The balance sheet is a financial statement that depicts a company's financial condition at a specified moment. It shows what the company owns, its assets; what the company owes, its liabilities; and its net worth (owners' equity), the difference between assets and liabilities. Fair and book value are two metrics used to valuate the worth of balance sheet assets.
Book value can have two definitions in accounting. The first defines the liquidation value of a firm as in bankruptcy liquidation. Book value can also refer to the depreciated value of fixed assets. Assume a company bought a building for $1 million 10 years ago and is depreciating the building on a fixed schedule of $33,000 per year over 30 years. The book value of the building today is $667,000 ($1 million minus $333,000 in depreciation).
Unlike buildings that are relatively easy to valuate, some balance sheet assets are hard to quantify without valuation rules that instill confidence that the process is logical and the results are rational. The rules for valuating hard-to-quantify assets are explained in SFAS 157, which is a Statement from the Financial Accounting Standards Board that took effect in February 2007. SFAS 157 has the objective of removing uncertainty that asset stated values represent "fair value" consistent with Generally Accepted Accounting Principles, or GAAP.
SFAS 157 sets guidelines for quantifying the fair value of assets based on the "selling" or "exit" price of assets in active markets. Where active markets don't exist, SFAS 157 allows companies to make their own assumptions using specific FASB guidelines. SFAS 157 groups assets into three categories: Level 1 assets with active markets and verifiable selling prices; Level 2 assets without active markets and require computer modeling techniques using the selling prices of similar assets; and Level 3 assets that don't have active markets or similar assets for selling price equivalencies.
Fair Value Accounting
Fair value accounting requires companies to adjust assets in a timely manner to reflect current market prices. This adjustment, called "mark-to-market," can sometimes hurt companies in volatile industries. Consider the 2008 housing crisis when the market demand for mortgage-backed securities collapsed. Companies holding mortgage-backed securities as Level 1 assets saw those assets deteriorate to Level 3 assets virtually overnight. In consequence, many of the nation's largest financial institutions had to take huge asset write-downs (reductions in value) to comply with SFAS 157. In turn, this reduced stockholder equity in many financial institutions because owners' equity equals assets minus liabilities.
Relevance of Fair Value Accounting to Consumers
Fair value accounting impacts ordinary consumers in many ways. Consider, for example, access to credit. The Federal Deposit Insurance Corporation requires that banks maintain a minimum capital (owners' equity) to total assets ratio of 4 percent. Most bank assets are loans to bank customers. For every $100 a bank lends to consumers, it must have $4 in owners' equity on the balance sheet. When banks had to mark-to-market mortgage-backed securities in 2008, it reduced the value of their assets and their owners' equity, which restricted the ability of many banks to make loans to consumers for mortgages and other consumer expenditures.
Book value is the price paid for a particular asset. This price never changes so long as you own the asset. On the other hand, market value is the current price at which you can sell an asset.
For example, if you bought a house 10 years ago for $300,000, its book value for your entire period of ownership will remain $300,000. If you can sell the house today for $500,000, this would be the market value.
Book values are useful to help track profits and losses. If you have owned an investment for a long period of time, the difference between book and market values indicates the profit (or loss) incurred.
The need for book value also arises when it comes to generally accepted accounting principles. According to these rules, hard assets (like buildings and equipment) listed on a company's balance sheet can only be stated according to book value. This sometimes creates problems for companies with assets that have greatly appreciated - these assets cannot be re-priced and added to the overall value of the company.