Assets are vital for any business as they can be a source of future revenue as well as can be a means of meeting its liabilities. Valuation of assets is an important part of both financial as well as tax accounting. Valuation of assets also plays an important role in gauging the net worth of a business.
This article looks at meaning of and differences between two different types of asset valuations – book value and fair value.
Definitions and meanings
The book value of an asset is the amount at which it has been originally recorded in the books of accounts at the time of recording of the related transaction. This means that the book value is determined with reference to balance sheet values on any given date.
Book value for different assets/liabilities can be derived as follow:
- Historical cost i.e., original cost of purchase for tangible fixed assets
- Cost of development originally recorded for intangible fixed assets
- Amount due as per books of accounts for debtors and other receivables
For example, XYZ and co. has purchased machinery for $10,000 at the start of Year 1. This is depreciated as per accounting policies at 15% written down value method each year. The book value of this machinery will change each year:
As demonstrated above, book value of assets especially fixed assets change over time, primarily due to wear and tear in use.
Book value of assets is of relevance in businesses that follow historical-cost method accountant. Book value concept is also more important for asset heavy businesses such as manufacturing companies rather than service companies which do not rely so much on fixed assets for revenue generation.
The fair value (also termed as fair market value) of an asset is the monetary amount that the asset can be reasonably expected to fetch in the open market at the prevalent prices. Fair value effectively indicates the true worth of an asset.
There are several approaches which can be applied for determination of fair value of assets:
This involves determination of the market price of an asset by reference to market information on similar assets
Determination of replacement cost of the asset i.e.: the amount that would be required to replace the asset at current market prices and conditions
Determination of present value of future cash flows expected to be generated from the operational use of the asset. This method is mostly used when market information on prices is not available.
Example – stock investments are generally valued at their fair values i.e., their net asset value (NAV) as on the date of the balance sheet.
Fair value of assets is important when businesses apply fair value accounting. It is also important in the determination of true net worth of a business for which fair value of assets would be relevant.
Difference between book value and fair value
The main difference between book value and fair value of assets have been detailed below:
- The book value of an asset is the amount at which it has been recorded when the related transaction was accounted for.
- The fair value of an asset is the monetary value that the asset expects to get when sold in the open market.
2. Method of determination
- There is primarily one method of determining book value of assets – identification of historical cost with reference to balance sheet values.
- Fair value can be determined by one of 3 methods – market approach, cost approach and income approach
3. Ease of determination of value
- Book value of assets is easier to determine as it requires reference to reported balance sheet values.
- Fair value of assets is more complex to determine as it requires detailed information of market conditions and prices. If market prices are not available then information on future cash flows is required.
4. Applicable to method of accounting
- Book value of assets is of relevance in historical cost method of accounting.
- Fair value of assets is of relevance in fair value method of accounting.
5. Relevance of period of time
- Book value considers past or historical costs which have been recorded in the books of accounts at the time of occurrence of the transaction.
- Fair value on the other hand considers current market price or present value of future cash flows. Historical cost has limited relevance.
6. Factors effecting it
- There are limited factors that impact change in book value of assets – primarily passage of time and wear and tear in use.
- There are multiple factors that impact change in fair value – market conditions such as competition, demand and supply, availability of buyers etc.
- Book values are less accurate in reflecting true net worth of a business as they reflect past costs, not the current fair market values.
- Fair values are more accurate in reflecting true net worth as they consider prevalent market prices.
- Book value concept is more relevant for fixed assets such as plant and machinery and such tangible assets which are recorded at cost and depreciated over time.
- Fair value concept is more relevant for assets whose values vary significantly in relation to market conditions such as stock investments.
Book value versus fair value – tabular comparison
A tabular comparison of book value and fair value is given below:
|Transaction value at which asset has been recorded||Money value that can be expected to be received when asset is sold in the open market|
|Method of determination|
|One – reference to balance sheet values||Three – market approach, cost approach, income approach|
|Ease of determination|
|Applicable to method of accounting|
|Historical cost method||Fair value method|
|Relevance of period of time|
|Considers past or historical costs||Considers prevalent market price or present value of expected cash flows|
|Factors affecting it|
|Accuracy in determination of net worth of business|
|Less accurate||More accurate|
|Plant and machinery valued at original cost of purchase less accumulated depreciation||Stock investments and marketable securities recorded at net asset value|
Conclusion – book value vs fair value:
Both book value and fair value of assets are used to determine net worth of a business. Which one of the two values is more useful depends on the information needs of each individual user. Investors can compare the net worth resulting under these two methods to gauge whether a business is correctly valued or not. To determine the true worth of a business, the fair values of assets are more relevant than the book value.