Measurement Principles | Accounting 101

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This is the third video in the Accounting 101 series! Throughout the series, we're going to be covering everything you need to know in your average college accounting class. It will be informative, and hopefully even a little bit entertaining. I hope you can join us for the ride!

In this video, we go over the two measurement principles accountants can use under GAAP.

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There are two measurement principles that Accountants can use under GAAP.

The first is the Historical Cost Principle. Under this principle, a company would record any asset it purchases at cost! If SugarJuice bought a building for $400,000 then it would record down a building of $400,000.
What happens, though, if, at the end of the year, that same building is now worth $500,000?
Under the Historical Cost Principle… nothing! All assets are recorded at cost, and they stay that way!

The second principle is the Fair Value Principle. Under the fair value principle, a company would record the fair value of whatever asset they purchase. So, going back to our example, if at the end of the year that same building is now worth $500,000, then for year 2 SugraJuice would record $500,000!

The main difference between the Historical Cost Principle and the Fair Value Principle is the difference between Faithful representation and Relevance.

Faithful representation means that the numbers match what actually happened - they are factual.

Relevance means that financial information will help you make a decision.

When deciding between using the Historical Cost Principle and the Fair Value Principle companies need to decide between the factual nature of cost and the relevance of fair value. Most companies typically choose to use the cost principle unless they are in a situation where assets are actively traded, like investment securities. In that case, companies apply the fair value principle so that they always know where their assets are sitting at!