Explore the difference between market value and book value and see comparisons in this video.
- Although the balance sheet is useful in showing the financial status of a company, it does have limitations. Primarily it does not reflect the current value or worth of a company. What the balance sheet reflects is the value of a company's net assets, assets less liabilities that are recorded on the books, or in other words, the company's book value. Reorganizing the accounting equation results in the following. Assets minus liabilities equals owners' equity, and owners' equity is the owners' residual interest in the company as per the books, or the book value of the owners' interest.
Now if the balance sheet were perfect, meaning that it included all economic assets reported at their current market values, then the amount of owners' equity would be equal to the market value of the company. Another way to say that is if the balance sheet were perfect, the book value of a company would equal its market value. In the case of Microsoft, for example, the company's book value on June 30th, 2017 was $72 billion. That was computed as shown here.
$241 billion in assets less $168 billion in liabilities equals $72 billion in owners' equity. In contrast, Microsoft's market value on that day was over $530 billion. How could the balance sheet be so wrong? The discrepancy between recorded balance sheet value and actual market value is the result of the following factors. First, accountants record many assets at their purchase cost, not at their current market value.
Market value is the price that would have to be paid today to buy the same asset. For example, if land was obtained 10 years ago, it would still be reported on the balance sheet at its original cost, even though its market value may have increased dramatically. And second, not all economic assets are included in the balance sheet. For example, some of the most important economic assets of Microsoft are its employees, its installed user base and suite of software programs.
These intangible factors are all very valuable economic assets. In fact, they are by far the most valuable assets Microsoft has. Nevertheless, these important economic assets are outside the normal accounting process. Because the balance sheet can under-report the value of some long-term assets and not report other important economic assets, the accounting book value of a company, measured by the amount of owners' equity, is usually less than the company's market value as measured by the market price per share times the number of shares of stock.
Yet despite its deficiencies, the balance sheet is a useful source of information regarding the financial position of a business. A lender would never loan a company money without knowing what assets the company has and what other loans the company is already obligated to repay. An investor shouldn't pay money in exchange for ownership in a company without knowing something about the company's existing resources and obligations. When a balance sheet is classified and when comparative data are provided, the balance sheet provides an informative picture of a company's financial position.
Stay tuned for Part 2 of the training series, which covers ratio analysis, forecasting, and business valuation.
- Explain the equality required in the basic accounting equation.
- Recall why accounts payable are considered Current Liabilities.
- Identify which financial statement can be described as a “snapshot” of a company’s final position.
- Name the term used to refer to a company where the Operating Cash exceeds the investing and Financing activities.
- Identify the result of entering a debit in an expense account.
- Name the account that is closed at the end of the year.