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Fair value accounting

Difference between Historical Cost and Fair Value Accounting. Created by Sal Khan.

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  • mr pants teal style avatar for user Fletcher Young
    Is 'fair value' sometimes referred to as 'mark-to-market'?
    (12 votes)
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  • leaf green style avatar for user Aaron
    At he mentions most accounting standards boards want you to report the fair value. If there is an "appraiser" available for that asset, is there a requirement or expectation to do an appraisal every year or x years to keep up with your fair market value?
    (9 votes)
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    • female robot grace style avatar for user Aurimas Barkauskas
      You are right, there is an expectation of frequency of appraisals, yet they differ between standards, markets and asset groups. In general as frequent as its necessary to show fair value. It can be annually but in most cases 3 to 5 years. For networks and infrastructure it can go up to 10 years.

      IAS 16 states in 31 "Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially", it expands in 34 "Some items of property, plant and equipment experience significant and volatile changes in fair value, thus necessitating annual revaluation. Such frequent revaluations are unnecessary for items of property, plant and equipment with only insignificant changes in fair value. Instead, it may be necessary to revalue the item only every three or five years."
      (15 votes)
  • blobby green style avatar for user Arbind Kumar
    Does the Historical Value is same as Book Value? If no than what is the difference between Historical Value and Book Value?
    (7 votes)
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    • leaf green style avatar for user Ryan
      Usually historical value means the value that was originally recorded when the asset or liability was first put on the balance sheet.

      The book value is similar, but it can change over time due to things like write downs and re-valuation due to impairment.
      (11 votes)
  • orange juice squid orange style avatar for user EerieIratxoak
    Does the historical value account for inflation? Why or why not?
    (8 votes)
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  • leaf grey style avatar for user Matthew Wu
    If you had your assets appraised, say, two years ago, and never had them reappraised, would the fair value become the historical value after it was appraised? Or would the historical value still stand, and any reports afterward revert back to the initial value at purchase?
    (4 votes)
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  • starky ultimate style avatar for user Max
    When your asset value increases, does that count as income that you have to pay taxes on? Like income tax or capital gains tax?
    (7 votes)
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  • piceratops ultimate style avatar for user Jurģis Zālītis
    How sheep & land value increase affects passive side of balance sheet?
    (4 votes)
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  • male robot hal style avatar for user Pavlos Nikolaidis
    Is it true that fair value (instead of historical cost) accounting is the trend which the IFRS and the US GAAP are currently following? If that's so, what are the benefits and the drawbacks?
    (2 votes)
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    • leaf green style avatar for user Ryan
      Yes...kind of. There are literally different rules for every line item on financial statements. But, things that are bought and sold on a regular basis and can be easily valued are usually valued at fair value or something close to it. Or, like inventory, it will be at historical cost, or fair market value, whichever is lower.

      Things that are more difficult to value, or aren't used as often, like land, goodwill, PP&E, intangible assets, securities held to maturity and long term debt, are held at historical cost, or depreciated cost. They are usually tested at least annually for impairment. Meaning if they have been deemed to have lost a significant amount of value, they will be written down to a lower value.
      (6 votes)
  • aqualine sapling style avatar for user Barbra Ann S
    So, what if the historical value is more then the fair value?
    (1 vote)
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  • leaf green style avatar for user judiechen2006
    about how we want to account for the sheep and the land
    In this sentence, what does mean for 'account for'?
    (1 vote)
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Video transcript

Let's say I run some type of sheep farm, maybe some type of wool producing business. And in year one, I go out there, I buy a bunch of sheep, and I put them on some land. And I go and I buy the sheep for $1 million. And I buy the land for $1.2 million. So I have $2.2 million in assets. Nothing confusing there. Now, let's go to year two, and think about how we want to account for the sheep and the land. So one way we could say is, oh look, the sheep are still there. The land is still there. I paid a $1 million for the sheep and they're all still there. So I'll put on my books that the sheep are still $1 million. And I paid $1.2 million for the land. So I'll put on my books that the land is $1.2 million. So in this situation, I've accounted for the sheep and the land based on their historical cost. So let me write this down. This is based on historical cost. Now, this is a legitimate way to account for things, especially if there's no other way to really think about what my sheep or my land are worth. I'd say, look, this is what I paid for them. Now let's say that there is an active market in sheep, and you can get a sheep appraiser to come over to your farm and tell you what your sheep are worth. And your sheep appraiser comes and says, wow, your sheep are looking good. There's been a big-- I don't know-- sheep epidemic in another part of the country. So there's a sheep shortage. So your sheep are actually worth a lot more than they were last year. And they say, I think your sheep are now worth $2 million. So you say, hey, wow, the market value of my sheep is $2 million. So you could say, well, instead of putting $1 million there, let me put $2 million. Let me put $2 million for my sheep. And let's say that the land is also appreciated. A highway's gone by and someone wants to build a development nearby. So the fair value of your land has also gone up, maybe it's also $2 million. So both of these. So this is $2 million. And this is $2 million. So this right over here, you could view as the market value or the fair value of your sheep. Now, either one of these are legitimate ways of accounting, but it's good to know the difference. This is historical cost accounting. This is fair value accounting. In general, most accounting standards boards want people to report the fair value or to market value as frequently as possible. And it's very easy to do if there is kind of a market in that. Or you can get an appraiser in and they can give you a pretty good estimate of what these things are worth. If that isn't around, or if it's just inefficient to do it, then you'd probably want to do the historical cost method. So that's all the difference. Historical cost, how much you paid for it. Fair value, what's the current market value today. So they sound like very fancy words, but it's a pretty simple idea.