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Fair value accounting

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

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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.