Introduction
A warehouse a company bought in 1990 still sits on its balance sheet at what it cost in 1990, less thirty-odd years of depreciation, even if the land beneath it is now worth ten times as much. A block of listed shares the same company bought last week is marked to its market price at every quarter end. Both appear on the same balance sheet, side by side, measured on entirely different bases. That mix is not an inconsistency to be fixed; it is how US generally accepted accounting principles (US GAAP) are designed, and it explains much of the gap between a company's book value and what the market or a buyer says it is worth.
Every balance sheet item is measured on one of two broad bases. Historical cost records what was paid and adjusts it only for use and loss of value. Fair value records what the item could be sold for today. Knowing which basis applies to each line tells a banker which figures can be taken at face value, which are out of date, and which will move earnings when markets move.
Two Measurement Bases on One Balance Sheet
Most operating assets, the property, equipment, inventory and intangible assets that a business uses to produce its revenue, are carried at historical cost. They start at the price paid, including costs to get them ready for use, and are reduced over time by depreciation or amortization and, when their value falls below their carrying amount, by impairment. Most financial liabilities, including the company's own debt, sit at amortized cost, a historical-cost relative that starts at the cash received and accretes any discount up to the face amount over the life of the loan.
- Historical cost
The measurement basis that records an asset at the price paid to acquire it, including costs to bring it into use, and then reduces it for depreciation, amortization and impairment. It is not adjusted upward when the asset's market value rises.
Fair value applies mainly to financial instruments whose prices change daily and can be observed or estimated: equity securities, many debt securities held for trading or sale, and derivatives. The main measurement bases on a typical US GAAP balance sheet look like this:
| Balance sheet item | Usual measurement | Where changes in value appear |
|---|---|---|
| Property, plant and equipment | Cost less depreciation and impairment | Depreciation and impairment in net income; no increases |
| Inventory | Lower of cost and net realizable value | Write-downs in cost of goods sold |
| Acquired intangibles and goodwill | Cost less amortization if finite-lived; goodwill and indefinite-lived intangibles only tested for impairment | Amortization and impairment in net income |
| Receivables | Amortized cost less an allowance for credit losses | Credit loss expense in net income |
| Equity securities with readily determinable prices | Fair value | Net income, every period |
| Available-for-sale debt securities | Fair value | Other comprehensive income |
| Derivatives | Fair value | Net income, unless hedge accounting applies |
| The company's own debt | Amortized cost | Interest expense; fair value only disclosed |
The pattern is consistent: items held to be used are carried at cost, items held to be traded or sold are carried at fair value. The detailed rules for securities are covered in investments in securities at fair value, and the inventory test in inventory write-downs.
What Fair Value Means
Under Accounting Standards Codification (ASC) 820, the standard that defines the term, fair value is not what a company thinks an asset is worth to it. Deloitte's roadmap on fair value measurement quotes the definition: the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is an exit price, measured from the perspective of a hypothetical buyer, not the company's own intentions or synergies.
- Fair value
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, as defined in ASC 820. It is an exit price based on market participants' assumptions, not the holder's own view of value.
Because not every asset trades on an exchange, ASC 820 ranks the inputs to a fair value estimate in a three-level fair value hierarchy:
- Level 1: quoted prices in active markets for identical assets, such as a listed share's closing price.
- Level 2: observable inputs other than those quotes, such as prices of similar bonds or market interest rate curves.
- Level 3: unobservable inputs the company develops itself, often from its own data adjusted to what market participants would assume, such as a discounted cash flow model for a private company stake.
Why US GAAP Holds Most Assets at Cost
Historical cost survives because it is verifiable: the price paid is a fact backed by an invoice, while the current value of a specialized factory is an opinion. Carrying operating assets at cost keeps the balance sheet free of estimates that would be hard to audit and easy to manage. The trade-off is that cost-based figures grow stale, and the staleness runs mostly one way.
That asymmetry is the key point. When an asset's carrying amount can no longer be recovered from the cash flows it will generate, US GAAP requires an impairment write-down to fair value, but when its value rises, nothing is recorded until the asset is sold. Land bought decades ago, a fully depreciated building in a city center, or a brand built over generations can all be worth far more than their book amounts, while assets that fail an impairment test are written down. The tests that trigger write-downs are explained in impairment of long-lived assets.
What the Two Bases Mean for a Banker
The first consequence is earnings volatility where fair value runs through net income. US GAAP requires changes in the fair value of most equity securities to be recorded in net income, and Berkshire Hathaway, with one of the largest equity portfolios of any company, shows the effect. Its results for 2022 report operating earnings of $30.8 billion and investment and derivative losses of $53.6 billion, producing a net loss of $22.8 billion in a year when its businesses performed well. Berkshire explains that GAAP requires it to include changes in unrealized gains and losses on its equity investments in earnings, and presents operating earnings alongside net income for that reason.
The second consequence is understated book value. Because cost-based assets are never written up, a mature company with old real estate, valuable internally built brands or long-held investments can have a book value far below what its assets would fetch, which is one reason price-to-book ratios vary so much across companies and industries, as discussed in book value vs market value.
Acquisitions and Debt: Where the Bases Collide
The third consequence arrives with an acquisition. When one company buys another, the buyer records the target's identifiable assets and liabilities at fair value on the acquisition date, so decades of stale historical costs are reset in a single day, and the remainder of the price becomes goodwill. The step-up creates new depreciation and amortization that reduce the combined company's earnings, a process worked through in purchase price allocation. The same company's assets can therefore sit at old cost on its own balance sheet and at fair value on its acquirer's, which is why a target's book value is rarely a useful guide to the goodwill a deal will create.
Finally, the basis matters for net debt. Debt is carried at amortized cost, not at market value, so when a company's bonds trade well below par because rates have risen or its credit has weakened, the balance sheet still shows close to the face amount. For an enterprise value bridge, bankers normally use that carrying amount or the face value, while the fair value disclosed in the notes tells them what it would cost to buy the debt back. Each figure answers a different question, and the habit worth building is to ask, for every number taken from a balance sheet, which basis produced it and whether that basis fits the question being asked.
