Historical cost accounting and mark-to-market, or fair value, accounting are two methods used to record the price or value of an asset. Historical cost measures the value of the original cost of an asset, whereas mark to market measures the current market value of the asset.
Historical cost accounting is an accounting method in which the assets listed on a company’s financial statements are recorded based on the price at which the assets were purchased. Under generally accepted accounting principles (GAAP) in the United States, the historical cost principle accounts for the assets on a company’s balance sheet based on the amount of capital spent to buy the asset. This method is based on a company’s past transactions and is conservative, easier to calculate and reliable. However, the historical cost of an asset may not be relevant. For example, if a company purchased a building 60 years ago, the market value of the building could be worth a lot more than the balance sheet indicates.
For example, suppose company ABC bought multiple properties in New York City 100 years ago for $50,000. Under historical accounting, the cost of the properties recorded on the balance sheet is $50,000. However, a real estate appraiser inspects all of the properties and concludes that the expected market value is $50 million. Due to this discrepancy, some practitioners record assets on a mark-to-market, or fair value, basis when reporting financial statements.
Mark-to-market accounting records the current market price of an asset or liability on companies’ financial statements. Fair value accounting is a financial accounting approach that companies use to report their assets and liabilities at estimated prices, which they would receive if they were to sell the assets or the liabilities they would pay if they were to be alleviated of their liabilities. Mark-to-market accounting aims to make financial accounting information more accurate and relevant. However, this can be a problem is market prices fluctuate a great deal.
For example, under historical accounting, company ABC records its assets located in New York City at a value of $50,000. However, under market-to-market, or fair value, accounting, the assets are recorded as $50 million on its balance sheet.
The problems of fair value accounting were exposed during the 2007-2008 financial crisis. Companies and banks were using fair value accounting, which caused the increase in performance metrics up until the financial crisis. As companies’ asset prices were increasing due to the boom in the housing market, the gains calculated using the fair value approach were realized as companies’ net incomes. However, there was a rapid decline in the asset prices, and mark-to-market accounting was to blame. When an unpredictable fluctuation in prices occurs, mark-to-market accounting proves to be inaccurate. Unlike mark to market, with historical cost accounting the costs remain the same and may have been helpful during the financial crisis.