An overview of book value and fair value
Book value and fair value are two different accounting measures used to determine the value of a company’s assets.
Book value or book value is an asset based on the company’s balance sheet, which takes the cost of the asset and subtracts its depreciation over time. The fair value of an asset is usually determined by the market and agreed upon by a willing buyer and seller, and can often fluctuate. In other words, book value usually reflects equity, while fair value reflects the current market price.
Because an asset’s fair value can be more volatile than its book value or book value, large discrepancies between the two metrics can arise. The market value can be above or below the book value at any time. These differences are not typically examined until assets are valued or sold to determine whether they are undervalued or overvalued.
The book value of an asset is based on figures from a company’s balance sheet. When a company first acquires an asset, its carrying amount is equal to its cost. However, this is changing over time. To calculate the book value, or book value, of an asset at any point in time, you must subtract any accumulated depreciation, amortization, or depreciation costs from its original cost.
Book value example
Let’s say company ABC bought a 3D printing machine to design prototypes of their product. The 3D printing machine costs $50,000 and has a depreciation expense of $3,000 per year over its 15-year useful life under the straight-line calculation basis of depreciation and amortization.
The linear basis is a simple way to calculate an asset’s depreciation over time. This calculation is particularly useful for physical assets – such as a device – which a company could sell in whole or in part at the end of its useful life. Therefore, after 15 years, the book value of the 3D printing machine is $5,000 or $50,000 – ($3,000 x 15).
Unlike the book value, the fair value of assets and liabilities is calculated on a mark-to-market basis. In other words, the fair value of an asset is the amount that will be paid in a transaction between participants when it is sold in the open market. A willing buyer and seller have agreed on this value. However, due to the changing nature of open markets, the fair value of an asset can vary significantly over time.
Example of fair value
Suppose an investment company has long positions in stocks in its portfolio. By taking long positions, the company anticipates favorable market conditions, also known as “bull markets”. The company holds onto these stocks with the expectation that they will appreciate in price over time.
The investment company’s original cost for these assets was $6 million. However, after two negative rates of gross domestic product (GDP), the market is experiencing a significant downturn. The value of the company’s portfolio falls 40% to $3.6 million. Therefore, the fair value of the asset is $3.6 million or $6 million – ($6 million x 0.40).
Determining the fair value of an asset can be difficult if there is no competitive, open market for it – for example, an unusual piece of equipment at a manufacturing facility.
The central theses
- Book value and fair value are two different accounting measures used to determine the value of a company’s assets.
- The book value of an asset is based on figures from a company’s balance sheet.
- The fair value of an asset is the amount that will be paid in a transaction between participants when it is sold in the open market.