Understanding Costs and Other Balance Sheet Values
2 of 10 in Series: The Essentials of Business Financial Statements
The values for assets and the costs reported in a balance sheet can be a source of confusion for both business managers and investors, who tend to put all dollar amounts on the same value basis. In their minds, a dollar is a dollar, whether it’s in accounts receivable, inventory, fixed assets, accounts payable, or retained earnings.
This assumption glosses over important differences and can lead to serious misinterpretation of the balance sheet. A balance sheet reports a rainbow of values — not just one color. This is the nature of the generally accepted accounting principles (GAAP) — the accounting methods used to prepare financial statements for the external financial reporting by a business.
Book values are the amounts recorded in the accounting process and reported in financial statements. Do not assume that the book values reported in a balance sheet necessarily equal the current market values. Book values are based on the accounting methods used by a business.
The amounts reported for cash, accounts receivable, and liabilities are equal to or are very close to their current market or settlement values. For example, accounts receivable will be turned into cash for the amount recorded on the balance sheet, and liabilities will be paid off at the amounts reported in the balance sheet. It’s the book values of inventory and fixed assets, as well as any other assets in which the business invested some time ago, that are often lower than current replacement values.
Different businesses select different accounting methods to determine their cost of inventory and how much of each of their fixed assets’ costs are allocated to depreciation expense each year. A business is free to use very conservative accounting methods — with the result that its inventory cost value and the undepreciated cost of its fixed assets may be considerably lower than the current replacement cost values of these assets.
A business may use accounting methods that have the effect of recording higher profit and higher asset values than would exist under more conservative accounting methods. Even so, the current replacement values of its inventory and fixed assets may be quite a bit higher than the recorded costs of these assets, in particular for buildings, land, heavy machinery, and equipment.
For example, the aircraft fleet of United Airlines, as reported in its balance sheet, is hundreds of millions of dollars less than the current cost it would have to pay to replace the planes. Complicating matters is the fact that many of its older planes are not being produced any more, and United would replace the older planes with newer models.
Businesses are not permitted under GAAP to write up the book values of their assets to current market or replacement values. (Investments in marketable securities held or available for sale have to be written up, or down, but this is an exception to the general rule.)