Functional obsolescence is the loss of an asset’s usefulness and value caused by something inside the asset itself, its design, layout, capacity or technology, rather than by wear and tear or by conditions outside it. An asset can be in full working order and still be functionally obsolete, because what the market expects that asset to do has moved and the asset has not. In appraisal wording it is a loss in utility and value due to a reduction in desirability, caused by factors inherent to the property (California State Board of Equalization, Assessors’ Handbook Section 502). It is one branch of the wider term obsolescence.
Functional Versus External Obsolescence
External obsolescence, also called economic obsolescence, is a loss in value caused by negative influences outside the subject property that are generally beyond the control of the owner or tenant, while physical deterioration and functional obsolescence are intrinsic to the property (Assessors’ Handbook Section 502). Fair value measurement folds both into one cost-approach adjustment, set out in obsolescence.
Curable and Incurable Functional Obsolescence
Whether functional obsolescence can be cured is an economic question, not an engineering one. An item is curable if the value added will be equal to or greater than the cost to cure and curing it will allow the entire property to maintain its value, and when a cure is possible but carries no economic advantage the item is incurable (Assessors’ Handbook Section 502).
The cause is either a deficiency or a superadequacy. With a deficiency the asset falls below the standard the market sets; with a superadequacy it exceeds that standard, and most superadequacies are considered incurable (Assessors’ Handbook Section 502). A machine specified for volume the business never runs still carries the upkeep of the larger unit, and the extra capacity returns nothing.
What It Changes on the Fixed Asset Register
Functional obsolescence signals that the remaining useful life carried on the register was estimated against conditions that have since changed. Federal tax law names obsolescence inside the depreciation allowance, but a shorter life has to be shown rather than asserted, and property recovered under MACRS has a statutory recovery period rather than an estimated life to shorten. Both limits are worked through in obsolescence and depreciated. A revised life feeds straight into the periodic book charge, the arithmetic in straight line depreciation.
It can also be the kind of change in circumstances that triggers a recoverability test, the test impairment losses works through, because a long-lived asset or asset group has to be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable (FASB Statement No. 144, paragraph 8). When a long-lived asset or asset group is tested for recoverability, it may also be necessary to review the depreciation estimates and method, and any revision to remaining useful life coming out of that review has to be considered in the cash flow estimates used to run the test (FASB Statement No. 144, paragraph 9).
Common Questions
A server that still runs but no longer takes the current release of the software a practice depends on. A scanning setup built around a workflow the firm has already replaced.
Physical, functional and external, the headings a replacement cost estimate is adjusted for, each defined in obsolescence.
Sometimes, and two tests decide it. The value added has to be equal to or greater than the cost to cure, and curing the item has to allow the entire property to maintain its value. What happens on the books matters as much. A taxpayer must capitalize as an improvement an amount paid for a betterment to a unit of property, and an amount is paid for a betterment only if it ameliorates a material condition or defect that predates the taxpayer’s acquisition or arose during production, is for a material addition to the unit of property or a material increase in its capacity, or is reasonably expected to materially increase its productivity, efficiency, strength, quality or output (26 CFR 1.263(a)-3(j)(1)). Replacing a part that can no longer reasonably be replaced with the same type of part, with an improved but comparable part, does not by itself make the amount a betterment (26 CFR 1.263(a)-3(j)(2)(iii)).
Physical deterioration is wear and tear on the asset itself. Functional obsolescence needs no deterioration at all, because an asset can be close to new and still fail the standard the market now applies to it.
Firms carrying fixed asset and depreciation review through a busy season can put a block of that work through Accountably’s offshore team and review chain in a trial task first.
