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.