Most people consider accounting quite daunting because of the many rules and theoretical foundations in place. In The process of accounting, we learned that accounting is a process of measurement – however the term measurement is open to many interpretations. When we measure transactions, we are assigning each one a value – and there are five methods for determining value:
Assets of a company are recorded at the price for which they were originally acquired. For example, if a business bought a machine for $250,000, this asset would be entered into the accounts at its purchase price of $250,000.
A measure of an item’s market price on a particular date in the normal course of business, hence it is sometimes called “market value”. Fair value can be objectively determined at any time. It is just an estimate, upon which people may have differing views. The global accounting standards (International Financial Reporting Standards or IFRS) and Australian accounting standards (AASBs) do require some items in the financial statements to be recorded at fair value, though there are strict rules to follow. In this introductory text, we won’t go any further into fair value – but if you choose to study accounting in more detail in your major or specialisation – then fair value is a topic you will cover at a later date.
The cost to a business of acquiring an asset identical to, or with the same functions, as an existing asset. It is a type of present value, because at the time of purchase, the replacement cost is equivalent to the original cost. This value will change with time as prices for that item fluctuate. For example, pre-COVID19, a computer monitor may have cost $250. However, due to computer chip shortages and subsequent price rises, the replacement cost for that monitor may now be $350.
Net realisable value
The value of a product after subtracting the expected costs of production, transaction costs and taxes related to the sale of the item, or the value of some other asset after taking account usage, wear and tear. It can commonly be calculated as the historical cost less depreciation. Depreciation is a process used by accountants to recognise that assets get used up over time. For example, the further distance you drive your car, the less it is likely to be worth when you sell it. Depreciation is something we will get into in much more detail in Chapter 3 and in greater detail again in Accounting, Business and Society.
The value at the present time of a payment or cash flow occurring in the past or future. Measuring present value involves taking future cash flows and discounting them at an appropriate rate. It is a measurement that takes into account the changing value of money over time. Students often learn more about present value in finance-related subjects.
Which method of value do we use in our measurement?
Soon we’ll be learning more about historical cost, but in a nutshell, our global accounting standards (IFRS) require us to mostly use the historical cost measurement method. There are some parts of accounting standards that do require fair value (such as an intangible asset like a patent), but that isn’t something to worry about at the introductory level.