the formula/ratio method, physical deterioration is estimated based on a property's use. Use is a good indicator of physical deterioration when the requisite production statistics can be obtained. The age/life variation of the formula/ ratio method uses the ratio of a property's "age" to its "life" to measure physical deterioration. Although this is straight-line depreciation, it should not be confused with accounting depreciation, because the appraiser uses valuation concepts of age and life.¹¹

22. Functional Obsolescence. The appraisal report should (1) describe the concept of functional obsolescence, (2) explain the method(s) used to identify and quantify functional obsolescence and (3) describe the data sources used in the functional obsolescence analysis. Valuing Machinery and Equipment offers the following definitions of functional obsolescence (and of the related value decrement, technological obsolescence):

The next step in implementing the cost approach is to consider functional obsolescence. Functional obsolescence has been previously defined as the loss in value or usefulness of property caused by inefficiencies or inadequacies of the property itself, when compared to a more efficient or less costly replacement property that new technology has developed. Symptoms suggesting the presence of functional obsolescence are excess operating (i.e., manufacturing), cost, excess construction (excess capital cost), over-capacity, inadequacy, lack of utility or similar conditions. Some appraisers draw a distinction between functional obsolescence and technological obsolescence. They define functional obsolescence as a loss in value resulting from differences in capability between a new machine and the appraised machine, and technological obsolescence as a loss in value resulting from the difference between design and materials of construction used in present-day machines compared with those used in the machine being appraised. There is a legitimate difference of opinion as to how appraisers apply the concepts to measure the functional and technological aspects affecting value. Regardless of the terms used, the important thing is for the appraiser to measure the various factors that contribute to functional obsolescence.¹²

The two common methods to quantify personal property functional obsolescence are:

1. analysis of excess capital costs and
2. analysis of excess operating costs.

Valuing Machinery and Equipment explains common instances of functional obsolescence. If applicable to the subject personal property, these instances should be noted in the appraisal report:

Functional obsolescence, particularly operating obsolescence, is typically found in the following situations:

1. plants involved in the process industries
2. plants involved in industries that either use assets or manufacture products with a high degree of technology
3. older plants that have increased in size over time
4. plants in which there are a number of identical units
5. plants involved in industries that handle large volumes of material
6. plants with areas of inactive machinery.¹³

23. External Obsolescence. In the bankruptcy appraisal report, the appraiser should describe (1) the factors considered in identifying external obsolescence, (2) the methods used to quantify external obsolescence and (3) the specific data sources relied on in the external obsolescence analysis. Many appraisers distinguish between two forms of external obsolescence: (1) economic obsolescence (where the subject property does not generate adequate income to provide a fair rate of return to the property owner) and (2) locational obsolescence (when the obsolescence is a result of the location of the subject property). Locational obsolescence affects real estate more often than it affects personal property. If applicable, the appraisal report should distinguish between these two forms of external obsolescence.

24. Income Capitalization Approach. The income approach is particularly applicable to the valuation of personal property that is commonly leased. Examples include commercial aircraft, railroad locomotives and rolling stock, over-the-road tractor/trailers, etc. When estimating value by the income approach, the appraiser converts the property's expected income or cash flow into a present value. There are two categories of income capitalization methods: (1) direct capitalization and (2) yield capitalization. Direct capitalization methods rely on direct capitalization rates typically extracted from comparable sales. Additionally, yield capitalization methods rely on yield capitalization rates that are typically derived as the internal rate of return required by the typical investor. Since personal property has a limited life, yield capitalization is more commonly used than direct capitalization in property tax appraisals.

Value estimates may be calculated by applying an appropriate multiplier or capitalization rate to the subject personal property's expected income or cash flow. The term "direct capitalization" is sometimes used to refer to the procedure of extracting income multipliers or capitalization rates from comparable sales. However, capitalization rates and income multipliers derived from comparable sales do not explicitly address profitability. Rather, they are simply observed ratios of income to value. However, such market-derived capitalization rates can provide reliable estimates of value if:

1. the expected cash flow is a representative income projection.
2. the income multiplier or capitalization rate is derived from comparable sales with the same potential for future income.

The most common direct capitalization multiplier used for personal property is the gross income multiplier (GIM). The GIM is derived by (1) extracting GIMs from comparable personal property sales, (2) comparing the comparable property attributes (physical, functional and financial) to the subject property and (3) selecting an appropriate multiplier. When either calculating value or extracting multipliers, the appraiser should ensure that the income (however measured) is calculated on the same basis.

Personal property value is commonly estimated by dividing the one-period net operating income (NOI) by a capitalization rate. The rate is estimated by (1) extracting overall rates from comparable property sales, (2) comparing the comparable property attributes (physical, functional and financial) to the subject property and (3) selecting an appropriate capitalization rate.

Values are often estimated by projecting cash flow over a typical holding period and discounting the cash flow to a present value estimate using a discount rate. This valuation method is called yield capitalization (or a discounted cash flow analysis). The discount rate directly addresses the expected profitability of the subject personal property. The cash-flow components typically projected in a property tax appraisal are (1) NOI and (2) the net proceeds from the property resale. The discount rate is sometimes called the yield rate.

Sales Comparison Approach

The comparability of the selected sale transactions is typically the most controversial aspect of the sales-comparison-approach analysis. Therefore, market sale transactions should not be used unless the sale data have been confirmed by the appraiser or by a reliable delegate. This confirmation process should include inquiries into the circumstances causing the sale or affecting the transaction price.

Transactions selected for the sales-comparison-approach analysis should be adjusted, if necessary, to compensate for the effect of economic forces that influenced the personal property market during the time interval clasped between (1) the date of the comparable sale and (2) the appraisal date. Market prices move upward or downward with changes in supply and demand, variations in business cycles and changes in the value of money.

Another controversial issue is the appraiser's adjustments to the comparable sales to account for differences between the comparable properties and the subject personal property. Any adjustments related to differences due to variations in age, features and quality of comparable subject property should be identified and quantified in the appraisal report.

Market comparisons are based on an overall judgment as to the percentage-value adjustment called for in order to make each sale comparable with the subject property. The overall percentage applied to each property in turn is justified by the appraiser's explanation that the subject property is better, poorer or the same in relation to its type, size, features, age and condition. By adjusting the comparable sale prices upward or downward in accordance with the characteristics of the subject personal property, a market value estimate is derived.

The sales-comparison approach is well adapted to situations where there are an adequate number of similar properties that have recently sold. In using these sales, the appraiser should try to verify each sale in order to confirm the relationship of the parties, date of sale and any financing terms. In analyzing comparable sales, it may be necessary to adjust a price if prices have changed between (1) the time the comparable property sold and (2) the subject appraisal date. Also, an adjustment is typically required if a comparable sale property's price was influenced by financing terms. The "cash equivalency" method is often used to adjust for this price influence. The purpose of this adjustment is to reveal the price that a comparable property would have brought without the influence of atypical financing.

25. Reconciliation and Opinion of Value. The final procedure is the reconciliation of the various value indications into a final opinion of value. For appraisals performed for many purposes, it is reasonable to conclude a range of values as the final value opinion. For bankruptcy appraisals, however, it is much more common to conclude the appointed estimate as the final value opinion. The nature of the reconciliation procedure depends on (1) the purpose and objective of the appraisal, (2) the individual valuation approaches and methods used, and (3) the appraiser's estimate of the reliability of each value indications derived.

When all three valuation approaches are used, the appraiser typically considers the relative dependability and applicability of each approach given (1) the subject personal property type and (2) the quantity and quality of data used. In the reconciliation section of the appraisal report, the appraiser may (1) explain variations among the value indications of the different approaches used and (2) account for differences between the value conclusions derived.

26. Professional Qualifications of the Appraiser. The statement of the professional qualifications should describe the appraiser's education and training, experience and expertise, and professional credentials and designations. For bankruptcy appraisals, this statement should emphasize the appraiser's (1) experience in conducting bankruptcy appraisals and (2) experience appraising properties like the subject personal property.

27. Addendum and Secondary Exhibits. This section of the appraisal report should include all exhibits, diagrams, schematics, flow charts, photographs, financial statements, legal documents and other supplemental data not included in the narrative section of the report. It is a good idea to include a table of contents at the beginning of the addendum. This table of contents should list the contents of the appraisal report addendum.

Summary and Conclusion

The bankruptcy appraisal report is the culmination of the personal property valuation process. The appraisal report is used by parties-in-interest and their legal counsel in bankruptcy controversies. Most importantly, however, the appraisal report is used by the ultimate finder of fact in the bankruptcy matter. The finder of fact should be able to rely on the appraisal report to provide factual description and data, rigorous empirical research, comprehensive quantitative and qualitative analysis, and impartial conclusions. To meet professional standards, the appraiser should be impartial and unbiased. However, the appraisal report should be clear, convincing and cogent.

This discussion summarized the topical components of a narrative personal property appraisal report prepared for bankruptcy purposes. This discussion may be used as a checklist or guide by (1) debtors and creditors, to ensure that the appraisal report they receive is comprehensive; (2) bankruptcy lawyers, to determine that the appraisal report will withstand a contrarian challenge; (3) the appraiser, in the pre-issuance report review process; and (4) the finder of fact, to evaluate the degree of reliance to assign to an expert witness appraisal report.

Footnotes

¹ Ibid., p. 1. Return to article

² Ibid., p. 4. Return to article

³ Ibid., p. 64. Return to article

⁴ USPAP, p. 3. Return to article

⁵ Valuing Machinery and Equipment, American Society of Appraisers, 2000, p. 46. Return to article

⁶ Ibid., p. 53. Return to article

⁷ Ibid., p. 62. Return to article

⁸ Ibid., p. 64. Return to article

⁹ Ibid., p. 67. Return to article

¹⁰ Ibid., pp. 69-70. Return to article

¹¹ Ibid., p. 109. Return to article

¹² Ibid., pp. 89-90. Return to article

¹³ Ibid. Return to article