Business Acquisitions – Book Value Vs Fair Market Value

Book value is the accounting value of a firm and often bears little relation to an asset’s market value. It is a generally accepted accounting principal (GAAP) term that reflects the net dollar value at which the historical cost of assets are recorded on a firm’s balance sheet and represents the price paid for an asset minus the accumulated depreciation. Carrying value or depreciated cost are other terms that the financial community will use to reference book value.

Fair Market Value (FMV) is the most widely recognized and accepted standard of value for asset transfer in business acquisition and sales. The ASA definition of FMV is “the amount at which the property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.”* The concept of FMV relates to the value at which a transfer of assets should be anticipated to occur under conditions existing at the time and date of a business valuation.

The easiest way to describe the two values is to understand that book value represents the depreciated value of what was paid for a particular asset, while market value represents the current price at which that asset can be purchased in the marketplace.

Fixed assets like machinery, equipment, buildings, and vehicles which are expected to last for more than 1 year can be depreciated as an expense on the profit and loss statement based upon the annualized usage cost of these assets. From an accounting perspective, depreciation transfers a component of the asset’s cost from the balance sheet to the P&L during each year of the anticipated life of the asset. There are a variety of depreciation methods that meet the GAAP standards and they are typically grouped into two classes: (1) straight line (2) accelerated. The fact that many owners choose an accelerated method to reduce their short term tax liabilities adds additional confusion when evaluating balance sheet values.

For example, let’s say that a business bought a piece of machinery or vehicle for $50,000 which had an expected life of 5 years. If the owner decided to use straight-line depreciation, the book value is decreased by $10,000 for each of the 5 years. If instead they opted for an accelerated method, like double declining balance, the book value is decreased by $20,000 the first year. In each of these cases the “book” value of the asset will be different and neither will have a bearing on the “market” value, as there is absolutely no way to calculate the market value of a business asset from a balance sheet.

According to the IRS, there is no simple formula to derive FMV. Depending upon the type of asset, there are many methods and industry resources utilized to value items, similar to “blue books” for automobiles. The original value of an item can also be irrelevant especially when considering that a variety of assets have appreciated in value during the very same period that the CPA has been depreciating them. This will cause certain assets being listed on the balance sheet at a fraction of their FMV value. Replacement cost is another indicator of FMV but even this process may not have a direct relationship to the assets true worth. When the FMV is in question, the recommended approach is to engage a professional firm who specializes in the valuation of each particular asset classifications.