Deconstructing the assumptions used for reported book values
Getting familiar with the concepts of book value, depreciation, and amortization can help you understand the costs of creating a company's goods and services.
- DST Systems, Inc.
The book value of a company asset as reported in the company's balance sheet may or may not represent the actual market value of that asset or the future economic value to the company. This article looks at assumptions used to generate reported book values that may contribute to potential divergence.
Conceptual overview of book value
Fundamentally, the book value of an asset is the value at which it is carried on the company balance sheet. Initially, the typical tangible business asset's book value is its net acquisition or creation cost. But as the asset is used over time, its value on the balance sheet is reduced to reflect the fact that assets are typically worn out or used up eventually. For a physical asset such as a computer or motor vehicle, the reduction in value is called depreciation. For an intangible asset such as a patent, the reduction in value is called amortization.
The overall methodologies that can be used for depreciation and amortization calculations are governed by generally accepted accounting principles. The amount of the reduction is normally fixed by formula (a percentage or dollar value for each unit of use), by schedule (a fixed amount for each specified unit of time) or by some combination of those factors. Keep in mind that land and certain other assets are not normally depreciated but are retained on the balance sheet and generally valued based on their historical cost.
The total of depreciation and amortization reductions is recorded each accounting period and deducted from the previous period's book values. The same amounts also appear in the expense category of the income statement.
Special case 1: Asset impairment
Business assets can lose economic value more rapidly than originally foreseen. Dramatic increases in energy prices, for example, depressed the values of inefficient aircraft, trucks, and power plants, making it economically impractical to run them. Development of new technologies, products, and markets can make serviceable but older machinery obsolete. Inefficient or obsolete units can be simply idled for some time with the expectation that changing conditions will make them economically viable again, or they can be classed as impaired.
An asset that is idled simply incurs costs for maintenance and storage. But once an item is determined to be impaired, it must have its value reduced to an appropriately lower level, and the amount of the reduction must be recognized as a charge against income. If the value of the asset rebounds after an impairment write-down, there may be ways to harvest the gain. But asset impairments that remain unrecognized and unaccounted for can be a significant hidden cost for investors.
Special case 2: Capturing changes in an asset's market value
The equipment used to produce goods and services is often the largest single category of depreciating assets on a company balance sheet. Such assets are commonly valued using their historical acquisition or creation cost as the basis. But there are many assets that can or should carry a balance sheet value derived from recent market activity rather than historical cost. And when the market signals a change in these asset values, the asset holder's balance sheet value should be revised accordingly. This is the root of the shorthand term mark-to-market.
Financial securities are a major category for this kind of asset and they may represent a significant portion of the assets held by many nonfinancial corporations as well as by banks. Among the reasons for these holdings are activities such as commodity and currency hedging, pension plan financing, and long-term cash management. Generally speaking, only financial securities designated to be held to maturity can be valued based on their historical cost and amortization factors. All other securities must be marked to market in each reporting period, with gains or losses reported either as an element of income (for securities held for trading) or a change in shareholder equity for that period (for securities held as available for sale). In all of these cases, the practices used by a company to categorize its mark-to-market assets can have a material impact on the effects of its marking to market activities; so can the company's choice of market value benchmarks.
Special case 3: Exclusion from depreciation or amortization
Goodwill and real property are 2 major asset categories for which there may typically be no depreciation or amortization.
As an asset, goodwill is created when a company buys a functioning business and integrates the new business into existing operations. All identifiable assets of the new acquisition are recorded by the acquiring company at their individual acquisition-time fair market values. If the sum of those values is less than the purchase price of the entity as a whole, the difference is recorded as an asset known as goodwill. To the extent that goodwill represents factors such as the brand equity and customer relationships of the acquired firm, it can have an indefinite useful life so it need not be subject to periodic reduction by amortization. Instead, the acquiring company should reevaluate its goodwill assets periodically to determine whether they have become impaired and if so, by how much, applying those values to the balance sheet and income statement as appropriate. As with marking to market, management practices of goodwill and its potential impairments can have a material impact on a company's post-acquisition results.
For the purposes of depreciation, real property is considered distinct from the buildings and other structures on the land. The so-called improvements are generally depreciated; only the value of the land itself is not. Few publicly traded companies are likely to have material amounts of real property assets on their balance sheets. Notable exceptions might be holdings of farm, grazing, forest, and mineral tracts. Long-time holdings of these resources may be carried on the books at prices that had prevailed decades ago, which means they may represent significantly undervalued assets.
The concepts of book value, depreciation, and amortization were formulated largely to help investors understand the costs of creating a company's goods and services. Other uses of book value may have limitations or call for adjustments.
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