Developing the Cost Index & Depreciation Schedules

1. Developing the Cost Index & Depreciation Schedules By Dave Duty Property Valuation Specialist II North Carolina Department of Revenue Local Government Division Property Tax Section 2011 Advanced Personal Property Seminar Sheraton Four Seasons Hotel, Greensboro, NC Tuesday September 13th, 2011

2. Let’s talk about these things: • The Cost Approach to Value • The NCDOR Cost Index & Depreciation Schedules • The Producer Price Index • Historical Cost vs. Allocated Price • Mass Appraisals • Variations in the Trend Factors • Variances From the Schedules • Trends in the Billboard Manual

3. Review of the Cost Approach to Value What is it? Installed cost-The Westmoreland Case Replacement cost new Composite resources Depreciation Economic life

4. Cost Approach to Value • The cost approach estimates market value on the premise that the cost new of an asset is reduced by an amount equivalent to the total loss in value that has occurred through all forms of depreciation • Considered to be the best or most effective way to value machinery and equipment • Proven methodology, data is readily available, taxpayers tend to understand the concept fairly well • Most closely approximates the fair market value • Must determine the original historical installed cost, the current replacement cost new, the loss in value due to depreciation, & obtain the useful economic life of the asset

5. Installed Cost • Invoice cost and all other costs necessary to achieve normal utility of an asset • Bringing asset into production includes freight, taxes, installation, warranties, training, etc. • These costs are normally capitalized by the owner for accounting purposes • These costs offset income which lowers federal income tax liability

6. Support from Westmoreland Case in Halifax County • NC Court of Appeals case page 8 & 9 • …the Department of Revenue has the power to “prescribe the forms, books, and records to be used in the listing, appraisal, and assessment of property… • …guidelines provide that the acquisition cost of property includes “installation, sales tax, freight, and all other costs incurred with obtaining the property and making it ready for its intended use.”…

7. RCN • The cost to replace property with assets which are comparable and have equivalent utility and functionality • Not reproduction cost which is the cost to construct an exact replica of the asset • Data comes from vendor catalogs, internet searches, dealer quotes, cost manuals

8. Ouch! • Wouldn’t it be nice if we could go to one source of information that tracks increases and decreases in the costs of machinery and equipment?

9. Enter the NCDOR Cost Index & Depreciation Schedules !!!!!!!!!! • We use index factors to represent the overall price level changes for certain classes of property • The trending process applies the proper percentage of adjustment either positive or negative to historical cost data to find the replacement cost of an asset

10. Enter the NCDOR Cost Index & Depreciation Schedules !!!!!!!!!! • Normally, it costs more to make a product so the index factor increases • After depreciation is then applied, that remaining number is the good factor • So, higher costs to produce with pre-determined amounts of depreciation = lower good factors and lower values as the asset ages

11. Enter the NCDOR Cost Index & Depreciation Schedules !!!!!!!!!! • Depreciation is the loss in value from all causes of property having a limited economic life • RCN less Depreciation = Remaining good factors • Economic Life is the time period over which an asset may reasonably be expected to maintain utility or functionality

12. Review of the NCDOR Cost Index and Depreciation Schedules Manual What is it? Memorandum Introduction Major Category Descriptions Valuation Tables

13. Cost Index & Dep. Schedules • An effective & efficient method for determining current replacement cost new less depreciation to value property • Utilizes the cost approach to valuation • Widely accepted, but not required to be used by county appraisers

14. Annual Memorandum • Summarizes changes from the previous year • More clarity in the category • New prevalent industry descriptions • Life year adjustments • Reminders • Example: Propane gas tanks • Special schedules

16. Introduction • A great description of what the schedules are and how the factors are determined • Example of how the good factors are calculated • Good factors-the product of the trending factor and straight-line depreciation over the economic life of the asset groupings

18. Major Category Descriptions • From aerospace to woodworking equipment and industry categorization • Reference to the page number, schedule to use, and life years • Helps focus on the primary function of the business and the dominate type of equipment used • NAICS Code/Principle business in the county-captured on listing form

20. Valuation Tables • Provide the good factor percentages to apply to the reported costs • A method to arrive at Fair Market Value • Data provided on the tables: The year acquired, the age of the asset, the trend factor, the economic life in years, and the good factors • Good factors represent the remaining amount of replacement value new after depreciation-Import File

22. Import File

23. Producer Price Index Data What is it? Website tables Migrate over to NCDOR Schedules Examples Facts about PPI

24. Producer Price Index • Comes from Bureau of Labor Statistics Data • Family of indexes that measures the average change over time in selling prices of goods & services • Makes use of NAICS codes! • Data is from a sampling of producers in manufacturing, mining, and service industries

25. Producer Price Index Industry Data

26. Percentage change over a 12 month period: Select the month of September Take 2010 figure, subtract 2009 figure and divide product by 2009 figure to arrive at percentage change 228.0 – 224.2 = 3.80 3.80 / 224.2 = + 0.017 Multiply by 100 x 0.017 = +1.7 % overall change

28. Consider the relationship between the depreciation taken and the value remaining- A -10 means it takes 10 years to fully depreciate the remaining value of the asset: Yr. Depreciation Taken Remaining Value 1st 10% 90% 2nd 20% 80% 3rd 30% 70% 4th 40% 60% 5th 50% 50% 6th 60% 40% 7th 70% 30% 8th 80% 20% 9th 90% 10% 10th 100% 0%

29. Calculate the good factor based on the trending factor x the straight-line depreciation factor- Yr. Acq’d Age Trend R-Value Good Factor Good Factor % 2010 1 1.00 0.90 0.900 90% 2009 2 1.01 0.80 0.808 81% 2008 3 1.02 0.70 0.714 71% 2007 4 1.07 0.60 0.642 64% 2006 5 1.10 0.50 0.550 55% 2005 6 1.13 0.40 0.452 45% 2004 7 1.18 0.30 0.354 35% 2003 8 1.22 0.20 0.240 24%*** 2002 9 1.24 0.10 0.124 12% 2001 10 1.24 0.00 0.000 0% ***BUT-we stop at a 25% residual value!

31. Facts • Targets US producers so imports are excluded • Price collected is revenue received by producers-not sales tax, excise tax, etc.-these are not revenue to producer • Used to deflate revenue streams to measure real growth • One of the oldest economic time series compiled by the Fed. Gov.-1891

32. Historical Costs vs. Allocated Purchase Price Value What is it? Our goal for equitable valuation Undesirable features of allocated purchase price Example of higher tax liability Questions to ask

33. Historical vs. Allocated • Historical cost is the cost of the property when it was first placed into service by its original owner • Allocated cost or Acquisition cost is the price paid for an asset when acquired by the present owner

34. Our Goal for Equity • Historical cost works well with the trend tables-value is gradually reduced over time • A full installed cost approach to disclosing reportable costs • The audit is an examination of the accounting records of the business owner

35. Undesirable Allocated Purchase Price • Short circuits the use of the CI&DS • Not based on cost new in the year of manufacture • Arbitrary number selected by a non-appraiser • Motive is to lower income tax liability • Could increase value on M & E, then decrease value on “good will” to inflate the amount of depreciation, thus less income tax on the business

36. Allocation? : ( • Requested amount could be after a write down of assets • Could be a distressed sale or not an arm’s length transaction-may I have a copy of your sales contract? • This may be an assigned value that fails to capture installed costs • What portion of the allocated cost do you remove when the asset is disposed of?

37. Allocation?  • Using the allocated price is a disservice to all other taxpayers-not uniform & equitable • Why can’t the new owner get the old records from the seller? • Why can’t the new owner get permission from the seller to allow the county to release the old records so the new owner can complete the listing properly?

38. The Last Resort! • Westmoreland case supports both the inclusion of all costs and the methodology that the NCDOR has adopted and recommended • DO NOT DEPRECIATE the allocated purchase price-that price IS THE VALUE!!! • Leave good records in the file about why you accepted this methodology

39. Higher Tax Liability??? • Given Data: • 2002 Commercial Bread Baking Oven • Historical Installed Cost = $100,000 • Use A-10 Schedule • Sitused in Wake County = $0.534 rate • So…$100,000 x 25% = 25,000 divided by 100 = 250 units of value x $0.534 = $13.35

40. Higher Tax Liability??? • Bought asset in 2010 • Allocated purchase price = $30,000 • So…$30,000 reported in current year divided by 100 = 300 units of value x $0.534 = $160.20 • Dear Mr. Business owner, Would you rather pay $13.35 or $160.20 ??????

41. Questions to ask----------------- • Does the price paid represent fair market value? • Were all of the assets purchased from the prior owner? • Have any of the assets been sold by the new owner since the purchase? • Were the reported costs of the prior owner ever audited? • What is the purchase price allocation based on?

42. Questions to ask----------------- • Was an appraisal made of the property prior to the sale? • Was an appraisal made of the property after the sale? • How many business locations were involved in the purchase? • May I read the sales contract? • Are you sure you can’t get me the historical installed costs?

43. Mass Appraisals??? What is it? How the schedules accomplish our goal Elements to consider Reverse Trending

44. Massive Numbers • Appraising mass numbers of groups of assets vs. mass numbers of individual pieces of equipment • M & E, F & F, Computers, etc. • Consider all elements in 105-317.1 • Getting a value by going backwards

45. Variations in the Trend Factors The “T” Schedules Example of the effects of a positive trend Other impacted schedules Residual values

47. Example of a positive trend • Yr. Acq’d Age Trend R-Value Good Factor Good % • 2010 1 1.00 0.98 0.980 98% • 2009 2 1.01 0.96 0.970 97% • 2008 3 1.06 0.94 0.996 99% • 2007 4 1.17 0.92 1.076 108% • 2006 5 1.21 0.90 1.089 109% • 2005 6 1.29 0.88 1.135 113% • 2004 7 1.32 0.86 1.135 114% • 2003 8 1.35 0.84 1.134 113% • 2002 9 1.36 0.82 1.115 111% • 2001 10 1.35 0.80 1.080 108% • 2000 11 1.38 0.78 1.076 107% • 1999 12 1.39 0.76 1.056 106%

48. Variations • U-12 stops @ 35% for tractors • U-5 goes down to 10% for data processing • U-6 & U-8 goes to 15% for semi-conductors, digital & switching equip. • B-5 goes to 10% for analog TV equip. • D-6 goes to 15 % for POS, hand held data, & electronic cash register equip. • M- does not drop below 40%-vaults

49. Residual Values • 25% is a conservative amount of value • Difficult to value older equipment • Remaining value is a “going concern” value

50. Variances From the Schedules Idle and non-idle equipment Construction in Progress Expensed items Leased equipment Leasehold improvements Inventory Questions to ask