Asset Management
Should Assets Be Valued at Cost or Market Price? How to Choose the Right Asset Valuation Method
Dahlia Fayez
Content Marketing Specialist
"Price is what you pay. Value is what you get." Warren Buffett's timeless words perfectly capture the tension between historical cost and market value. Picture a family business that purchased a downtown warehouse decades ago for $100,000—a figure still etched in their ledger. Today, developers offer millions for that same property. This gap between what the books say and what the market demands isn't just an accounting technicality; it's a fundamental challenge that shapes financial decisions across industries. Let's explore why these two valuation methods exist, when each matters, and how their differences impact everything from tax bills to investment strategies.
What is the historical cost of an asset?
The historical cost of an asset refers to its original purchase price, including all associated costs necessary to bring the asset to its intended use (e.g., taxes, shipping, installation). This value is recorded on the balance sheet and remains unchanged over time, adhering to the cost principle in accounting.
For example,
For example,
If a company purchased machinery for 100,000 with 5,000 in delivery fees, its historical cost would be Riyal 105,000, regardless of subsequent market fluctuations.
Historical cost provides objectivity and verifiability but may not reflect current economic value.
What is the Market Value of the Asset?
The market value represents the asset’s current worth in the open market, based on supply, demand, and comparable transactions. Unlike historical cost, market value fluctuates over time and is influenced by factors like condition, technological obsolescence, or economic conditions.
For instance,
For instance,
The same machinery purchased for 105,000 might now sell for 80,000 due to depreciation or newer models entering the market. Market value is critical for decision-making (e.g., selling, insuring) but isn’t typically recorded on financial statements unless impairment is recognized.
When to Use Historical Cost
Historical cost is primarily used in financial reporting to record assets and liabilities at their original purchase price, providing a reliable and verifiable basis for accounting. This method is essential when preparing balance sheets, as it adheres to the cost principle under GAAP and IFRS, ensuring consistency and comparability across financial statements. Historical cost is useful for long-term assets, particularly property, plant, and equipment (PP&E), where market values can fluctuate significantly, making it impractical to adjust the books continuously. It is also preferred when objectivity is crucial, such as during audits, since the original transaction value is easily documented and free from subjective market estimates. However, historical cost may not reflect current economic realities, so it is typically supplemented with disclosures about fair value when material differences exist.
Disadvantages of using Historical Cost
The historical cost method has several limitations, primarily
- Its inability to reflect current market conditions. Since assets are recorded at their original purchase price, the balance sheet may significantly understate or overstate their true economic value over time, especially during inflation intervals or technological obsolescence. This can distort financial ratios, mislead investors, and reduce the relevance of financial statements for decision-making.
- Additionally, historical cost does not account for opportunity costs or changing replacement values, potentially leading to suboptimal business decisions. For assets like real estate or securities that appreciate or depreciate substantially, historical cost fails to provide timely information, requiring supplemental fair value disclosures to present a more accurate picture.
When to Use Market Value or Fair Value
Market value or fair value should be used when the goal is to reflect an asset’s current economic worth, particularly for financial reporting, investment analysis, or transactional decisions. This approach is essential for actively traded assets (e.g., stocks, bonds), where real-time pricing is critical, or when impairment testing indicates a significant decline in value. Fair value is also preferred in mergers and acquisitions (M&A), loan collateral assessments, and shareholder reporting, as it provides a more transparent and up-to-date valuation. Under IFRS and GAAP, certain assets (e.g., investment securities, derivatives) must be reported at the fair value to ensure financial statements remain relevant and useful to stakeholders.
Key Differences Between Historical Cost and Market Value
In accounting and finance, historical cost and market value represent two fundamentally different approaches to asset valuation, each serving distinct purposes. Historical cost records assets at their original purchase price, providing stability and verifiability in financial reporting, while market value reflects the current price an asset could fetch in the open market, offering relevance for decision-making. Understanding their differences is critical for accurate financial analysis, compliance, and strategic planning. Below are the key distinctions:
Historical Cost
Historical cost refers to the original purchase price of an asset, including all necessary expenses to bring it to its usable state (e.g., taxes, shipping, installation). This valuation method is objective, verifiable, and stable, making it the foundation of financial reporting under GAAP and IFRS.
Key characteristics of historical cost:
- Fixed Value: Remains unchanged on the balance sheet unless impaired.
- Reliability: Eliminates subjectivity since it’s based on actual transaction data.
- Use Case: Preferred for long-term assets (e.g., property, equipment) and audit compliance.
- Limitation: Fails to reflect current economic value, especially for appreciating/depreciating assets.
Example:
Example:
A company buys machinery for 50,000 in 2010. Its historical cost stays 50,000 (plus depreciation), even if its market value today is 30,000 or 70,000.
Market Value (Fair Value)
Market value represents the current price an asset could fetch in the open market, based on supply/demand, appraisals, or comparable sales. It’s dynamic and market-driven, providing real-time relevance for decision-making.
The market value's Key characteristics:
- Fluctuates: Changes with market conditions, asset condition, and economic trends.
- Relevance: Critical for investment analysis, M&A, and impairment testing.
- Use Case: Required for traded securities, derivatives, and asset sales.
- Limitation: Can be volatile or subjective (e.g., illiquid assets).
Example:
Example:
The same machinery’s market value might be 60,000 today due to high demand, but drop to 40,000 next year if newer models emerge.
Historical Cost vs. Market Value for Intangible Assets
Historical Cost for Intangibles
Intangible assets (e.g., patents, trademarks, goodwill) are initially recorded at historical cost, which includes:
- Purchase Price: The Amount paid to acquire the asset.
- Direct Costs: Legal fees, registration fees, and other expenses to secure/develop the asset.
- Amortization: Systematic cost allocation over the asset’s useful life (except goodwill).
Historical cost cases of intangible assets:
Historical cost cases of intangible assets:
- Fails to reflect current earning potential (e.g., a patent’s value may soar after a breakthrough).
- Goodwill remains at historical cost unless impaired, even if brand value grows. Example: A company buys a patent for 100,000. Its book value stays 100,000 (minus amortization), even if competitors would now pay $1M for it.
Market Value for Intangibles
Market value for intangibles is estimates-based due to the lack of active markets. Methods include:
- Income Approach: Discounted cash flows from the asset (e.g., royalty savings from a trademark).
- Market Approach: Comparable transactions (e.g., similar patents sold).
- Cost Approach: Replacement cost (rarely used).
Challenges:
Challenges:
- Subjectivity: Valuations rely on assumptions (growth rates, discount rates).
- Volatility: Brand value can crash overnight (e.g., scandals).
Example: A trademark valued at 500,000 on books might have a 2 M market value if the brand gains cult status.
Also Read: The Silent Force in Share Pricing: Understanding Nominal Value.
The choice between historical cost and market value depends on the purpose of valuation—reliability for financial reporting versus relevance for decision-making. Historical cost provides stability and verifiability, making it essential for audits and compliance, while market value reflects real-time economic conditions, decisive for investors, M&A, and strategic planning. For intangible assets, this distinction becomes even more critical, as their true worth often diverges significantly from their book value.
Ultimately, modern financial practices increasingly blend both methods: historical cost for statutory reporting and market value disclosures for transparency. Understanding these differences empowers professionals to make informed choices, whether preparing financial statements, evaluating investments, or negotiating transactions.