What Is a Fair Market Value Balance Sheet?

A balance sheet is a snapshot of your company's financial health that can be read by accountants, investors and auditors to determine how well your company is doing. It's like an x-ray of your business because it lists all your assets and liabilities, which is not something your marketing manager typically reveals in a selfie.

Usually, a balance sheet shows the book value or cost of assets.

A fair market value balance sheet is different in that it shows the liquidation value of assets instead.

Understanding Book Value Costs

Most balance sheets show costs of assets minus depreciation, rather than what those assets might be worth if they were sold. These costs are also known as book values. This approach is so common that when you read the term balance sheet values, compared to fair market value, you can safely assume the writer is discussing cost balance sheets.

Assets are recorded using book value, what the company paid to acquire them, which is known as the historical cost. If the asset has a limited life span, like most equipment, the company slowly depreciates the value of the asset over the years. With a few exceptions, such as stocks and bonds, the book value can go down, but it can't go up.

Using book values in a balance sheet gives you a better understanding of a company's actual performance of its invested capital, as well as a picture of changes in owner equity or the company's net worth.

Understanding Fair Market Value

Fair market value (FMV) or market value is the price someone is willing to pay for an asset in an arm's-length purchase, in which the buyer is unrelated to the seller and under circumstances in which neither party is under pressure, and both have the necessary facts about the item.

For most assets, there is no way to accurately assess a fair market value until the asset has been sold. Some securities are an exception because the price can be easily determined by looking at its current selling price in the market.

You can, however, estimate fair market value.

A fair market value balance sheet adds capital gains to retained earnings to show changes in owner equity, so it can be more difficult to see what retained earnings are or what changes there have been to net worth.

Depreciation Vs. Market Value

There are times when the depreciated book value of an asset may approximate its market value, but this isn't usually the case. Depreciation is just an accounting tool used to spread the cost of an item over its expected life span.

Suppose you bought a new chair at a retail price of $350 and use the General Depreciation System rule recommended by the IRS for office furniture to depreciate it over seven years. After the first year, you would expense $50, and its depreciated value would be $300. This would be much higher than its fair market value since few people would be willing to buy a used chair for only $50 less than a new one.

Why You May Need an FMV Balance Sheet

Lenders like to see cost balance sheets because they can illustrate the company's financial performance over time. Each year the business retains more earnings, the more its net worth grows and, thus, the better able the company should be able to pay back loans.

Cost balance sheets don't show the whole picture, though. The cost value of assets is often below market value, which means that a company may be worth more than the cost balance sheet shows. So, in terms of liquidity, a fair market value balance sheet could reveal more worth and better creditworthiness than the cost balance sheet.

This is why some lenders may want to see both balance sheets.

As noted by Professor Michael Langemeier of Purdue University, this is often the case for farms. The liquidity value of a farm may be far higher than its book value based on costs, especially if the value of the land has appreciated.

As a simplified example, imagine you were starting a landscaping business and bought an old truck and some tools for $5,000 at an auction. However, you got an outstanding deal, and if you were to sell those assets, you would likely get $20,000 - their fair market value. If you're applying for a $10,000 loan, a bank manager would have a much easier time approving that loan if she knew your business was holding $20,000 in collateral.

Determining Fair Market Value

There are four ways to determine the fair market value of an asset.

Cost Minus Economic Depreciation: Provided you bought the asset at fair market value, to begin with, you can usually use this method. Note that economic depreciation is different than depreciation used by accountants or the IRS. Instead of depreciating the asset at a fixed amount every year, economic depreciation usually falls quickly after you purchase a new item and then slowly depreciates more each year, based on things like wear and tear.

As an example, if you bought a new vehicle for your business, it's likely to depreciate in value by 20% in the first year. Then it will typically depreciate another 10% each year for the next four years. So if you bought a new vehicle for $20,000, at the start of the sixth year, its fair market value might be around 50%, or $10,500.

Comparable Sales: This is a common way to determine FMV and is often used to determine the value of real estate. Find two or three assets comparable to yours that have recently been sold and average their values to estimate your asset's FMV.

Replacement cost: Insurance companies often discuss replacement costs when determining fair market value, but for assessing the value of your assets, it's not usually the best method. Looking at the replacement cost, however, can help you determine if your assessment is too high. If you estimated the FMV of some equipment to be $50,000, but you find out you could replace it with new equipment for $40,000, then your initial assessment was at least $10,000 too high.

Appraisals: Getting an expert opinion is often the most reliable way of determining FMV, other than actually putting your assets up for sale.

Elements of an FMV Balance Sheet

The elements of a fair market value balance sheet can be the same as a cost balance sheet. The only difference is how the dollar value of the assets is recorded.

In his market value balance sheet templates for farms, Michael Langemeier recommends using three columns, one showing the value at the beginning of the year, one for the end of the year, with the third column being the average value of the two. These average values can be used to calculate financial ratios.

The balance sheet should begin with a list of all your business assets, followed by a list of all your business liabilities and owner equity. To calculate owner equity, subtract total liabilities from total assets.

Because an FMV balance sheet is often used to determine liquidity and solvency, you can include these at the end of the balance sheet. Liquidity determines how much your business would be worth if it were sold today, while solvency measures the amount of debt and expense obligations compared to the amount of equity you, as the owner, have invested in the company.

Because an FMV balance sheet shows liquidation values, you should keep in mind that there is usually a tax liability involved if you were to sell those assets. Consequently, it may be prudent to include deferred taxes as liabilities when drafting an FMV balance sheet.