Accountants will often use terms like fair value or book value for valuations. These are also terms used in the finance world. Fair value and book value are different aspects of assessing the value of an asset. It’s important for anyone in the finance and accounting world to properly understand the meaning of both terms and what differentiates them apart. We will be exploring the meaning of fair value and book value along with their differences in this article.
Fair Value: Definition
An item’s fair value is defined as an estimation of its intrinsic value. This intrinsic value should be determined without any bias in judgment. Take it as the item’s potential value if it were to be sold. Since evaluating fair value requires some level of judgment, it can lead to fraud since management can easily manipulate the data and calculations of fair value.
Book Value: Definition
Book value is a little more straightforward than fair value since it’s easier to determine and less prone to fraud. An item’s book value is essentially the cost of acquisition minus amortization, any depreciation or impairment costs. In accounting, assets are recorded at their book value on the balance sheet, which is also known as the historical cost. As time goes by, the book value is adjusted with amortization, depreciation or impairment. Knowing the book value of an asset is important as it allows management to analyze whether there’s any gains or losses on an asset when compared to the fair value.
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Fair Value vs Book Value: Differences
We learned what fair value and book value means, which now allow us to better understand their differences:
- Book value is related to the cost of an asset whereas fair value represents what an asset is worth.
- Book value is obtained by adjusting the cost with any impairment, amortization or depreciation. Fair value can be determined in multiple ways, such as using the market price, comparable prices of similar items or discounted cash flows.
- Book value is an objective value, usually determined with tangible evidence (proof of purchase for example) whereas fair value is more subjective and requires judgment in determining the value.
- Fair value represents the value of an asset more accurately than book value since the fair value reflects what an asset can be sold or exchanged for.
- Fair value can be at more risk of fraud due to the subjectivity level it requires in the calculation and determination of fair value. Book value can be a little less manipulated since it’s the cost of an asset adjusted by depreciation, amortization and impairment. Although the concepts of depreciation, amortization and impairment are not perfectly accurate, it’s still easier to calculate than fair value.
- Book value tends to stay the same or falls (due to amortization, depreciation or impairment) whereas fair value can fall or rise.
- Fair value is often used as a replacement value. This means that when you need to replace an asset, you generally need to know the fair value of the asset since the replacement will require you to pay the fair value representing the value of an asset in the current market instead of the book value, which is a historical cost and no longer applicable.
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The Bottom Line: Fair Value vs Book Value
Fair value and book value are two very different concepts when it comes to the valuation of assets. Understanding the difference between the two concepts will be crucial for anyone working in accounting or finance. Book value is defined as the acquisition cost of an asset adjusted by any decrease in value due to wear and tear such as depreciation, amortization or impairment.
It’s an objective way of evaluating an asset. Fair value on the other hand, is a bit more subjective and requires judgment. It represents the worth of an asset. Fair value is essentially how much money you can receive if you sell the asset. The difference between the fair value and the book value will represent a gain or loss.
