When you buy a long-term asset such as a vehicle or machinery, you get to write down or depreciate the cost of that asset, year-after-year, until the recorded cost is zero. The net book value of an asset is the cost of the asset minus accumulated depreciation. This figure gets recorded on the company's balance sheet.
Understanding Accumulated Depreciation
To understand net book value, you first have to understand the concept of depreciation. It works like this: Whenever you buy an asset for your business that you're going to use for more than one year, you have to write off the expense over time instead of deducting it all in the year of purchase. So if you bought a new drill press for $10,000, you'd write off the value at $2,000 per year for each year of its 5-year useful life. Accumulated depreciation is the total of the depreciation you're recording. After three years, the accumulated depreciation for your drill press would be $2,000 plus $2,000 plus $2,000, or $6,000.
How to Calculate Net Book Value
To calculate the net book value for an asset, apply the following formula:
Net Book Value = Cost of the Asset - Accumulated Depreciation
Here's a quick example: Suppose Company X bought a vehicle three years ago for $40,000. The vehicle depreciates by $4,000 a year over 10 years. The NBV of the vehicle is:
$40,000 - ($4,000 + $4,000 + $4,000) = $28,000
Why NBV Matters
Net book value represents the theoretical value of what an asset is worth. This means it should reflect, more or less, the amount you would receive if you sold the asset on the open market. When you add the NBV of all your assets together, the resulting figure represents the amount you'd receive if you sold all your business assets. Deduct the company's liabilities from this figure, and you get the net worth of the business. In a broad sense, NBV feeds directly into the company's valuation.
Things to Watch Out For
While theoretically, the net book value calculation should equal the asset's market value, it almost never does. That's because the asset is recorded on the balance sheet at cost, with depreciation reducing the cost down to zero over time. The balance sheet does not get updated as prices change. So, if you bought a building for $750,000 and depreciated it by $20,000 per year, after two years the NBV would be $750,000 - ($20,000 + $20,000), or $710,000. Now imagine that real estate prices have shot up by 10 percent since you bought the building. This means that your building is worth somewhere in the region of $825,000. The NBV recorded on your balance sheet is far below the real estate's market value, and does not give an accurate picture of its true worth.
The Way You Record Depreciation Matters
Accumulated depreciation is a key component of the net book value formula, which means that changing the way you calculate depreciation can change the NBV. For most businesses, the default method for calculating depreciation is the straight-line method where the same amount gets deducted over each year of the asset's useful life. That's the method Company X used to depreciate its vehicle. However, some assets lose value much more quickly during the earlier years of their life. Technology is a good example since smartphones and computer applications can quickly become obsolete. Where assets lose value quickly, it's better to use the accelerated method of depreciation which weights depreciation more heavily towards the early years of an asset's life.
As a quick example, imagine that Company X depreciates its vehicle by 15 percent per year instead of a fixed $4,000 per year. In year one, the depreciation would be $6,000 ($40,000 x 15 percent). The vehicle is worth $34,000 at the end of year one. In year two, depreciation is $5,100 ($34,000 x 15 percent) and in year three, depreciation is $4,335 ($28,900 x 15 percent). The net book value after three years would be $40,000 - ($6,000 + $5,100 + $4,335) or $24,565. This figure is far lower than the NBV you get under the straight-line method, which reflects the higher rate of depreciation at the beginning of the vehicle's life.