A company's balance sheet gives investors an idea of the total value of its assets, which has a host of implications for company valuation and measures of profitability and efficiency. However, it's critical to recognize that there is more than one way to measure value. Asset values reported on the balance sheet may be very close to fair market value – that is, what the company could get for the assets if it sold them. But they may also be markedly different.
Balance Sheet Value
Under corporate accounting standards, when a company acquires an asset, it puts that asset on its balance sheet with a value equal to its "historical cost" – what the company paid for it. If it's a fixed asset with a limited lifespan, such as a building or a piece of equipment, the company gradually depreciates that asset over time, which reduces its balance sheet value. Even if the company has good reason to believe that an asset has risen in value, it still cannot increase that asset's "book value," the value reported on the balance sheet. Tradable securities, such as stocks and bonds, are an exception, however, are "marked to market," or reported at their current market price.
Fair Market Value
The fair market value of an asset is the price someone would pay for it in an "arm's-length transaction," which accounting standards define as a sale between an unrelated seller and buyer, neither of whom is under pressure to make the deal. Companies may have a good idea of the fair market values of their assets, but they can't use those values on the balance sheet because the only way to "prove" that they're correct would be to actually sell the assets. The reason some securities can be marked to market is that their fair market value can be easily and objectively determined simply by looking at the current price in financial markets.
Role of Depreciation
People commonly refer to depreciation as the decline in value of an asset due to wear and tear. Since the balance sheet value of an asset is its cost minus any depreciation, that would suggest that the balance sheet value is in fact also the market value. But in fact, depreciation isn't used to establish the value of an asset; rather, it's an accounting technique used to spread the expense of the asset over its estimated lifetime. For example, if a company spends $100 million on a factory and depreciates the cost evenly over 50 years, then after one year, the balance sheet value will be $98 million, and the company with report a $2 million expense; after two years, the book value will be $96 million, and the company reports another $2 million expense; and so on. But the factory itself may still have a fair market value of $100 million or even more.
Many companies have incredibly valuable assets that don't appear on the balance sheet at all. Famous examples include the secret formula for Coca-Cola or the rights to Mickey Mouse. Coke didn't buy its secret formula from anyone, and Disney didn't buy Mickey. These assets were generated by the companies themselves, so they have no measurable historical cost. There's nothing to put on the balance sheet. Further, unless Coke sells its formula to someone else or Disney puts Mickey up for auction, there's no way to determine fair market value. These assets remain "invisible" in the companies' financial statements.
- Jupiterimages/Creatas/Getty Images