Book Value

April 13, 2006

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When valuing a business interest as part of a buy-sell agreement, book value represents the allocated amount of the particular interest, as recorded in the entity's accounting records. Thus, the amount is already determined. Accordingly, book value has the advantage that a costly appraisal is unnecessary.

On the other hand, book value should never be confused with fair market value. When an interest is being purchased at book value, the seller is not receiving the fair market value of his interest. Typically, but not always, book value will be lower than fair market value. Thus, purchase at book value is simple, but can be inherently unfair to the withdrawing owner.

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The book value of a business is the amount recorded in the entity's accounting records for the owners' equity in the business. The book value of the business is also equal to the recorded "net assets" of the entity (i.e., the recorded amount for the assets, minus the recorded amount for the liabilities).

Book value is likely to be significantly lower than fair market value, especially in a thriving business, for two reasons. Under conventional accounting practices, one very valuable asset is not even recorded in the entity's accounting records--the business's internally generated goodwill. In many small businesses, this will be the entity's most valuable asset, one that, in fact, would represent a significant portion of the purchase price if the business were sold to an outsider. Because goodwill is not recorded, book value automatically excludes goodwill.

In addition, conventional accounting practice is still largely based on the historical cost principle. This principle dictates that, generally, with the exception of certain investments, assets remain in the entity's books at historical cost. In particular, subject to this narrow exception, while assets are written off or depreciated as they expire or, in some cases, when they suffer a decline in value, the recorded amount for assets is never increased for increases in the assets' fair value.

In short, the amounts for assets in the entity's accounting records (i.e., the book value) do not reflect fair market value, but instead reflect the original cost or a lower amount. In fact, with buildings, the discrepancy between book value and fair market value can be extreme. As buildings age, they are written off, through a process termed "depreciation." Yet, in reality, buildings usually appreciate in value. Thus, over time, the two amounts actually move in opposite directions, making the discrepancy larger.