An appraisal is best defined as an expert’s estimate of the value of “something.” Within the context of business and finance, that “something” is usually an asset (or a group of assets).
Examples of assets that can be appraised include, but are not limited to:
Real property (both commercial and residential)
Equipment (including vehicles)
Inventory (particularly unique, finished products – as opposed to commodities or raw materials)
A private business (or a portfolio of private businesses)
Unique or rare goods (such as fine art, antiques, and jewelry)
An appraisal is conducted by an appraiser; the appraiser is the expert providing the valuation estimate, based on their experience and their training. The valuation estimate, along with supporting documentation, is included in what’s generally referred to as an appraisal report.
An appraisal is an independent and objective estimate of an asset’s value conducted by an expert with appropriate credentials.
The appraiser conducting the estimate of value must be completely independent of all other stakeholders in the transaction.
While there are different “types” of appraisals (depending on the asset being valued), their purpose and their formats tend to be very similar.
Purpose of an Appraisal
Appraisals may be commissioned for a variety of reasons, based on any number of unique circumstances. Broadly speaking, however, these reports are commissioned because one (or more) stakeholders require(s) a fair and unbiased estimate of an asset’s value.
Circumstances that may require an appraisal include:
To facilitate a transaction involving a specific asset – Both the buyer and the seller need to understand what the asset’s estimated value is to help negotiate a clearing price.
To secure financing – Particularly credit. Financial institutions generally lend some loan-to-value (LTV) against different asset classes, so they require an estimate of value before extending credit.
To take out an insurance policy against an asset – Insurance companies cannot assign a policy value to an asset without understanding what the asset is worth or what it would cost to replace.
For will and estate planning – Families, as well as their lawyers and wealth advisors, may wish to better understand what assets are worth in order to support the division of those assets among beneficiaries.
“Disputes” – It’s common when shareholders in a private business have some sort of dispute around control of a company; an independent valuation of that business may be required in order to facilitate a buy-out. Divorce and/or separation is a similar justification for seeking the valuation of assets, including a private business (or businesses).
For tax purposes – An example is if an asset is being donated to a non-profit organization; the “value” of that asset could be tax deductible for the donor, but a fair and objective estimate of value is required. In the US, the Internal Revenue Service (IRS) requires what’s called a Qualified Appraisal in this instance, the standards of which are higher than for most other appraisal circumstances.
The one common requirement for all appraisals is that the valuation estimate must be completely objective. It’s imperative that the appraiser commissioned to conduct an appraisal be completely independent (sometimes called “arm’s length”) from any of the stakeholders involved, thus permitting them to truly provide a fair, independent, and unbiased opinion of value.
What is Included in an Appraisal Report?
Most appraisal reports usually include the following key sections:
Cover Page – Introduces the appraiser and their firm, as well as the date the inspection was completed.
Letter of Transmittal – This section includes who commissioned the appraisal (i.e., the vendor), its intended purpose (i.e.. to facilitate the sale of the asset), as well as who the intended legal user (or users) is/are (i.e., XYZ Bank – to support a financing request).
Executive Summary – This section usually highlights some of the key findings in a short, single page format. This may include the estimate of value, although without much information about the method(s) used to arrive at the estimate, as well as a brief description of the asset (or assets).
Asset Description – Whether it’s real property or an equipment asset, this section includes any and all legal identifiers (such as legal addresses and serial numbers). It also features an analysis of the asset, including notes around quality, remaining useful life, specific deficiencies or repairs, and a recent sales history.
Asset Valuation – This section has much more information around the different types of valuation approaches employed, as well as any comparable properties (or other comparable assets) that have been used to support the analysis.
Certificate of the Appraiser – This section is where the appraiser’s qualifications are highlighted so stakeholders can cross reference which governing bodies have signed off on their credentials.
Appendices – It’s common for an appraisal report to have dozens of pages of “addenda” or “appendices.” These have all kinds of supporting documentation like maps, financial statements, information about calculations that were made, and many other types of relevant information that doesn’t fit elsewhere in the report.
As with financial statements, however, there are different “levels” of appraisals that can be commissioned, depending on the needs of the stakeholders involved.
For example, commercial real estate appraisals in the United States can be Restricted Use, Summary, or Self-Contained appraisal reports, with the latter being the most comprehensive (similar to how Compilation, Review, and Audit engagement reports work in Accounting – from least to most comprehensive, respectively).
Types of Appraisals
While almost all appraisal reports will include the above-noted sections, there is some nuance depending on the nature of the asset being valued.
Equipment appraisals, for example, offer three types of valuation estimates: fair market value (FMV), orderly liquidation value (OLV), and forced liquidation value (FLV). These different estimates of value may serve unique purposes for different stakeholders.
Real Estate Appraisals
Valuing real estate is itself unique, and there are a few different valuation approaches that can be employed. These are cost, income, and the direct comparison approaches.
Real estate is also interesting because it can’t be picked up and moved, so properties may be subject to certain zoning or land use restrictions. It’s also common that property is acquired with the goal of rezoning and redeveloping it. As such, property appraisals often include what’s referred to as the “highest and best use” of the property (which may not be the same as the site’s current purpose).
Qualified appraisals are a subset of appraisals that meet certain strict criteria set out by the IRS in the United States. These appraisals are quite rigorous; appraising an asset for tax purposes in the US requires that a “Qualified Appraiser” conduct the analysis and prepare the corresponding report.
Thank you for reading CFI’s explanation of Appraisal. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: