Accounting Measures Cost, Not Values
The next distinction to make is the difference between cost and market values. When an asset is acquired, the price paid for it is probably its value at that time. Thereafter, however, accounting traces what happens to the cost of the asset—for long-lived assets, how much of the cost is debited as an expense each period; for inventory, what was the cost of the goods sold in the period. If land was acquired ten years ago at a cost of $10,000, it appears on the most recent balance sheet at $10,000, even though its market value may have doubled during the 10 years. There are at least three reasons to emphasize costs, rather than values.
- The current market value of most assets is difficult to estimate, and accounting reports based on such estimates would be unreliable.
- Except for inventory held for sale, you are going to use most non-monetary assets in the entity's operation.
- Accounting traces the amount of funds invested in various assets, and these funds represent the cost of the asset at the time you made the investment.
The balance sheet does not report the value of assets, except for cash, accounts receivable, and similar monetary assets. The balance sheet does report the cost of assets. For long-lived assets, the balance sheet reports the portion of the cost that has not been debited as depreciation expense.
The total of the assets side of the balance sheet is not the value of the entity. The value of the entity is what someone is willing to pay for it, which usually bears little relation to the amount reported as assets.
Similarly, the amount reported as equity on the right-hand side is not the value of the equity. Although this amount is sometimes referred to as net worth, it does not measure what the owners' claim on assets is worth.
Failure to appreciate this point is one of the most common causes of misunderstanding about the meaning of accounting numbers.
This overview of accounting describes the main ideas, but by no means discusses all the problems that arise in accounting for even a small entity. If you belong to an industry association, the association may have publications that explain the accounting techniques appropriate for your industry.