Inventory Appraisals for Bankruptcy

There are many reasons why inventory needs to be
appraised, but two are prevalent. One is for use in obtaining a DIP loan using
the revolver loan vehicle. The second is for those states having <i>ad valorem</i> tax applied to inventory, where the apraisal is
important to determine the true value within the market. There is no question
that one of the most attractive asset-based loans for lenders is the inventory
revolver, second only to receivables. As banks and other lenders become more
aware of the various factors that affect value, appraisers are being asked to
become more sophisticated in their analysis. This also needs to be understood
by those representing debtors so that good decisions are made in using that
asset to assist in the rehabilitation.

</p><p>Not
too long ago, lenders would make certain assumptions, then use the
borrowers' cost and fund an acceptable percentage as might be prescribed
by the internal limits or guidelines of that financial institution. Since that
time, many new technologies have been developed that allow a better analysis so
that higher or more competitive loans could be made against these types of
assets. In some cases, these analyses have proven that the advance rates were
too aggressive. The biggest change, after the computer and larger hard drives
with faster operating systems, was the ability to load the inventory files from
the prospective client to the appraisers' computers so that all of the
data could be analyzed.

</p><p>From this beginning, there
has been added special programming using large data storage computers with very
fast operating systems to further enhance the inventory appraisal process.
Other areas could be looked at as well, such as cost comparatives for like
items, cost trends, new and older items, categorization, exclusions (items not
marketable that should be excluded for lending) and many other areas. Some
appraisers thought that this was all that was necessary and therefore would
simply do this exercise and then apply a percentage no differently than the
past lending practices. Many debtors do not look at their inventory in the same
way as required by lenders. Some companies do not have the resources to have a
full and complete inventory computer run, though there are ways to handle this.
These are taught in an appraisal course offered by the American Society of
Appraisers (ASA). The course is designed in order to teach about the unique
characteristics of some inventories and the manner in which they may be kept.

</p><blockquote><blockquote>
<hr>
<big><center><i>
An inventory appraisal is not an audit, but there
should be some confidence in the reasonable accuracy of the on-site inspection.
</i></center></big>
<hr>
</blockquote></blockquote>

<p>There is nothing better than
being involved in the education and application from a lender's point of
view. It is extremely difficult to recognize the situations and/or forecast
events that could put a value in jeopardy, although some of these may be
unavoidable. A few of the problems arise from economic or functional
obsolescence. An economic occurrence is the recent saturation of Boeing 727
aircraft parts that has driven the re-market price for these assets to an
all-time low. When this happens, those in that market may not want the parts at
anything other than a giveaway price, and the bidders are few. The depreciable
effect is not simply linear to the market but exponentially lower, due to all
of the other effects including an unknown length but anticipated holding
period. "Stage Three" (government imposed noise restriction for
engines) in aircraft is another anticipated effect and can now or later affect
aircraft and their associated parts. Computers and the equipment that becomes
outdated is an example of functional obsolescence.

</p><h3>Selecting the Appraiser</h3>

<p>The very first thing to look
at is the appraiser or his/her company to see how many inventories or workouts
they have personally conducted. The appraiser should have some expertise on the
subject category of the inventory. This may include being involved in the
industry, doing work associated with the subject and so forth. For example, how
can one appraise an aircraft if never before associated with the subject? This
area is very specialized, and most of these individuals were formerly or
currently pilots as well members of the appraisal profession. One can hire an
outside contractor that knows the subject, but to do such a study without that
expertise on that type of category would be improper.

</p><h3>Methodology</h3>

<p>It is not good enough to
simply use a computer and come to some conclusion other than to show the work
that was done in order to apply the additional required analysis. The new
technology is good and will assist an appraiser to make a more logical and accurate
decision. However, there is much more that needs to go into the valuation so
that the indication represents a good analysis of what may be forecastable.
This means that the onsite work and questionnaire should be representative of
the current and future market as may be forecast.

</p><p>On-site sampling and testing
should be conducted regardless of any recent audit. An inventory appraisal is
not an audit, but there should be some confidence in the reasonable accuracy of
the on-site inspection. A recent aircraft inventory appraisal was conducted
for a major airline, and the representation of a portion of the inventory was
at a multimillion dollar level. The on-site inspection found huge errors in the
unit-of-measure areas. As an example, 9,000 rivets may have been shown at a
cost of $13.23 each, whereas the unit of measure was by the pound and there
were four pounds. There were cotton swabs at a cost of $5 or $6 each and tongue
depressors listed in this data at some ridiculous amount. The difference on the
unit of measure and miscellaneous items was more than $700,000; a desktop may
not have caught this, although the unit of measure cost, if individually
observed in the data, may have been suspect.

</p><p>With aircraft parts, there
are many factors, such as condition indicators, that must be established with
the items, and only an on-site observation would allow that to be confirmed.
Condition of any inventory, whether it be manufacturer or distributor or
retail, requires the on-site inspection, so what good are updates if no
inspection is required? The update can show differences in mix and turns unless
there is fraud involved. Since the on-site work is not an audit, there may be
undetected fraud, but certainly there is more chance of discovery if there are
more inspections. Lenders are developing certain guidelines and can require
audits for confirmation of those assets and the related mix in intervals that
would be recommended due to the nature of the subject. This should be expected
if one is going to use the inventory revolver loan for a debtor that is going after
that type of financing. The lender is going to cross-check invoices to confirm
that the cost prices are appropriate.

</p><p>Another new development is
referred to as the "exit strategy." Nearly all lenders are now
asking for this to be included in the appraisal report as a best estimate for
how to liquidate in the event they have to sell the inventory. The appraisers
who are selling as well as appraising have some unique perspectives on this
subject and could be helpful in assisting the debtor in looking at the
potential for obtaining the revolver loan. In addition, there are times where
the reorganization plan may have a liquidation aspect where the liquidator/
appraiser could be helpful. There is always the criticism that can be made
about a conflict of interest in being in both positions of selling and
appraising. Although there is some merit in this point, there is no way to be
qualified in the exit strategy without having some expertise in the selling.
There is always the possibility of having the appraiser as the advisor and
another appraiser is used as an overseer of the sale. However, this may not be
necessary if the use of the expert is accomplished in the proper way. It is
always possible that the initiation of a loan does not mean that there will be
a liquidation effort in the future. Remember, at that point, the idea is all
about the rehabilitation of the company.

</p><h3>Conclusion</h3>

<p>Appraisals are appropriate
for revolver loans and, if conducted by those in the know, can be very valuable
guidelines. That is not the end-all, as anyone who wishes to create bad
inventory status reports can do so. One must be monitoring these inventories,
and most inventory lenders recommend that an inventory valuation should be
obtained from an appraiser that allows a proper cross-check for inventory
changes. Most appraisers will be able to give a value-added feature within the
original study. They should be able to give appropriate advice as to what could
be expected based on the type and mix of inventory. There are still changes
going on and new innovations by the appraisers that originated the use of these
type of studies.