To continue with one of the analogies set out above, unlike a real estate report, an inventory appraisal has no standardized, formal structure. In other words, an inventory valuation can be compiled by virtually anyone, and can contain virtually anything, which obviously presents the client with an extreme challenge.
Some of the Chief Appraisers at many of the largest lending institutions in the country are making great inroads into compiling basic standards, but it may take some time before these standards filter downstream. Even the most rudimentary requirements set forth in the Uniform Standards of Professional Appraisal Practice (USPAP) offer no more than the often-vague suggestions in Standards 7 & 8; vague in the sense they were written for “Personal Property” in general. Again, there is nothing specific to either assist or constrain the “inventory appraiser” from establishing or following any set of proscribed guidelines.
Based on the writers own reporting requirements that have been developed over many years, and were derived not only from experience but also a varied and continually evolving range of suggestions and requirements from clients, inventory appraisals must include at least the following broad parameters:
1. Letter of Transmittal: The letter of transmittal is a synopsis of the overall scope of the assignment and serves, in summary fashion, as a presentation of the contractual understanding between the appraiser and the client. In addition to the original engagement letter between the parties, the letter of transmittal presents what the appraiser has agreed to in the assignment. This should include, at a minimum, the value concept, effective date, formal name of the company and any subsidiaries appraised, and compliance or lack thereof with the Uniform Standards of Professional Appraisal Practice (USPAP). In addition, any invocation of a particular departure from USPAP or other mitigating circumstances attendant to the value conclusions should be clearly defined.
2. Recapitulation & Summary of Findings: This is helpful to the client as a precursor to the narrative that follows, but is not necessarily required. For asset-based lending, the Recapitulation of Value is typically expressed as a percentage of recovery as compared to the total reported “cost”, though this should be qualified for any exclusion with a reference to any relevant details. The Summary of Value is a more detailed breakdown of the value conclusion, which is also expressed as a percentage of cost recovery.
3. Purpose & Function of the Appraisal: These terms are often confused as interchangeable; however, the purpose of an appraisal refers to the applied value concept and the function of an appraisal refers to the intended use. Additionally, not only does USPAP require that the purpose section of an appraisal include the type and definition of value to be developed, but also what the terms of value are relative to the price if the value concept under consideration is a market value. An example of these terms would be:
a. In terms of cash; or
b. in terms of financial arrangements equivalent to cash; or
c. in other precisely defined terms.
USPAP also requires that this section include an opinion of reasonable exposure time linked to the value opinion, as well as clearly identifying whether or not the value opinion is based on non-market financing or financing with unusual conditions or incentives when dealing with a market value concept.
On the other hand, the function section of an appraisal should indicate clearly the interest(s) appraised. For most assignments, the appraiser assesses value for fee simple ownership, which is presumed to be free and clear of any encumbrances. If there are any known encumbrances or if the interest appraised is anything other than fee simple (such as a leased fee estate), this section is the area in which this should be fully disclosed.
As part of the function, the inventory appraiser may often elect to qualify the appraisal results by referring to “internal standards” in which the client may choose to apply the actual value conclusions, as the client may elect to calculate an assessment against the appraised value. For example, a lender may determine that a 20% deduction to the net value is warranted as an additional protection for the always-unforeseen factors that accompany any liquidation. This type of reductive adjustment is purely at the discretion of each individual client and is independent of the appraised value. Additionally, any such adjustments subsequent to the stated appraised value, as of the effective date of the report, does not change the function of the appraisal, which is the original intended use as stated by the client upon initiation of the appraisal assignment.
4. Scope of Appraisal: The scope of an appraisal must involve all aspects of typical appraisal development. It should be consistent with the expectations of the client, any intended users (individuals or corporate entities), and the appraiser’s peers when considering actions that would be taken for the same or similar appraisal services that comply with all current regulations of the Uniform Standards of Professional Appraisal Practice.
Assignment conditions or other factors relative to the appraisal assignment should not limit the extent of the appraiser’s research or analysis to such a degree that the resulting opinions and conclusions developed are not credible in the context of the purpose (value concept) and function (intended use) of the appraisal.
5. Highest & Best Use: This is generally construed as something of a holdover from the real property discipline in the sense that “highest and best use” may seem inapplicable to inventory, especially under forced sale conditions. For example, inventory acquired for the purpose of resale into the retail market that is liquidated for less than its intended retail price certainly was not sold at its “highest and best use.” This does not mean, however, that such sales do not occur.
Technically this term requires, as one of its components, that the hypothetical sale of the property be a “legal use” that is “physically possible”, “appropriately supported”, “financially feasible”, and one that results in the “highest value”. Identifying specific circumstances that may depart from these parameters is incumbent on the appraiser. Under any of the liquidation value concepts, highest and best use is understood to be interpreted as the highest recovery available under the less than favorable conditions, which is indicated in VRG’s “Exit Strategy” section.
Also to be included in this section is the name of the client and the user, which may be the same but, in the case of the user, can include parties other than the client. The intended use should also be specified, whether it be for financing and/or internal considerations, or for any other stated use.
The discussion of the principal adjustments to the appraised value such as any factors unique to the inventory, which may include physical deterioration, functional and economic obsolescence, should also be referenced and considered in this section as appropriate.
6. Approaches to Value: This section is perhaps one of the most overlooked single elements in the appraisal of inventories. Any inventory, whatever its constitution, is by its very nature unique. If there were to be one misconception that could be isolated in explaining the difference between the valuation of inventory and virtually any other asset, it would be that there is simply no “Sales Comparison” or “Market Approach” to which one inventory can be compared. Because the mix of unique items in even the most homogenous of inventories is so diverse, comparison between inventories of seemingly identical product types is almost always misleading.
An inventory of, say, “auto parts” that liquidated for fifty cents on the cost dollar in one case should not be applied to all “auto parts” inventories, as there is simply no direct correlation. Without compensatory adjustments for mix, timing, expense structure, exit avenues, and all of the other factors related to the sale of a unique group of items, efforts at any direct comparison leads to erroneous conclusions. This is not to say that generalizations by industry are not helpful, but that trends should be monitored very closely. The suggestion is that any valuation of a specific inventory be made on the merits of whatever mix is measured for that inventory, as of the effective date, and not what occurred on a prior sale.
The Cost Approach, for all practical purposes, is intended to apply toward those assets whose depreciable characteristics can be demonstrably quantified. Except for purposes of value expression, and write-downs to perpetual inventory nomenclature, the cost approach does not apply to inventory, except as a mode of value expression. As stated earlier, the preponderance of inventory appraisals is measured in their conclusion as a percentage of “cost”, which is explained in the narrative report. Endemic to the calculations made to the perpetual inventories are all depreciable factors, which are physical, economic, and functional. Typically, the appraiser will state, in a general manner, which of these factors has been considered in the value conclusion, and it is understood that any consideration or observations in this respect are determined and applied at the individual part number level.
The Income Approach is generally applicable to real property and intangibles, but is not typically utilized in the appraisal of most inventories. The exception to this is for inventories that are valued as part of a product line in which the intangibles are included as a part of the overall appraisal. This method is something of a hybrid and is only employed in very carefully defined situations.
7. Approaches to Value Not Used: Consistent with USPAP guidelines, it is central to an inventory appraisal, as it is with any appraisal of tangible property that all three approaches to value at least be “considered”, even to their individual exclusions. As such, in this section, the appraiser should state and explain any permitted departures from specific requirements of Standard 7 and the reason for excluding any of the usual valuation approaches.
8. Definition: Obviously, the Definition is the key component in understanding and interpreting any appraisal and any appraiser, lender, accountant, attorney, or other user of an appraisal is well acquainted with the frustration resulting from the use and misuse of terms such as “Liquidation Value”, “Market Value”, “Fair Value”, and the like. Despite concerted efforts by the various appraisal bodies, there is no concrete set of definitions acceptable to all appraisers or appraisal companies, beyond those in “common” use. For example, “Fair Market Value” (a/k/a Fair Value) is generally understood to include, at least conceptually, the idea of both a “willing buyer” and “willing seller” and that this concept is a benchmark for an asset's “value in exchange”. On the other hand, the liquidation concepts have as their basis the concept of a forced seller. Beyond these basic precepts, the definition section should specify all factors contributing to or departing from the essential components unique to each definition.
9. Identification of Inventory: Identification should include, at a minimum, segregation of manufacturing inventories into the classes of finished goods, work-in-process, and raw materials. For distribution inventories, identification should include a full discussion of each product line.
10. Site Observations: There is great deal of fluidity in this area of an inventory appraisal, and many appraisers have vastly different ideas as to what should and should not be included in this section. Certainly, the inventory appraiser will disclose, in a general manner, what steps were taken in the field investigation for factors such as “cost” structures, physical condition, and count accuracy. However, there are no specific minimum requirements for fieldwork, nor is there any fixed agenda. This is why site observations is one aspect of an inventory appraisal where experience plays a large role, as the appraiser must adapt to whatever he or she encounters during their field investigation.
11. Documents Reviewed: As is indicated in the “Monitoring Requirements” section of VRG’s inventory appraisals, a list of all reviewed documents, both on-site and in-house, should be listed in the appraisal. In addition to showing the breadth of the appraiser’s work, this listing allows any lender, auditor, or other user of the report to request these same reports from the subject company. This section can also include a list, where necessary, of reports that were requested, but either could not or would not be provided by the client.
12. Cost Reporting System: This section may often begin with a disclaimer to the effect that an appraisal is not an audit, which can also appear in the purpose section of a report, as this can be extremely important, particularly in litigation. Most appraisers are not certified accountants and even those with multi-disciplined training in cost accounting would probably not want to assert that the report is some sort of hybrid appraisal/audit. While it is certainly appropriate though not required to investigate what the subject company means by “cost”, the level of depth will not generally approach what an auditor would undertake as part of an actual audit. There are simply too many terms, i.e., FIFO, LIFO, Average Cost, Standard Cost, and Lower-of-Cost-or-Market, requiring too many adjustments for the appraiser to indicate accurately anything other than the most basic assessment. Generally, the method of accounting on both the perpetual and the general ledger should be indicated in the report, which is often different.
As with most elements of an inventory appraisal, there are numerous exceptions to this general rule. Commodity inventories, such as steel, oil, plastics, and the like are often “costed” by the subject company on an average cost basis. It is appropriate for the appraiser to inquire into and seek out supporting documentation for the last time the “average cost” was adjusted to the market. Take, for example, a steel inventory of standard, 48", imported master coil that was last adjusted to the market six months prior to the assignment. It is highly unlikely that this “average cost” is representative of the current market and, in this case, the appraiser may elect to make and disclose specific adjustments to the perpetual cost.
13. Product Origin: This should be discussed particularly where import inventories are involved and would include any unusual characteristics resulting from different points of origin. Often, overseas inventories are excluded as a matter of course, but this is not always the case and the lender will typically advise the appraiser of any exceptions.
14. Client Base: Discussion of a company’s client base may not always be a required component, but it is of profound importance under any of the liquidation concepts where the clients are exclusively dependent on the subject for short-term inventories. A manufacturer who is a single-source supplier or a client who operates on a just-in-time inventory system presents an advantage to a liquidator, which may not apply to a commodity.
15. Special Considerations: This section of an appraisal is also somewhat subjective and is often tailored to the needs and requests of specific lenders/clients. Areas such as seasonality, absorption, unusual market conditions, and industry or company specific concerns can be elaborated on is this section. Asset-based lenders, for example, are very sensitive to seasonality, as they may have created borrowing bases that require seasonal adjustments. Absorption can also be an atypical, contributory factor to the liquidation scenario. Industries dominated by a few inventory suppliers may not have the capacity to absorb a particular company’s inventory within a short time frame. Therefore, an extension to the market period may be justified and should be discussed, where required.
This section is also an appropriate area to discuss any potentially negative factors that the lender may encounter in a liquidation. For instance, there may be legal restrictions such as government regulations, tax considerations, royalties (which can be especially troublesome), labor situations, and a host of other factors endemic to an industry or a specific company. This section is another one of those “value-added” elements of an inventory appraisal that is both highly subjective, but also extremely important. Over time, an inventory appraiser will develop an “ear” for potential problems that may elude an audit, which is not necessarily due to any lack of diligence on the part of the auditors, but due to the fact that an appraiser is trained to excavate factors unique to a potential liquidation of the collateral. Increasingly, lenders responsible for making credit decisions in which an inventory is a significant component of the collateral are demanding elucidation of these factors.
Narrative reporting in these areas has always been considered the provenance of real estate appraisals; however, proliferation of these factors has also been seen in some machinery and equipment appraisals. Therefore, it is incumbent on the inventory appraiser to include pertinent consideration of these areas and others, which would have an impact on the value in the written report.
16. Exemptions: The exemptions section of an inventory appraisal has evolved over the last several years to include any number of inventory categories that a lender may choose to either exclude or reserve when compiling the borrowing base. The exemption listing can be bifurcated into the following distinct areas:
a. Those classes of inventory historically excluded by most asset-based lenders, and
b. those classes that the inventory appraiser has identified as elements for potential “special treatment”.
Lender dictated exemptions traditionally include foreign inventories, consigned inventories, “bill and hold” items, packaging, work-in-process, and any number of inventories specific to the industry, the company, or a particular lender’s requirements. Still, the appraiser should exercise deliberation in classifying an inventory segment as “exempt” and only after consultation with the client or based on repeated experience in inventory collateral reviews with a particular lender. In this section, the traditionally excluded areas should be carefully identified by the appraiser and numerically precise.
The second exemptions category should include inventory segments the appraiser has identified during a comprehensive field analysis, as well as a complete data analysis on the perpetual inventory supplied by the subject company. Some of these categories are more or less self-evident from the field inspection, i.e., damaged items, returns, rusted or weather-damaged items, and the like, which are often already reserved on the general ledger. However, as with all general ledger calculations, the inventory appraiser should be cognizant of the fact that these accounting entries are not always fully inclusive.
Other categories of appraiser-identified areas for potential exemption may include items buried in the description field of the perpetual inventory report. “Soft Costs” such as maintenance, labor, and even taxes are frequently included in the perpetual inventory, which can typically only be identified with a line-items analysis of the perpetual; an analysis for which internally developed inventory valuation software must be employed to ferret out even isolated cases of non-inventory part numbers. There have been cases of six-figure entries under a single part number described as nothing more than “inventory” that, upon investigation, turned out to be items that were not inventory at all. These can be flagged in the description field by employing a keyword tag that catches character combinations. This is only one example of many, but the appraiser should enlist every effort to identify and calculate the cost of any specific areas in a perpetual inventory report that the lender may choose to exclude.
17. Exit Strategy: Perhaps among all of the elements that constitute a complete inventory appraisal, this section is by far the most difficult to effectively “teach”. Though largely intuitive, it is difficult to devise a cogent, plausible, and credible method of undertaking a hypothetical liquidation of an inventory without direct experience in all of the vagaries that will invariably surround any sale under forced conditions. Company management, for example, will have a decidedly positive view of the recovery that can essentially be “guaranteed” if their particular inventory were to be liquidated, which translates into pride of ownership. It is highly unlikely that management has any actual liquidation experience, at least with an entire inventory being liquidated all at once. In fact, too much liquidation experience by management can be a red flag in its own right.
A good amount of emphasis has been placed on the requirement of an appraiser to consult with competitors to garner opinions on “what they will pay” for a company’s inventory in the past, though this type of information is often found to be of questionable value. A competitor may either have an unknown agenda, be close to or have been coached by outside parties, or simply may not have been exposed to such opportunities in the past. Further compounding the problem is the simple fact that most companies would not countenance the appraiser cold-calling competitors in often closed industries, certainly none with unsolicited inquires about potential liquidation values, and more than a few inventory appraisers have been severely chastised for making such calls.
Perhaps the most difficult problem to overcome and certainly the toughest to explain, is that there are really no comparable sales for inventories, not the type that are found for real estate or machinery and equipment, as inventory mixes are unique. Comparison of a liquidation in a particular industry of a specific company does not translate to a potential liquidation sale in an identical industry group for inventory. This is undoubtedly the most common misconception pursued by an unseasoned inventory appraiser. To reiterate the prior example, a 50% recovery on the cost dollar on, for example, an auto parts company does not mean that this recovery can always, or ever, be expected on another auto parts company. This is because any inventory appraisal is case specific, and an appraisal of another auto parts company could very well indicate a gross recovery of 10% or, alternatively, 70%.
This section of an inventory appraisal is where the inventory appraiser should explain, in as much detail as is necessary, the reasons why the value conclusions indicated are as shown, as it is often the factors surrounding the liquidation that deviate from the norm. There have been far too many case studies developed to elaborate on, which demonstrates this most pernicious side of an inventory appraisal and suffice it say that the exit strategy section of an inventory appraisal is where the inventory appraiser must shine. Further, it is not the responsibility of the lender, the borrower, the auditors, or the appraiser in another discipline to understand, explain, and quantify why the values, which are a direct and indivisible result of the manner in which they should be sold, are precisely as they are.
18. Liquidation Expenses: The segregation of inventory value conclusions into both a gross and net recovery has been around for some time. However, liquidation expenses are sometimes misunderstood, as these expenses can be specific to a particular lender or client. At a minimum, the expense summary should include all direct out-of-pocket cash items the party-in-possession might be expected to incur in a liquidation of the subject inventory, but only expenses for non-inventory collateral may be different. These expenses would typically include:
a. Rent, or Lease Expense:
This may or may not include off-site or even customer facilities.
b. Utilities:
Utilities will typically decline with the marketing period.
c. Insurance:
This will generally include insurance of the facility itself and its contents, but may be specific to the inventory itself.
d. Labor:
Labor should be calculated with some degree of interchangeability between existing employees and prevailing regional rates for contract employees. For the inventory segment of a liquidation, labor includes but is not strictly limited to, equipment operators, shipping, payables, and any other expenses strictly related to a direct sale of the inventory itself. The obvious exception would be in a potential finish-out of the work-in-process or raw material inventories in which a trained labor force is employed. This portion of liquidation expenses is a much more complicated analysis, and one that should be fully quantified.
e. As a subset to direct cash expenses, it may be wise to list those personal property assets required for a liquidation of the inventory under consideration, as the machinery and equipment may be auctioned before the inventory has been sold. If, as a part of either or both the real property and machinery and equipment having been previously sold, the assets necessary to liquidate the inventories are no longer available to the liquidating agent; therefore, similar items may have to be leased at a much higher cost. Subsequently, forklifts, pallet trucks, bridge cranes, packaging machines, and even items such as desks, chairs, and computers should be identified when they are a necessary component in the liquidation process. The inventory appraiser should identify these items, hopefully by model and serial number, if for no other reason than to apprise the lender or client that some items should be held back until the inventory has been sold. Inquiries should be made as to the existence of any leases, which should be categorized as either operating or capital.
19. Certification of Appraiser: According to USPAP, a signed certification is an integral part of an appraisal report. Also according to USPAP, an appraiser who signs any part of the appraisal report, including the letter of transmittal, must also sign the certification. Additionally, any appraiser(s) who signs a certification accepts full responsibility for all elements of the certification, for the assignment results, and for the contents of the appraisal report.
When a signing appraiser(s) has relied on work done by others who do not sign the certification, the signing appraiser is responsible for the decision to rely on their work and the signing appraiser(s) is required to have a reasonable basis for believing that those individuals performing the work are competent and that their work is credible.
The names of individuals providing significant appraisal assistance who do not sign a certification must be also be stated in the certification. However, it is not required that a description of their assistance be contained in the certification, but disclosure of their assistance is required in accordance with SR 8-2(a), (b), or (c) (vii), as applicable.
As an example of what the certification should contain, see the current edition of the Uniform Standards of Professional Appraisal Practice (USPAP).
20. Qualification of Appraiser: This section is included in VRG’s appraisals to assist our clients in identifying the appraisal qualifications, experience, background, and education of the appraisers involved in a specific appraisal assignment.
The following chart has been included to show the minimum base appraisal requirements mandated by the Appraisal Foundation in order to conform to the corresponding written appraisal reports as accepted under USPAP. The expansion or retraction of these requirements, as well as any modified elements contained within a report is designed to meet requirements unique to each assignment. However, the lack of clear conformity has led to much confusion, especially when comparing different appraisal reports on the same subject. It cannot be emphasized enough how important these considerations can be in subsequent interpretation, particularly with regard to litigation and file support. Yet, many inventory appraisal reports continue to be issued without, what appears to be, any effort toward compliance.
