Difference between book value and fair value


Learning objective:
What is the Difference between book value and fair value?

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

Book value:

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:

  1. Historical cost i.e., original cost of purchase for tangible fixed assets
  2. Cost of development originally recorded for intangible fixed assets
  3. Amount due as per books of accounts for debtors and other receivables

In the case of fixed assets, the book value would be reflected as the above amount/s net of any accumulated depreciation or amortization arisen out of normal wear and tear and impairment if any.

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.

Fair value:

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:

Market approach:
This involves determination of the market price of an asset by reference to market information on similar assets

Cost approach:
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

Income approach:
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:

1. Meaning

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.

The fair 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.

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.

7. Accuracy

Book values are less accurate in reflecting true net worth of a business as it reflects past costs.

Fair values are more accurate in reflecting true net worth as they consider prevalent market prices.

8. Examples

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:

Book value vs Fair value
Meaning
Amount at which it has been originally recorded in the books of accounts Amount that the asset can be reasonably expected to fetch in the open market at the prevalent prices
Method of determination
One – reference to balance sheet values Three – market approach, cost approach, income approach
Ease of determination
Simpler More complex
Applicable to method of accounting
Historical cost method Fair value method
Relevance of period of time
Considers past or historical costs Considers current market price or present value of future cash flows
Factors affecting it
Limited Multiple
Accuracy in determination of net worth of business
Less accurate More accurate
Example
Plant and machinery valued at original cost of purchase less accumulated depreciation Stock investments 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.

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