Development of a methodology for the valuation of public sector funded assets

Abstract

The Treasury of the New Zealand Government must ensure that all public financial resources of the Crown are properly recorded in accordance with accepted accounting practices. Tertiary Education Institutions and Hospital Health Service Sector Crown Companies together comprise 16% of the total financial interest in State-Owned Entities, or, 19% of the Crown's total interest in physical assets. When State-Owned Enterprises (SOE's) are excluded the respective interests are 25% and 33% for Crown Entities.

There are three accepted methods of valuing property; comparative market, present value of future income and depreciated replacement cost. Crown Entities are rarely if ever traded in the open market. It is argued that Discounted Free Cash Flow (DFCF) is the theoretically pure method of valuation but is not available for the valuation of an organisation with a service function. Depreciated Replacement Cost (DRC) is the adopted surrogate, refined by various degrees of optimisation. Refinements have included the development of the Modem Equivalent Asset (MEA) and recognition of all forms of depreciation in the calculation of Residual Lives (RL).

Residual Life calculations invariably have regard to the age of the building. This is shown to be an incorrect approach under Optimised Depreciated Replacement Cost (ODRC).

The business entity is rarely consulted in depth on the categorisation of assets, valuation methodology, the optimisation of assets, or total economic lives. This is contradictory to an optimisation process.

The literature review traces the history of DRC and identifies defects in the existing procedures and definitions. Flaws in current methodology are exposed. A questionnaire was sent to all 23 Hospital and Health Service Sector organisations and 37 Tertiary Education Institutions in New Zealand to explore industry understanding and, if possible, to determine whether changes in methodology were required. Responses indicate a degree of industry confusion, the limitations of existing valuation standards, the need for a consistent methodology with some guidance on the direction methodology improvement should take.

Valuation methodology changes are recommended, including full optimisation, the inclusion of comparative Net Realisable Values (NRV's) in valuation reports and the establishment of industry benchmarks. This approach should help to address criticisms raised by respondents.

A non-market methodology is likely to exhibit unacceptable behavioural characteristics. ODRC methodology is a sound surrogate and can provide consistency but has limitations that must be acknowledged and understood. The quality of a valuation of Public Sector assets based on the recommended methodology will be more robust than existing practices, should satisfy accountants' expectations of reporting and provide the necessary industry consistency and accountability required of Crown Entities.