Historical costs. Generally, the company's assets are stated as historical costs. For example, land acquired 20 years ago for $300,000 is carried on the books at $300,000, even though its current market value may be significantly more. In addition, book value reflects the "capitalized" cost of an asset less accumulated depreciation, depletion or amortization. This means that a piece of equipment acquired for $60,000 and expected to have a 10 year life will have a book value of $36,000 after 4 years, assuming straight-line depreciation of $6,000 per year. This value says nothing about the equipment's salvage value, replacement cost or productive value to the business.

Example

Corporations can distribute their assets to shareholders in a variety of ways—paying dividends, capital (non-earnings) distributions, and stock redemptions and repurchases. Nearly all corporation statutes, however, set limits on when corporate distributions are legally authorized.

Some jurisdictions use so-called “balance sheet tests” to decide when distributions are authorized. As the name implies, these tests use entries made on the corporation’s balance sheet to evaluate whether specified accounts are sufficiently large for a particular distribution to be made. Of course, this book value measure of a company’s financial condition almost invariably bears little resemblance to reality.

Supporters of “balance sheet tests” generally concede that historical cost measurements fail to account for the usually higher going-concern value of the company, but they stress that asset values provide creditors a valuation “floor”—a guarantee of at least a minimal amount “legal capital.”

Though these statutory balance sheet tests are falling out of favor in many states, they still linger on in some key jurisdictions—most notably Delaware. See Del. GCL § 170 (dividends), § 160 (repurchases).

Critique of book value. Book valuation suffers from a number of defects:

• Accountants tend to be conservative and do not "write up" the book value of assets to reflect appreciation or an asset's current market value.
• Many assets (such as equipment) are depreciated on the accounting books and may have minimal book value, even though they have significant market value and contribute significantly to earnings.
• Sometimes depreciation is accelerated to take advantage of favorable tax rules -- for example, R&D equipment can be depreciated over 5 years even though its useful life might be 30 years.
• Some extremely valuable assets (such as trademarks and customer goodwill) and terribly relevant liabilities (such as pending lawsuits or environmental claims) are not reflected on the books at all.

Compare the book value of a publicly traded company’s common stock as reported on its balance sheet to the market price. [Look at the attached balance sheet of General Electric (from 2001 annual report)]. Its common stock had a book value of $14.84 per share. Nonetheless, on the New York Stock Exchange, the company's shares never traded below $30 per share during the company’s 2001 fiscal year. Book value for GE, as is true for many companies, has no relation to the value investors place on the shares.

Nonetheless, perhaps irrationally, many investors consider book value to be a floor below which stock prices should not fall. In fact, a company with small or even negative book value may be paying significant dividends -- something which normally increases a company's value.

[example of book value difference between inventory carried using LIFO versus FIFO]

Example

Does book value every play a significant role in major business valuations. Amazingly, yes.

A startling example can be found in the 1998 merger of NationsBank (Charlotte) into the old BankAmerica (San Francisco) -- now combined as Charlotte’s Bank of America. One of BankAmerica’s assets was a portfolio of bonds with a book value of $20 billion. During the time leading up the merger these bonds had fallen in value by hundreds of millions of dollars. What value was reported to the NationsBank and BankAmerica shareholders who had to approve the merger?

Answer: Book value! The shareholders did not know that this investment was hemorrhaging money until after the merger was consummated.

Was this an example of corporate fraud? Not at all. National banks are subject to a special regime of financial disclosure regulation under federal law—different from the accounting standards under GAAP imposed by FASB and the SEC. The banks were acting well within these special reporting requirements. Martin Mayer, a fellow at the Brookings Institution, explained:

Asked in October why the bank continued to carry its Shaw investment [the bond portfolio] at cost in August, when the losses in the deal became overwhelmingly apparent, a spokesman said the bank had believed that the values would come back with the passage of time—and, anyway, the Comptroller of the Currency, the bank's federal supervisor, had known all about it. If Shaw as an investment company had tried to value its holdings in the joint venture at cost, somebody could have gone to jail. But the bank could do so, because banking regulators have long permitted banks to state their assets at "historic cost," without reference to market value.

Bonds held in a bank's trading portfolio, as distinguished from bonds in its investment portfolio, must be carried at market price, but the bank itself decides which portfolio is which. In an activity called cherry-picking, bonds that show a profit can be moved into the trading account and sold to improve reported earnings while bonds that show a loss are slotted into the investment account and carried at cost. To keep bonds in the investment account, a bank need merely declare an "intention" to hold the paper to maturity. The chief accountant of the Securities and Exchange Commission in the late 1980s expressed his distaste for this brand of "psychiatric accounting," but banks are supervised by banking regulators, not by the SEC.

Martin Mayer, “BankAmerica Disaster Arose From a Lack of Standards,” Wall St. J., A22 (Oct. 27, 1998).