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What is the difference between book value and market value?

Which should we use for decision making purpose?


The book value of an asset is its original purchase cost, adjusted for any
subsequent changes, such as for impairment or depreciation. Market value
is the price that could be obtained by selling an asset on a competitive,
open market.
There is nearly always a disparity between book value and market value,
since the first is a recorded historical cost, and the second is based on the
perceived supply and demand for an asset, which can vary constantly.
For example, a company buys a machine for $100,000 and subsequently
records depreciation of $20,000 for that machine, resulting in net book
value of $80,000. If the company were to then sell the machine at its
current market price of $90,000, the business would record a gain on the
sale of $10,000.
As indicated by the example, the disparity between book value and
market value is recognized at the point of sale of an asset, since the price
at which it is sold is the market price, and its net book value is essentially
the cost of goods sold. Prior to a sale transaction, there is no reason to
account for any differences in value between book value and market
value.
One case in which a business can recognize changes in the value of assets
is for marketable securities classified as trading securities. A business is
required to continually record holding gains and losses on these securities
for as long as they are held. In this case, market value is the same as book
value.
When the difference between book value and market value is
considerable, it can be difficult to place a value on a business, since an
appraisal process must be used to adjust the book value of its assets to
their market values.
There are situations when the market value of a fixed asset is much higher
than book value, such as when the market value of an office building sky
rockets due to increased demand. In these situations, there is no way
under Generally Accepted Accounting Principles (GAAP) to recognize the
gain in a company's accounting records. However, revaluation is allowed
under International Financial Reporting Standards (IFRS).

Current assets and liabilities generally have book values and market values
that are very close. This is not necessarily the case with the other assets,
liabilities and equity of the firm.
Assets are listed at historical costs less accumulated depreciation this
may bear little resemblance to what they could actually be sold for today.
The balance sheet also does not include the value of many important
assets, such as human capital. Consequently, the Total Assets line on the
balance sheet is generally not a very good estimate of what the assets of
the firm are actually worth.
Liabilities are listed at face value. When interest rates change or the risk of
the firm changes, the value of those liabilities change in the market as well.
This is especially true for longer-term liabilities.
Equity is the ownership interest in the firm. The market value of equity
(stock price times number of shares) depends on the future growth
prospects of the firm and on the markets estimation of the current value of
ALL of the assets of the firm.
The best estimate of the market value of the firms assets is market value
of liabilities + market value of equity.
Market values are generally more important for the decision making
process because they are more reflective of the cash flows that would occur
today.

Shareholders are the ones that benefit from increases in the market value
of a firms assets. They are also the ones that bear the losses of a
decrease in market value. Consequently, managers need to consider the
impact of their decisions on the market value of assets, not on their book
value. Here is a good illustration:
Suppose that the MV of assets declined to $700 and the market value of
long-term debt remained unchanged. What would happen to the market
value of equity? It would decrease to 700 500 = 200.
The market-to-book ratio, which compares the market value of equity to
the book value of equity, is often used by analysts as a measure of
valuation for a stock. It is generally a bad sign if a companys market-tobook ratio approaches 1.00 (meaning market value = book value) because
of the GAAP employed in creating a balance sheet. It is definitely a bad
sign if the ratio is less than 1.00.
GAAP does provide for some assets to be marked-to-market, primarily
those assets for which current market values are readily available due to
trading in liquid markets. However, it does not generally apply to longterm assets, where market values and book values are likely to differ the
most.

Accounting Income Definition


Accounting income is defined as an estimate of performance in the
operations of a company. It is influenced by financing and investing
decisions. Accounting income or loss generally recognizes realized gains
and losses, and does not recognize unrealized gains and losses.
For income to be realized it must be related to actual business
transactions; in effect, the cash you have must increase or decrease. A
change in market value rather than cash received is not an accounting
income; it is an economic income. Economic income or loss recognizes all
gains and losses whether realized or unrealized.
Central to the accounting profits definition is whether a gain or loss is
realized or unrealized. When a gain or loss is realized it becomes an
income suitable for accounting. The accounting value for this asset is
generally listed at the historical value of the transaction selling it. When a
gain or loss is unrealized it may or may not be accounted for in general.
This depends on the placement of the gaining or losing asset in
the balance sheet. Despite that this gain or loss may be accounted for, the
fact that it is unrealized makes it an economic income or loss. The accrual
accounting income statement will look very different from the fair value
accounting statement.
Essentially, accounting income defined the ways companies evaluate their
cash standing after the sale of an asset. This, once again, differs from
economic income in that economic income is the way for companies to
account for changes in the value of a given asset in the market. The
deciding factor is whether or not a transaction takes place.

Accounting Conservatism
Accounting income or loss does not incorporate unrealized gains and
losses because of the convention of accounting conservatism. When
accountants confront uncertainty in regard to method or procedure, they
conventionally choose the option that is least likely to overstate income or
asset value. In the case of realized versus unrealized gains and losses, it is
more conservative from an accounting perspective to exclude increases or
decreases in value that have not yet been actualized.

Accounting Profit Example


A perfect example of accounting profit occurs every day in the stock
market. Investco is a company which invests in market securities. Investco
currently owns a share of Google stock worth $600. The following week
Investco notices the share of Google stock has increased in value from
$600 to $650. Investco sells this share of Google stock and receives $650
from the sale of one share of Google stock. What is Investcos accounting
income? Accounting profit and economic profit demonstrate two different
principles.
Investco experienced an accounting income: their share of Google stock
was sold for $50 more than it was initially worth. Thus, Investco has a
realized accounting gain of $50. The accounting income calculation is
$650 $600 = $50.
If Investco never sold the share of Google stock it would have experienced
an economic gain of $50. This is shown by the fact that Investco did not
have a transaction in which cash increased by $50.
Accounting Income vs Taxable Income
The treatment of accounting income and taxable income is different. The
inclusion of tax accounting confuses the matter. Under Gaap, income and
expenses are matched to the period in which they are incurred. This
means that the accounting income Investco received was incurred on the
specific day that it sold the share of Google stock. With tax accounting,
however, taxable income and expenses are matched to the period upon
which the I.R.S. decides. Investco may or may not incur an increase in
taxable income based on I.R.S. regulations. It has incurred this potential
increase in the accounting period the I.R.S. chooses. This means that an
accounting income under Gaap may not be considered an accounting
profit under I.R.S. tax rules.
Cash Flow
Cash flow touches on money coming in and exiting a company's operating
vaults. Liquidity management is what finance people call the hodgepodge
of initiatives an entrepreneur takes to make money during one period,
make more of it over time, reduce expenses quarter after quarter and
maintain a profitable business down the road. A liquidity report or cash
flow statement is a data synopsis that provides insight into cash flows
from operating, investing and financing activities.
Interrelation
Accounting income has nothing to do with cash flow, but both concepts
interrelate. Ideally, net income translates into money, but this doesn't
happen if customers face financial tedium and can't remit funds. This is
why a business owner must set policies -- and even enlist the help of

collection agencies, if needed -- to monitor client remittances, identify


customers facing economic difficulties and initiate litigation against
patrons who don't want to pay or are willing to sign repayment plans. All
these policies prevent the company from incurring losses, so it doesn't
feel lost competitively and out of step with what cash managers, lenders
and investors recommend.
Financial Reporting Implications
Cash flow management covers a liquidity report, whereas accounting
income is part of an income statement, also known as P&L, report on
income and statement of profit and loss.

INCOME STATEMENT

Step 1.
Cost of goods sold is subtracted from net sales to arrive at the gross profit.

Step 2.
Operating expenses are subtracted from gross profit to arrive at operating income.

Step 3.
The net amount of nonoperating revenues, gains, nonoperating expenses and losses is
combined with the operating income to arrive at the net income or net loss.

There are three benefits to using a multiple-step income statement


instead of a single-step income statement:
1. The multiple-step income statement clearly states the gross profit
amount. Many readers of financial statements monitor a
company's gross margin (gross profit as a percentage of net sales).
Readers may compare a company's gross margin to its past gross
margins and to the gross margins of the industry.
2. The multiple-step income statement presents the subtotal operating
income, which indicates the profit earned from the company's
primary activities of buying and selling merchandise.
3. The bottom line of a multiple-step income statement reports the net
amount for all the items on the income statement. If the net amount
is positive, it is labeled as net income. If the net amount is negative,
it is labeled as net loss.

CASH FLOW

Example
Following is an illustrative example of an Income Statement prepared in accordance with the format
prescribed by IAS 1 Presentation of Financial Statements.

Income Statement for the Year Ended 31st December 2013


2013

2012

USD

USD

Notes

Revenue

16

120,000

100,000

Cost of Sales

17

(65,000)

(55,000)

55,000

45,000

Gross Profit

Other Income

18

17,000

12,000

Distribution Cost

19

(10,000)

(8,000)

Administrative Expenses

20

(18,000)

(16,000)

Other Expenses

21

(3,000)

(2,000)

Finance Charges

22

(1,000)

(1,000)

(15,000)

(15,000)

40,000

30,000

(12,000)

(9,000)

28,000

21,000

Profit before tax

Income tax

Net Profit

23

Basis of preparation
Income statement is prepared on the accruals basis of accounting.
This means that income (including revenue) is recognized when it is
earned rather than when receipts are realized (although in many
instances income may be earned and received in the same accounting
period).
Conversely, expenses are recognized in the income statement when they
are incurredeven if they are paid for in the previous or subsequent
accounting periods.
Income statement does not report transactions with the owners of an
entity.
Hence, dividends paid to ordinary shareholders are not presented as
an expense in the income statement and proceeds from the issuance of
shares is not recognized as an income. Transactions between the entity
and its owners are accounted for separately in the statement of changes
in equity.
Components
Income statement comprises of the following main elements:
Revenue
Revenue includes income earned from the principal activities of an entity.
So for example, in case of a manufacturer of electronic appliances,
revenue will comprise of the sales from electronic appliance business.
Conversely, if the same manufacturer earns interest on its bank account,
it shall not be classified as revenue but as other income.

Cost of Sales
Cost of sales represents the cost of goods sold or services rendered during
an accounting period.
Hence, for a retailer, cost of sales will be the sum of inventory at the start
of the period and purchases during the period minus any closing
inventory.
In case of a manufacturer however, cost of sales will also include
production costs incurred in the manufacture of goods during a period
such as the cost of direct labor, direct material consumption, depreciation
of plant and machinery and factory overheads, etc.
You may refer to the article on cost of sales for an explanation of its
calculation.
Other Income
Other income consists of income earned from activities that are not
related to the entity's main business. For example, other income of an
entity that manufactures electronic appliances may include:

Gain on disposal of fixed assets

Interest income on bank deposits

Exchange gain on translation of a foreign currency bank account

Distribution Cost
Distribution cost includes expenses incurred in delivering goods from the
business premises to customers.
Administrative Expenses
Administrative expenses generally
management and support functions
directly involved in the production
offered by the entity.
Examples of administrative expenses

comprise of costs relating to the


within an organization that are not
and supply of goods and services
include:

Salary cost of executive management

Legal and professional charges

Depreciation of head office building

Rent expense of offices used for administration and management


purposes

Cost of functions / departments not directly involved in production


such as finance department, HR department and administration
department

Other Expenses
This is essentially a residual category in which any expenses that are not
suitably classifiable elsewhere are included.
Finance Charges
Finance charges usually comprise of interest expense on loans and
debentures.
The effect of present value adjustments of discounted provisions are also
included in finance charges (e.g. unwinding of discount on provision for
decommissioning cost).
Income tax
Income tax expense recognized during a period is generally comprised of
the following three elements:

Current period's estimated tax charge

Prior period tax adjustments

Deferred tax expense

Prior Period Comparatives


Prior period financial information is presented along side current period's
financial results to facilitate comparison of performance over a period.
It is therefore important that prior period comparative figures presented in
the income statement relate to a similar period.
For example, if an organization is preparing income statement for the six
months ending 31 December 2013, comparative figures of prior period
should relate to the six months ending 31 December 2012.
Purpose & Use
Income Statement provides the basis for measuring performance of an
entity over the course of an accounting period.
Performance can be assessed from the income statement in terms of the
following:

Change in sales revenue over the period and in comparison to


industry growth

Change in gross profit margin, operating profit margin and net profit
margin over the period

Increase or decrease in net profit, operating profit and gross profit


over the period

Comparison of the entity's profitability with other organizations


operating in similar industries or sectors
Income statement also forms the basis of important financial evaluation of
an entity when it is analyzed in conjunction with information contained in
other financial statements such as:

Change in earnings per share over the period

Analysis of working capital in comparison to similar income


statement elements (e.g. the ratio of receivables reported in the
balance sheet to the credit sales reported in the income statement,
i.e. debtor turnover ratio)
Analysis of interest cover and dividend cover ratios