Economic obsolescence is defined as "the decrease in the value of an assets due to influences that are external to the subjects asset"(M.L. Zyla 2010, s. 125) or "loos in value of a property caused by factors external to the property"(G.R. Trugman 2017, s. 457).
The Economic obsolescence occurs when the asset cannot generate a sufficiently high rate of return over the potentially remaining useful life based on a given value. The Economic Obsolescence is considered by all economists as incurable and cannot be eliminated. It usually cannot be determined by physical control and is essentially the same for tangible and intangible assets (M.L. Zyla 2010, s. 125).
According to Gary's R. Trugman book, the external factors that causes decrease in property value are for example economic factors related to industry, such as the availability of financing, loss of required materials or loss of sources of work, increased cost of raw materials needed, increased competition or increased inflation. In his work he says that in order to check whether economic obsolescence occurs "a review must be made of the economics of the subject property and the industry in which it competes, as of the valuation date. The review can be made by examining the earnings history of the subject property and any local or other influences that may affect the economic perfomance the subject and its assets" (G.R. Trugman 2017, s. 457).
Causes of economic obsolescence
"The American Society of Appraisers lists common external causes of economic obsolescence as (M.L. Zyla 2010, s. 126):
- A declining industry
- Inability to get financing
- Loss of material or labor sources
- New legislation or ordinances Increases in the price of inputs without the ability to increase product prices
- Reduced demand for the product
- Increased competition
- Inflation or high interest rates".
Trugman says, that the factors determining the occurrence of Economic Obsolescence are (G.R. Trugman 2017, s. 458):
- "Reduced demand for the company's products;
- Overcapacity in the industry;
- Dislocation of raw material, supplies;
- Increasing cost of raw materials, labor, utilities, or transportation, while the selling price of the product remains fixed or increases at a much lower rate;
- Government regulations that require capital expenditures to be made with little or no return on the new investment raw material supplies;
- Environmental considerations that require capital expenditures to be made with little or no return on investment".
Types of Economic Obsolescence
There are 3 types of Economic Obsolescence (G.R. Trugman 2017, s. 458):
- Item specific economic obsolescence-is defined as customer responses after subtracting physical and functional depreciation factors. It is measured on the market as items similar to those currently being sold;
- Industry specific economic obsolescence-is associated with the industry in which the equipment operates. If the machine was operating in an industry where economics is good, an appraiser might conclude that the industry is standard and has no economic obsolescence. On the other hand, if the industry is in a bad economic situation it would be considered smaller than standard. In this case, there may be an economic penalty that is estimated in relation to other market companies that must compete for similar products or operations.
- Business specific economic obsolescence-this is the factor in which the entity is measured by the analyst as an enterprise in order to demonstrate whether the profit can be in line with the values provided by the property appraiser and other property appraisers, assuming that the profit can be in line with the values given. If a company demonstrates that its earnings are not in line with the figures given, this factor of economic obsolescence as a percentage of this difference is the specific economic obsolescence. It is only important because it relates to continuous use consistent with market value for current operations.
- Mettling S., Cusic D. (2019), Principles of Real Estate Practice: 6th Edition, Performance Programs Company, Tampa, s. 232
- Trugman G.R. (2017), Understanding Business Valuation: A Practical Guide To Valuing Small To Medium Sized Businesses, American Institute of Certified Public Accountants Inc., New York, s. 457-460
- Zyla M.L. (2010), Fair Value Measurements: Practical Guidance and Implementation, John Wiley & Sons Inc., Hoboken, s. 125-127
Author: Patrycja Czerwiec