Book value, simply defined, is the carrying value on the books for any asset or liability. Companies in the United States, in conjunction with Generally Accepted Accounting Principles (GAAP), initially record all assets at their acquisition price or historical cost.
The acquisition price for items such as buildings, land, and equipment is more than the value of the assets themselves. The acquisition cost for these items include incidental costs associated with purchasing the assets. These fees include such things as land preparation fees and broker fees. Although originally recorded at historical cost, all assets are not carried forward in the books at their acquisition cost. Buildings and equipment for example are depreciated each accounting period in conjunction with how much of their useful life has expired. An example of the effect of depreciation would be the purchase of tractor for $12,000 dollars with a useful life of six years and depreciated on a straight line depreciation basis. Using straight line depreciation, the book value of the tractor would decrease by $2000 each year eventually going down to zero by the end of the sixth year. Now, imagine that you wanted to sell that tractor after four years. Also, imagine that according to historical data, a tractor comparable to the one you own will sell for fifty percent of its original acquisition cost. What important distinctions can you make about the difference between book and market values? This simple example sheds light on a very important point: book and market value are very rarely the same. In this example, the tractor would be worth $6000 in the market, but only $4000 in the books ($12000 book value – (4*$2000) depreciation. How do we reconcile the difference between book and market value? In this case, if you sold the tractor for $6000, you would have to pay taxes on the difference between the sale price and the book vale. Using a 35% tax liability, you would have to pay ($6000- $4000)* .35 or $700. The theory behind this tax fee is the simple fact that in reality, the tractor was over-depreciated by $2000 and you therefore underpaid $700 in taxes.
Another simple example of the difference of book and market value can be seen when looking at the way land is treated on the books. Land is not depreciated and therefore remains on the books at its historical cost. It is obvious than, that the book value of land is an extremely inaccurate measure of the lands actual worth. The value of land fluctuates greatly, and usually increases as more time passes. Would the book value of an acre of land in Manhattan purchased in 1908 be an accurate portrayal of that lands value in 2008? Obviously, the value of that land has appreciated greatly and its book value is immaterial in relation to its actual market value.
In the previous two examples, I explicitly mentioned the effect of depreciation (buildings and equipment) as well as the lack of use of depreciation (land). It is important to remember that depreciation is not the only method for reducing the value of an asset. Depletion and amortization are also accounting conventions used to reduce the book value of assets as they are used up. Depletion is used to reduce the book value of natural resources as they are used. Likewise, amortization is used to decrease the value of intangible assets.
Thus far, I have only talked about book value as it pertains to assets. Not all things that are bought, however, are recorded on the books as assets and book value in general does not only pertain to things that are bought! In order to clarify, take expenses for example. Expenses can include any "incidental" purchases made in the normal flow of business. While these are purchased items, they are not treated as assets because they are used to continue daily operations. It is also necessary to understand, that book value applies to more than just things that are purchased. Accounts payable, for example, is a debt account and the value recorded under that account is considered its book value. As payments are made to satisfy the claims held against the borrower, the book value of the debt decreases.
In conclusion, book value is more than simply the historical cost of an asset. It is an accounting convention that has several applications, and is an integral valuation tool used in keeping efficient and accurate books.