17 Apr Depreciation and Collateral: Why Market Value Matters

Written by: Michael Schykerynec, ASA

(3-4 minute read)

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life and represents the gradual reduction in the value of an asset due to wear and tear, obsolescence, or passage of time. While depreciation affects financial reporting and tax calculations, it does not necessarily reflect an asset’s actual market value. This distinction is crucial for lenders assessing collateral for SBA loans.

According to the SBA’s SOP 50 10 7.1, lenders must adhere to specific guidelines when valuing fixed assets, particularly machinery and equipment, for collateral purposes. As per the SBA SOP 50 10 7.1:

“If the valuation of fixed assets is greater than their Net Book Value, an independent appraisal by a qualified individual must be obtained by the Lender to support the higher valuation.”[1]

Although the SBA SOP does not explicitly require an equipment appraisal for collateral, individual bank policies may dictate when one is necessary. Additionally, obtaining an equipment appraisal is highly recommended, particularly in cases where the equipment has been fully depreciated. This ensures a more accurate valuation, helping lenders make informed decisions regarding collateral and loan security, as relying solely on net book value can lead to undervaluation of collateral. Obtaining an independent appraisal that provides fair market value, as well as orderly or forced liquidation values, offers a more accurate assessment. Fair market value is essential for determining the enterprise’s overall worth, encompassing both tangible and intangible assets. Orderly or forced liquidation values are critical for estimating potential recovery amounts in the event of liquidation.

Depreciation methods, such as the Modified Accelerated Cost Recovery System (MACRS), often result in book values that decline more rapidly than market values. For instance, a machine shop lathe purchased for $65,000 and fully depreciated over seven years may have a net book value of zero. However, its fair market value could still be substantial, underscoring the importance of appraisals for accurate collateral valuation.

The comparison table below illustrates the differences between MACRS depreciation and Fair Market Value (FMV) depreciation for a $65,000 lathe over seven years. Under MACRS, the lathe’s book value declines rapidly, with larger depreciation expenses in the early years, dropping to $2,867 by year seven, before reaching zero in year eight. In contrast, the FMV depreciation follows a more realistic market trend, where the lathe loses value quickly in the first few years but retains $11,000 in resale value by year seven. While MACRS benefits businesses by accelerating tax deductions, the FMV method better reflects actual resale worth, showing that even after full depreciation under MACRS, the lathe still holds some market value.

 

Lenders should note that depreciation methods prescribed for tax purposes may not align with Generally Accepted Accounting Principles (GAAP). Given the variability in depreciation methods across companies, relying on net book values alone may not provide an accurate representation of an asset’s market value. For example, depreciation impacts a balance sheet by systematically reducing the book value of fixed assets over time. As depreciation accumulates each year, the net book value of the asset declines, reflecting its diminished useful life. Additionally, because depreciation lowers net income on the income statement, it also reduces retained earnings, thereby impacting the equity section of the balance sheet. However, since depreciation is a non-cash expense, it does not directly affect the company’s cash position but can influence cash flow by lowering taxable income and, consequently, tax liabilities. Although an appraiser will already normalize the cash flow in calculating EBITDA, removing any income statement inconsistencies due to different depreciation tactics, by obtaining independent appraisals, lenders can assign precise collateral values, facilitating sound lending decisions.

In summary, while net book value offers a standardized accounting measure, it may not reflect the true market value of machinery and equipment. Independent appraisals are essential for accurate collateral valuation, ensuring compliance with SBA guidelines and supporting prudent lending practices.

[1] SBA SOP 10 7.1 Page 117