Definition
Historical cost refers to the original monetary value of an asset, or its purchase cost, recorded at the time of its acquisition. On the other hand, fair value is a contemporary estimate of what an asset could be sold for in the current market. The main difference is that historical cost is based on actual expenditure, while fair value is an estimation based on current market conditions.
Key Takeaways
- Historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. It completely disregards the possible current market fluctuations.
- Fair value, on the other hand, is a measure of value that is updated regularly to reflect the price an entity would receive to sell a given asset or pay to transfer a given liability in an orderly transaction among market participants at the measurement date. It provides a more realistic value of an asset in the current marketplace.
- While historical cost provides a more clear-cut value and is less subject to manipulation, it may not accurately reflect the true value of an asset over time. Fair value, although it provides a more realistic value, can be subject to market volatility and other factors that may not necessarily reflect the true worth of an asset.
Importance
The comparison of historical cost and fair value in finance is crucial as it impacts the valuation of assets in a company’s financial reporting and affects investment decisions. Historical cost, or the original cost of an asset, provides a reliable and verifiable figure, contributing to conservatism in reporting.
On the other hand, fair value, or the estimated market value, offers a more relevant and timely value influenced by the current market conditions. Hence, the contrasting characteristics of these two valuation methods could significantly affect the reported financial status and performance of a company, thereby impacting stakeholders’ decisions.
Consequently, understanding and applying the appropriate valuation method – historical cost or fair value, is a matter of paramount importance in financial management and reporting.
Explanation
Historical Cost and Fair Value are two different methods used in accounting for assessing the value of assets, and their purpose mainly lies in providing accurate financial information to stakeholders, such as investors, creditors, or regulatory authorities. The Historical Cost approach records assets at their original purchase cost, and it maintains this value throughout the asset’s lifetime. This method is commonly used because it provides a clear, definitive value and is very objective since it relies on the original purchase price.
Its main purpose is to offer simple and verifiable information about assets and liabilities. The Fair Value approach, on the other hand, records assets at their current market value, which means the values fluctuate based on the market conditions. The primary purpose of the Fair Value method is to provide a realistic, current appraisal of a company’s financial situation.
Fair value accounting is mainly used in investment or securities industries, where the market price easily determines assets’ values. It provides more relevant information as the reported asset value is more reflective of the current market conditions. However, it may be less reliable due to its subjective nature, as it depends on estimations and judgments to determine the current market price.
Examples of Historical Cost vs Fair Value
Real Estate: In the real estate market, historical cost refers to the price an individual or company initially paid for a property. Over the years, the property’s value might increase or decrease based on various factors like the condition of the property, changes in the real estate market, or developments in the locality. This altered price reflects the fair value. For example, a property bought in 1970 for $50,000 may now actually worth $200,000 due to inflation and market growth. However, in the company’s books, it would still be listed at the historical cost of $50,000, while its fair value would be $200,
Stock Market: Suppose you bought shares in a company ten years ago for a total of $5000 (historical cost). Due to various market factors such as the performance of the company, market demand, macroeconomic condition, etc., the worth of the shares might alter. Let’s say the current market price of those shares is now $15,000, this is deemed the fair value.
Artworks: An individual or museum might purchase a piece of art at a certain price (historical cost). Over time, the piece of art may appreciate in value due to the artist’s increased popularity, rarity, condition of the piece, or inflation. This new appraisal price is the fair value of the artwork. The Mona Lisa, for example, was painted in the early 16th century and didn’t cost a significant amount then. However, today, it is evaluated to be worth hundreds of millions of dollars, which signifies its fair value.
FAQs: Historical Cost vs Fair Value
What is Historical Cost?
Historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company.
What is Fair Value?
Fair value is a measure of value that is used in accounting and economics, which provides a fair or accurate valuation of a particular asset, investment, or company.
What is the main difference between Historical Cost and Fair Value?
The primary difference between historical cost and fair value is that historical cost is the original cost of the asset, while fair value can change over time based on market conditions.
Which is more accurate, Historical Cost or Fair Value?
Neither is inherently more accurate, as they serve different purposes. Historical cost provides a tangible, definitive value, while fair value can offer a more realistic current value of an asset in today’s market.
Why would a company use Historical Cost instead of Fair Value?
A company might use historical cost because it’s more straightforward to calculate and more concrete than fair value. It removes the variable of market fluctuation, providing a more stable valuation method.
Why would a company use Fair Value instead of Historical Cost?
A company might use fair value if they are looking for a valuation method that accurately represents the current market conditions. Fair value calculations can include market factors, which can provide a more realistic evaluation of an asset’s worth.
Related Entrepreneurship Terms
- Mark-to-Market
- Amortized Cost
- Impairment
- Depreciation
- Revaluation
Sources for More Information
- Investopedia: A reliable source for investment and financial terminologies.
- Accounting Tools: A website that provides a wealth of information about accounting principles and terminologies.
- Corporate Finance Institute: Offers extensive topics around corporate finance including valuation methods used in finance.
- Deloitte IAS Plus: Provides comprehensive information about international financial reporting in the broad context of financial reporting functionality.
