A business entity is a for-profit organization that performs different operations to earn profit. For effective operations, different resources are required by the company. For instance, money is a resource that a company uses to acquire supplies, raw materials, machinery, patents, etc., to maintain the continuity of business operations.
The equipment, raw material, finished goods, patents, cash, account receivables, etc., all are assets of a company because the business entity owns them. However, there is further segregation among different types of assets.
Under the IFRS(International Financial Reporting Standards), a business concern mainly owns two types of assets: current and non-current assets. There are many other classifications of assets too. For instance, there are tangible and intangible assets in a business.
This article will discuss one category of the assets in any business entity that is non-current assets. We will specifically talk about the net book value of non-current assets, their importance, and calculating the net book value.
What are non-current assets?
A non-current asset can be defined as an asset that’s useful life is beyond one accounting year. In other words, the business entity cannot liquidate such assets into cash easily, and they last for years. The non-current assets bring economic benefits for the business entity over many years. Therefore, the value of such assets is periodically depreciated.
There are two sub-categories of non-current assets: tangible and intangible.
Tangible non-current assets are the assets that have a physical existence and bring economic benefits to the business entity for many years. The most common examples of tangible assets are property, plant, equipment, manufacturing unit, etc.
Intangible non-current assets do not have a physical appearance. Instead, these are usually intellectual or legal properties that entitle the holder to certain rights. The most common examples of intangible assets are patents, trademarks, copyrights, software, etc.
Net Book Value Of Non-Current Assets
The balance sheet of any business entity records the assets and liabilities to show the company’s financial position at the end of a financial period. Asset valuation is necessary to record a numerical value of the non-current assets. The asset valuation helps the business entity record the asset’s value based on the estimated usage and depreciation.
The value of a non-current asset recorded in the balance sheet is called the asset’s net book value. The book value of a non-current asset is the cost of assets minus the accumulated depreciation or amortization of a non-current asset.
Formula For Net Book Value
Net Book Value or NBV is always calculated about the asset’s historical cost, and any impairment expenses or depreciation are subtracted.
From the above definition of the net book value, we can derive the formula of the NBV as,
Net Book Value = Acquisition Cost – Depreciation/Amortization – Impairment Expenses
The acquisition cost or purchase cost of a non-current asset is the historical cost. The acquisition cost also includes any installation expenses and other expenses incurred to make the asset operational.
The accumulated depreciation is the total depreciation of a non-current asset from the date of acquisition to the current date. Depreciation is defined as the periodic allocation or writing off of a depreciable asset’s cost to expense over its useful life is termed depreciation.
Accumulated depreciation is the sum of all periodic installments of depreciation expense over the useful life of a tangible asset.
Amortization is writing off the intangible asset’s value. The concept of amortization is similar to depreciation. The difference is that amortization is calculated for intangible non-current assets.
During the use of an asset, it can go out of order requiring repairs. The company has to adjust the impairment losses of the asset by subtracting the amount from the historical value of the asset.
How To Calculate Net Book Value?
Let’s go through calculating the net book value of non-current assets in a company’s accounts. The tangible assets are depreciated, and intangible assets are amortized. Therefore, we will calculate the net book value of both asset classes by taking two distinct examples.
So let’s get into it.
Example 1: Tangible Non-Current Assets
Let’s say that Company ABC purchased machinery three years ago. The useful life of the machinery was estimated to be five years. The company uses the straight-line method for recording the depreciation. On estimation, it was decided to depreciate the asset by 20% in every financial period.
The cost of the asset was 140,000 USD with a residual value of 20,000 USD. The company wants to calculate the asset’s net book value at the end of the third year.
Cost of the asset/Historical cost = 140,000 USD
Depreciation Rate = 20% straight-line method
The residual value of the asset = 20,000 USD
Accumulated Depreciation = (Cost of asset – residual value) x 20% x 3
Accumulated Depreciation = (140,000 -20,000) X 0.2 X 3
Accumulated Depreciation = 72,000 USD.
Net Book Value Of Machinery = Acquisiton Cost – Accumulated Depreciation – Impairment Losses
Net book value of machinery = 140,000 USD – 72,000 USD – 0 USD
Net book value of machinery = 68,000 USD
Depreciation schedule with net book value:
|Year||Costs||Residual||Depreciation Rate||Depreciation Expenses||Accumulated Depreciation||Net book|
|1||$ 140,000||$ 20,000||20%||$ 24,000||$ 24,000||$ 116,000|
|2||$ 140,000||$ 20,000||20%||$ 24,000||$ 48,000||$ 92,000|
|3||$ 140,000||$ 20,000||20%||$ 24,000||$ 72,000||$ 68,000|
|4||$ 140,000||$ 20,000||20%||$ 24,000||$ 96,000||$ 44,000|
|5||$ 140,000||$ 20,000||20%||$ 24,000||$ 120,000||$ 20,000|
Example 2: Intangible Non-Current Assets
The amortization of an intangible asset depends on the asset’s life. It can be indefinite or definite life. The IAS 38 highlights factors in determining the life of an intangible asset as expected usage, product life cycle, technical obsolescence, and competitor action.
However, amortization is calculated by using the following formula under the straight-line method:
Amortization = (Book Value – Residual Value) / Useful life
Alternatively, the business entities can also calculate the amortization on a usage basis or revenue-based model.
Let’s take the example of an intangible non-current asset to understand amortization.
Company A has got a patent to manufacture trucks for five years. The book value of the patent is 500,000 USD. It is an intangible asset for the company with a residual value of 40,000 USD. The business entity is required to calculate the net book value of the patent at the end of the third year.
Book Value = 500,000 USD
Residual Value = 40,000 USD
Useful Life = 5 years
Amortization = ?
Amortization = (Book Value – Residual Value) / Useful life
Amortization = (500,000 – 40,000)/5
Amortization = 92,000 USD
Net Book Value at the end of third year = ?
Net book value = actual cost – amortization
Net book value = 500,000 –(92,000 X 3)
Net book value = 500,000 – 276,000
Net book value = 224,000 USD
In the above example, the amount of amortization calculated is the yearly amortization. To find the amortization for three years, the company will multiply yearly amortization by three.
Amortization schedule with net book value:
|Year||Costs||Residual||Depreciation Rate||Amortization||Accumulated Depreciation||Net book|
|1||$ 500,000||$ 40,000||5||$ 92,000||$ 92,000||$ 408,000|
|2||$ 500,000||$ 40,000||5||$ 92,000||$ 184,000||$ 316,000|
|3||$ 500,000||$ 40,000||5||$ 92,000||$ 276,000||$ 224,000|
|4||$ 500,000||$ 40,000||5||$ 92,000||$ 368,000||$ 132,000|
|5||$ 500,000||$ 40,000||5||$ 92,000||$ 460,000||$ 40,000|
Net Book Value Vs. Market Value
The above examples have clearly explained the difference between the net book value of a tangible and intangible non-current asset. However, many people get confused between the market value and the book value of the asset.
Net book value, as discussed, is the value of the company’s assets that is based on the historical cost. Book value is the value recorded in the balance sheet of a business entity. On the other hand, the market value of the assets that a company expects to get if it sells the assets in the market.
Importance Of Net Book Value
The net book value of the assets is an essential concept in financial reporting. It is indeed the most common financial measure when a company performs asset valuation. It assists the company in financial decision-making as it determines the accuracy and fairness of the accounting & financial records. The firm value can also be appropriated with the help of NBV.
The net book value of assets also lays the foundation of a business entity’s different financial and ratio analyses. For instance, Net Asset Value, the net worth of the firm, etc., are calculated by the following measures.
Limitations Of Net Book Value
Net book value of non-current assets is a significant financial metric, but there are some limitations. The biggest limitation of the net book value is that its implications are not widespread and only limited to business entities.
An individual who wants to calculate the net book value of his home, car, or any fixed asset cannot use the method for appropriation. The measure would be a more practical tool if it had implications in areas of personal finance too.
Another shortcoming of net book value is that it always takes the historical value as the basis of calculation. Accountants believe it to be a fair representation of the company’s value.
However, some non-current assets like land are not depreciated, and the historical cost is irrelevant compared to market value. Therefore, the measure has no implications for land owned by a business firm.
In a nutshell, the net book value of non-current assets is significant for financial reporting purposes. However, the method has some shortcomings regarding the practical implications in personal finance and financial exceptions.
The article has discussed the net book value of tangible and intangible assets with the depreciation and amortization model. After going through the method, you will make amortization and depreciation schedules and perform asset valuation more effectively.