Highest Value Principle and Lowest Value Principle

Highest Value Principle and Lowest Value Principle

Both terms are used in accounting and belong to the so-called generally accepted accounting principles, also known as GoBs for short.

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This refers to the rules that a merchant must follow when valuing his assets and liabilities. Both GoBs are derived from the principle of prudence, or more specifically, from the impairment principle. The legal basis for this is Sections 252 and 253 of the German Commercial Code (HGB).

Höchstwert

Highest Value Principle - § 253 HGB

If there are multiple valuations for the liabilities side, i.e., the entrepreneur's debts, on the balance sheet date, the highest valuation must be used. This principle applies particularly to liabilities denominated in other currencies due to exchange rate fluctuations. For example, if an entrepreneur has purchased goods on account for a total of €21,000 and determines on the balance sheet date that the value is now €25,000, the entrepreneur must adjust his liabilities upwards and enter €25,000 in the balance sheet.

Lowest Value Principle - §253 (3) HGB

This principle is the counterpart to the highest value principle and states that the merchant must always record the assets side of his balance sheet, i.e., his assets, at the lowest possible value. However, a distinction is made between the valuation of fixed assets and current assets, and depending on the asset's classification, a distinction is made between:

 

strict lower of cost or market principle - § 253 (4) HGB

  • This regulates the valuation of current assets, i.e., all assets that are not intended to serve the company's long-term purpose. Generally, these are assets that are intended for sale. The rule of thumb for length of service is usually one year.
  • There is no distinction here between temporary and permanent impairment. If it is clear on the balance sheet date that the assets have decreased in value, they must be written down to the lowest possible value. Therefore, the merchant has no choice.

mitigated lower of cost or market principle

  • This refers to the fixed assets, i.e. all the assets that are intended to serve the company permanently, such as machinery or the vehicle fleet
  • On the balance sheet date, the acquisition price is compared with the current market value or stock exchange price
  • In addition, a distinction is made as to whether the asset is permanently or only temporarily reduced in value

permanent impairment - §253 para. 3 sentence 5 HGB

A building owned by Entrepreneur B is severely damaged after a fire; the original purchase price was €1,000,000, but the value is now €200,000.

The contractor must write off the current value of €200,000. If the damage is repaired later, the building's value will be adjusted upwards on the balance sheet.
Note: If the market value is now even higher than the original purchase price, e.g. €1,200,000, the entrepreneur may still only set a maximum purchase price of €1,000,000
Reason: the realization principle would otherwise be violated

temporary impairment - Section 253 Paragraph 3 Sentence 6 HGB

For example, if the entrepreneur purchased shares at a price of €25 each, which are now worth only €21 per share on the balance sheet date, he or she may choose whether to record the shares on the balance sheet at their acquisition cost or current book value, or to write them down to the market price applicable on the balance sheet date. Only in this case does the entrepreneur have a choice.

Why do we need these principles?

The highest-cost-or-market principle and the lower-cost-or-market principle are intended to ensure that the merchant remains liquid and can thus meet future payment obligations. Behind both principles lies the prudence or impairment principle, which states that the merchant must account for losses in their balance sheet even if they have not yet occurred. Furthermore, the premise that the balance sheet is always drawn up is that the annual financial statements should provide a true and fair view of the economic situation.

By complying with both GoBs, profits are not falsely reported at the end of the year that the company hasn't realized, and consequently, no unearned profits are distributed. Ultimately, this also serves as a key protection for creditors.

 

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