Historical cost refers to the original cost of an asset when it was first acquired. It is also recorded as the first cost in accounting records, such as balance sheets.
Businesses following the historical cost principle are required to record actual purchase prices for assets, equities, and liabilities.
The historical cost principle does not account for currency fluctuations, so all financial records reflect the original value of the asset.
What Is the Historical Cost Concept?
Historical cost concept states that the value of an asset does not change even as an asset appreciates or depreciates causing it to differ from the current market value. This is different from the fair value concept which reflects current market value.
Evaluating assets using their historical cost prevents overvaluation in dynamic markets. However, it also has a downside in that it does not reflect an asset’s fair value.
For instance, the historical cost of an appreciating asset such as a building will remain the amount at which it was bought even though its market value has significantly appreciated.
Following the historical cost concept, balance sheets reflect the original purchase price of all equities, assets, and liabilities. Sales and purchase agreements also reflect the historical costs. However, these agreements are not bound by these principles and in some cases, may reflect fair value.
Historical Cost Adjustment
As time passes, historical costs require adjustment following conservative accounting concepts. These adjustments account for wear and tear reflecting the asset’s depreciation. Depreciation expenses are typically recorded for long-term assets which reduce in value over the course of their estimated useful life.
In case an asset’s value declines below its adjusted cost, an impairment charge is levied to record its net realizable value.
Your company bought a tangible asset worth $10 million 5 years ago, but its current market value is $40 million. The balance sheet will record this asset at its historical cost of $10 million.
The difference between the historical cost and current market value is $30 million, which indicates that the asset has appreciated, and its future market value is likely to be higher.
Historical Cost vs. Fair Value
As earlier discussed, historical cost is the original purchase price of an asset as indicated on the balance sheet. On the other hand, the fair value reflects its current market value. In the example above, the tangible asset’s historical cost is $10 million while its current market value is $40 million.
Fair value fluctuates to reflect market changes. This value can also be used to predict the cash flow that could be realized through prospective sales. However, if the historical cost of an asset remains higher than its current market value, it is an indicator its future market will move downwards.
Use of Historical Cost in Accounting?
Fixed assets are recorded at their cost of purchase or historical cost. Inventory may also be recorded at its original cost; however, it may be adjusted to reflect market value. GAAP requires all businesses to record certain assets at historical cost.
Historical costs may include shipping, delivery, setup, and training fees for tangible assets. With the exception of stocks and bonds, all other business assets must be recorded following the historical cost principle.
Intangible assets such as trademarks, patents, and copyrights are recorded using the cost of production. The historical cost, in this case, would include attorney fees used to register the trademark as well as the cost of creating the trademark.
Following the historical cost principle is standard practice for public companies that sell their stock on public stock exchanges.
The International Financial Reporting Standards Board has set up standards similar to Financial Accounting Standards Board’s GAAP that require companies to use historical costs.
Importance of the Historical Cost Principle in Accounting
Historical cost is one of the four financial reporting principles applied by all accounting businesses and professionals.
Following this principle, all goods and services purchased by a company must be recorded at historical cost and not fair market value.
For accounting professionals, analyzing business records and balance sheets, historical cost is important because it is:
- Reliable: The process of recording historical costs in business records such as the balance sheet is consistent. It is therefore reliable which gives any accounting professional looking at the books an accurate picture of the business’s financial health.
- Verifiable: Historical cost is easy to verify using records on the balance sheet.
- Comparable: Using the historical cost principle, it is easy to compare the cost of assets. This is particularly useful when determining which assets to liquidate.
Recording the historical cost of your assets makes it easy to assess the appreciation and depreciation of assets over time. Following this principle also makes it easy for external accounting professionals who rely on Generally Accepted Accounting Principles to carry out their duties effectively.
Recording historical cost also prevents overvaluation in turbulent markets by helping accountants quickly assess capital expenditures.
Overall, even as critics argue that it represents a conservative picture of an organization’s financial health, historical cost remains a key concept for recording assets.