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 Method
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 them. This method is based on a company's past transactions and is conservative, easy to calculate, and reliable.
However, the historical cost of an asset is not necessarily relevant at a later point in time. If a company purchased a building several decades ago, then the contemporary 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 100 years ago for $50,000. Now, 100 years later, a real estate appraiser inspects all of the properties and concludes that their expected market value is $50 million. However, if the company uses historical accounting principles, then the cost of the properties recorded on the balance sheet remains at $50,000. Many might feel that the properties' worth in particular, and the company's assets in general, are not being accurately reflected in the books. Due to this discrepancy, some accountants record assets on a mark-to-market basis when reporting financial statements.
The mark-to-market method of accounting records the current market price of an asset or a liability on financial statements. Also known as fair value accounting, it's an approach that companies use to report their assets and liabilities at the estimated amount of money they would receive if they were to sell the assets or be alleviated of their liabilities. By using contemporary measurements, mark-to-market accounting aims to make financial accounting information more accurate and relevant.
Let's continue with the sample used above: Company ABC bought multiple properties in New York 100 years ago for $50,000. They're now appraised at a market value of $50 million. If the company uses mark-to-market accounting principles then the cost of the properties recorded on the balance sheet rises to $50 million to more accurately reflect their value in today's market.
However, problems with this method can arise when market prices fluctuate abruptly—as occurred during the subprime mortgage meltdown in 2007-2008, which led to the Great Recession and years of depressed real estate prices. In the years before the financial crisis, companies and banks were using mark-to-market accounting, which caused an increase in performance metrics for companies.
As companies' asset prices rose due to the boom in the housing market, the gains calculated were realized as net incomes. However, when the crisis hit, there was a rapid decline in the prices of properties. Suddenly, all of the appraisals of their worth were violently off – and mark-to-market accounting was to blame.
When sharp, unpredictable volatility in prices occurs, mark-to-market accounting proves to be inaccurate. In contrast, with historical cost accounting, the costs remain steady—which can prove to be a more accurate gauge of worth in the long run.