What is Historical Cost?
In accounting, the historical cost of an asset refers to its purchase price or its original monetary value. Based on the historical cost principle, the transactions of a business tend to be recorded at their historical costs. The concept is in conjunction with the cost principle, which emphasizes that assets, equity investments, and liabilities should be recorded at their respective acquisition costs.
It is relatively easy to retrieve the original cost of an asset, provided records were kept. Trade, sales, or purchase documentation are used to determine the historical cost of an asset. However, it is important to know that the historical cost may not necessarily be a true reflection of the fair value of an asset.
The value of an asset is likely to deviate from its original purchase price over time. An example would be the acquisition of a block of offices valued at $5,000,000. The acquisition was made 15 years ago; however, in the current market, the building is worth over $12,000,000.
- The historical cost of an asset refers to its purchase price or its original monetary value.
- Based on the historical cost principle, the transactions of a business tend to be recorded at their historical costs.
- The principle states that a company or business must account for and record all assets at the original cost or purchase price in their balance sheet, and it also applies to liabilities.
The Historical Cost Principle
The historical cost principle states that a company or business must account for and record all assets at the original cost or purchase price on their balance sheet. No adjustments are made to reflect fluctuations in the market or changes resulting from inflationary fluctuations. The historical cost principle forms the foundation for an ongoing trade-off between usefulness and reliability of an asset.
Without necessary adjustments, the historical price of an asset is still reliable, although not entirely useful in the long term. Knowing that a company might have bought an office building for $5,000,000 15 years ago, does not provide an overview of the current fair value of an asset. As such, the fair market value of the asset will prove to be more useful; however, since fair market values are up to assumption and are subjective, the Financial Accounting Standards Board (FASB) is adamant on using the historical cost principle, as it is objective and reliable.
The historical cost principle also applies to liabilities. For example, debt instruments are recorded in the balance sheet at their original cost price.
Julius owns an investment firm that has acquired various properties across southern America. Assuming that inflation levels across the region have doubled over the recent years, the property investments are not worth anything close to what Julius spent on acquisition.
The historical cost principle does not account for adjustments due to currency fluctuations; hence, the financial statements will still record the value of the asset at the cost of purchase.
Adjusting Historical Costs
In accordance with the accounting principle of conservatism, Assets recorded at historical cost must be adjusted to account for the wear and tear through their usage.. For fixed and long-term assets, a depreciation expense is used to reduce the value of the assets over their useful life. In the case where the value of an asset has been impaired, such as when a piece of machinery becomes obsolete, an impairment charge MUST be taken to bring the recorded value of the asset to its net realizable value.
There are other ways to assign costs to assets. The historical cost of an asset is different from its inflation-adjusted cost or its replacement cost. The replacement cost is the current value one would pay to acquire a similar asset, and the inflation-adjusted cost is the upward or positive adjustment of the acquisition cost of an asset from the time of purchase, relative to changes in inflation.
Some assets must be recorded on the balance sheet using fair value accounting or at their market price. These are typically short term assets located in the current asset portion of the balance sheet. An example of a current asset is marketable investments. Recording these assets at market price is important as it shows a more accurate value of what the company would receive if they were sold immediately.
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