3.07 – Recognising The Confusing Mixture of Values Reported in Your Balance Sheet
Understanding Balance Sheet Values
The values reported for assets in a balance sheet can often be confusing for business managers and investors. While it might seem that all dollar amounts are equal, the reality is that some dollars are much older than others. For instance, a dollar reported in accounts receivable is quite different from a dollar in property, plant, and equipment or retained earnings.
The dollar amounts on a balance sheet result from various transactions recorded in assets, liabilities, and owners’ equity accounts. Some transactions from many years ago can still impact current asset balances. For example, the value of land purchased decades ago remains the same on the balance sheet, while accounts receivable typically reflect recent transactions.
Book Values vs. Market Values
Book values are the amounts recorded during the accounting process and reported in financial statements. It’s important to understand that these book values do not necessarily equal current market values. Generally, cash, accounts receivable, and liabilities are reported at amounts close to their market values. For example, accounts receivable are expected to be converted to cash at the reported amounts, and liabilities will be paid off at the reported amounts.
However, fixed assets and other long-term investments usually have book values lower than their current replacement values. For instance, the cost recorded for property, plant, and equipment does not reflect their current market value or replacement cost.
Unrecorded Assets
Businesses may also possess unrecorded or off-balance-sheet assets, which include intangible assets such as a strong reputation, secret formulas, patents, and a highly trained workforce. These assets, although not recorded on the balance sheet, contribute to the business’s overall value and often result in better-than-average profit performance.
Fixed Assets and Replacement Costs
The current replacement values of a company’s fixed assets, such as buildings, land, and machinery, can be significantly higher than their recorded costs. For example, the aircraft fleet of an airline might have a recorded value much lower than the cost of replacing those planes with new models. This discrepancy is due to the aging of assets and changes in market prices over time.
Market-to-Market Valuation
Businesses are generally not allowed to adjust the book values of their assets to current market or replacement values. Although investments in marketable securities may be written up or down, this is an exception. While recording assets at their market value might seem appealing, it’s not practical for businesses that rely on their assets for ongoing operations. These assets are typically used until the end of their useful lives and then sold for their residual values.
Market Value of a Business
The market value of a business is not simply the owners’ equity reported on the balance sheet. Valuing a business involves several factors beyond the latest balance sheet, including market conditions, future earning potential, and intangible assets.
