It’s about time people start getting excited about accounting. Those of us in the industry have long known the allure of generally accepted accounting principles (GAAP). But now others are finally paying attention.

With the volatile corn prices, decreasing ethanol prices, and credit market crunch, there has been much discussion among investors, managers, bankers, and analysts about ethanol plant valuations. The ultimate question is “What is our plant worth?”

Valuation specialists work through the mathematical gymnastics to arrive at an answer. This year we expect to see valuations that are substantially less than the net book value of plants on the financial statements.

Let’s say you are an investor in a 100 million gallon plant that originally cost $150 million and is now depreciated to a net book value of $125 million. Further, let’s say the identical plant across the road obtains an appraisal that indicates its market value is $50 million. The question arises: “Should we mark our plant to market?” The answer has serious implications for the financial statements and the financial condition of your investment.

What do the accounting rules say?

Generally, property and equipment are recorded at original cost and value is reduced over time through depreciation. However, there are times when events change this general presumption. GAAP Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” provides examples of these types of events, such as significant decreases in the market price of an asset or a current period cash flow loss combined with a history of cash flow losses.

If such events have occurred, an asset or group of assets must be evaluated to determine whether future cash flows will be sufficient to recover their net book value. Given the current industry and economic environment, we expect the management of certain plants will be asked to test the plant values for recoverability.

Where do we go from here?

Those who decide it is time to evaluate the plant must first estimate the future cash flows that are expected to arise from the use of the plant over its remaining useful life. These estimates need to include management’s own assumptions about the use of the plant and should consider all available evidence. That evidence might include the expected future selling price of ethanol, DDG/S and corn, interest rates, and operating costs. This forecasting involves a fair bit of scientific guesswork, but it is essential. We expect to see forecasts that include a high, medium, and low case, based upon a probability for each scenario.

Let’s say that you go through all this work and determine that a probability-based approach yields average annual cash flows of $15 million per year for the remaining plant life of 15 years. The undiscounted gross cash flows of the plant are expected to be $225 million. If the undiscounted cash flows are greater than the net book value of the plant ($125 million in our example), there is no plant impairment. You go on with life as normal (at least for another year).

However, if the results of your cash flow analysis had yielded average annual cash flows of $5 million per year for 15 years ($75 million undiscounted gross cash flows), you have an impairment problem. In this latter case, the plant would have to be written down to its market value.

Market value is different from undiscounted gross cash flows. The market value is the amount at which an asset could be bought or sold in a current transaction between willing parties. Market value most likely will be substantially less than the undiscounted gross cash flows. For many plants right now, marking a plant to market would involve a substantial reduction of the plant’s book value and its equity.

Just because the plant across the road obtains a low value appraisal doesn’t mean that you automatically have to adjust your plant’s value to current market value. Your plant’s ability to generate future cash flows will determine its market value. It’s all in the numbers. And it’s about time.