If accounting terms make your head spin you're not alone. But if you'd still like to have a grasp on a few of the basics, learning how to calculate net book value is a good place to start. While you may still want to hire professionals to maintain your books and file your taxes, it's nice to have a working knowledge of some of the essentials.
What Is Net Book Value?
For accounting purposes, businesses list their assets according to their net book value. To come up with the NBV of any item your business owns, you subtract depreciation or amortization from its original value. Use depreciation for tangible items like computers, machinery, furniture and so on. Use amortization for intangible things like patents and trademarks.
When you use net book value you're spreading out the expense of buying an asset over time. You're also getting "credit" for an asset's diminishing value. This helps to balance costs versus revenue, which can have tax advantages.
The terms net book value and net asset value are often used interchangeably. But strictly speaking, net asset value also includes liabilities. Net book value does not.
Depreciation of Tangible Assets
Depreciation is the devaluing of an item based on wear and tear. We all know that a brand-new car isn't worth what you paid for it as soon as you drive it off the dealer's lot. The same thing applies to that new copy machine you installed or the new sofa you put in the lobby.
Depreciation is usually calculated based on the anticipated useful life of an item. So let's say the copy machine cost $5,000 and it's expected to last for five years. You'd depreciate it on your books by $1,000 a year until the fifth year when it's worth zero.
Amortization of Intangible Assets
Like depreciation, amortization is a deduction from the original cost of an asset. However, amortization applies to intangible assets like patents and trademarks. You'll be reducing the value of these assets as they diminish to come up with their net book value.
Let's say your company developed a new drug. Drug patents are usually good for 20 years. (It's often said to be 10 years, which is not accurate. However, in a separate process, the Food and Drug Administration takes so long to approve drugs, the actual useful life of a drug patent usually turns out to be about 10 years.)
In your books, you've set the initial value of the patent at $1 million. When the patent expires, it's worth zero. So for each year that goes by from the time you applied for the patent, you'll reduce its original value of $1 million by $50,000 ($1 million divided by 20 years) to get its net book value.
Impairment of Intangible Assets
After the net book value of an intangible asset is recorded and something happens to reduce its value even further, you've got impairment. Impairments are sudden, negative impacts on an intangible asset's net book value. When an intangible asset is impaired, it's worth even less than its NBV.
For example, if the drug you manufactured is rejected by the FDA, the patent is worthless. Reducing the $1 million value of the patent by $50,000 a year no longer applies. You need to reduce its value to zero on your books.
Other Accounting Adjustments
In our examples, we've stuck to the most basic types of depreciation, amortization and impairment. There are more complex ways to make all of these adjustments on your books. The copy machine example above is straight line depreciation. But there's also declining balance, units of production and sum of years' digits depreciation.
Management usually makes the call on what method is used and what the useful life of an asset is. They also determine the scrap value of tangible assets, if any. But come tax time, the IRS has its own guidelines for depreciation and amortization.
You can find book value calculators online. But, as you might imagine, a lot of this is best left to the pros – your accountant and professional tax preparer.