Lender question:
Do you use historical costs or fair market value in a partnership’s balance sheet?
Linda says:
That word ‘value’ gets in the way in accounting. There is Fair Market Value, Liquidation Value and Book Value. Then there is historical cost. Which is used when?
Value definitions
In my series on Financial Statement Analysis at www.LendersOnlineTraining.com, the issue of what ‘value’ means comes up repeatedly. Here are some definitions from the eCourse on Financial Statement Terminology:
Fair Market Value: Willing buyer, willing seller, neither under pressure to buy or sell.
Liquidation Value: Seller must sell quickly and buyer might get a very good deal.
Book Value: Cost of the asset less accumulated depreciation based on Generally Accepted Accounting Principles (GAAP).
Historical cost vs Fair Market Value
On personal financial statements we use fair market value. This is often a guess rather than based on a recent appraisal.
On business financial statements prepared based on GAAP (or another comprehensive basis of accounting), we use historical cost.
And since depreciation has reduced the carrying ‘cost’ on the balance sheet, the impact of a fixed asset (equipment, buildings and the like) on the total assets figure on the balance sheet is reduced by the accumulated depreciation on those assets.
Thus, a business balance sheet is at historical cost and the fixed assets are reduced by accumulated depreciation, resulting in ‘Book value’. Another way this is expressed is ‘Assets net of accumulated depreciation’.
Wouldn’t Fair Market Value be more helpful?
Perhaps, but it sure would take longer to crank out the month-end financials. And the business would have to pay for an appraisal each month. So cost and timeliness factors lead us to use historical cost, a very objective figure that can be determined quickly and with accuracy.
It is critical, then, that users of business financial statements understand the difference.
What difference does it make?
If you are looking at personal financial statements, be skeptical of the ‘values’ the borrower has assigned to his/her assets. If you need to liquidate, or if they need to sell at fair market value, the market may have a different ‘value’ in mind.
If you are looking at business financial statements, be clear that the assets are not carried at fair market value or liquidation value. If the asset is collateral for a loan you are considering, you need current appraisal information.
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