Historical cost principle

Historical cost principle

What is the historical cost principle?

The historical cost principle is a conservative accounting principle that stipulates that the recording of asset values on a company's balance sheet must be the same as the original cost at the date of purchase.

In other words, the original cost price will be recorded when documenting asset values. The historical cost principle is one of the generally accepted accounting principles (GAAP) encapsulating the complexities, legalities, and details of corporate and business accounting.

How to calculate the historical cost of an asset

To understand the historical cost concept, it's essential to understand that other factors like inflation, depreciation and market value do not reflect in the cost concept. That is, an asset's historical price remains strictly its original price.

Here's a scenario to explain historical cost in a conceptual framework:

A business owner acquired a machine five years ago costing $20,000. In the current market, a new machine with those precise specifications costs double that amount ($40,000) because of inflation. However, as the machine has seen five years of use so far, its market value in its current condition is $10,000. 

In this case, despite the depreciating effects of using a fixed asset and the potential increase in the machine brand's value due to inflation, its historical cost remains the original purchase price of $20,000. 

Understanding historical cost in financial accounting 

The historical cost principle sometimes called the "cost principle," implies that asset values on balance sheets must reflect the original cost price.

However, this does not consider factors like depreciation and value increments over time resulting from inflation. As such, not all asset categories can be recorded at historical cost. A good example is marketable securities, such as ETFs, stocks, preferred shares, and bonds.

Marketable securities aren't recorded at historical costs because they are highly liquid assets. For instance, share prices in investments may change, leading to an equivalent change in the asset's valuation on the balance sheet. Such price adjustments, however, can help companies provide their investors and shareholders with complete transparency regarding asset valuation. 

Thus, marketable securities are not recorded at their historical cost in the balance sheet. Instead, they're documented at their fair market values, as this measure accurately represents their respective values. 

Fair value vs. historical cost

Fair value, otherwise known as fair market value, is an asset's current market value, considering real-time market conditions. In other words, fair value is the price that an asset would sell for in a competitive and open market where:

  • Both parties (sellers and buyers) have apt data on important market facts
  • Both parties have ample time to complete the deal
  • Both parties are under no compulsion to complete the deal
  • The prices are mutually agreed upon

Fair market value is a measure to determine the amount of money or cash flow that could be generated from the sale of an asset in the future. As such, fair market value is never fixed. Instead, it changes to reflect market conditions. When pitted against historical cost, i.e., original price, it becomes possible to assess an asset's market performance over time. 

If the asset's historical price stays higher than the fair market value, the market is on a downward trend. On the other hand, if the asset's fair market value is higher than its historical price, the market is on an upward trend. In other words, it means that the asset's value has appreciated. 

What happens when there are depreciations

When recording assets in the balance sheet at their original cost, there's no adjustment for market price fluctuations. Nevertheless, the wear and tear expenses that come with using long-term assets mean that certain modifications must be made. 

With such long-term assets, room must be made for depreciation. In the balance sheet, this depreciation expense reflects when recording the asset's value throughout its useful life. 

Here's an example to illustrate how depreciating expenses can affect the historical cost in business financial statements. 

A business owner purchases a fixed, depreciable asset of office furniture at the cost of $10,000. This cost ($10,000) goes into the balance sheet as the asset's historical cost. If the asset's useful life is five years, the depreciation expense for each of these five years would be $2000 annually ($10,000 divided by 5 years).

Subsequently, the balance sheet must show the asset's historical cost less accumulated yearly depreciation. 

Asset impairment vs. historical cost

Impaired assets refer to assets whose current market value is less than the value reflected on the balance sheet. When assets are "written off", it implies that they've been impaired. As such, the company has to document a loss when assets are determined to be impaired. Examples of impaired assets include notes receivables, accounts receivables, and goodwill.

When assessing the value of assets that have been impaired, it is more ideal or conservative to devalue the asset based on current market conditions rather than historical cost. This is because impaired assets are a depreciation expense. 

Mark-to-market vs. historical cost

Mark-to-market accounting differs from historical cost accounting in valuing liabilities and assets using current market prices rather than original prices. This makes it the appropriate accounting standard for derivatives such as futures and options contracts. 

Mark-to-market accounting is thus more volatile, as the reported values of liabilities and assets are subject to fluctuating real-world market conditions. 

Benefits of historical cost accounting

Below are some of the benefits of historical cost accounting:

It provides fact-based information

They are fact-based and can provide financial statement users with reliable and accurate information.

It is a transparent asset valuation method

Historical cost is a transparent accounting measure, as the costs are verifiable.

It is a consistent asset valuation method

Their values are consistent because the same method is used to assess liabilities and assets, which can be used in comparative business analysis over time. 

It is a cost-effective method of accounting

Historical costs are pretty economical because they accrue no additional costs in preparing financial statements. As such, businesses can save more via this accounting method. 

Limitations of the historical cost principle 

Historical cost accounting has some limitations, some of which are discussed below:

Non-disclosure of a company's current worth

There are better measures or approaches than historical cost accounting to assess a company's current worth. This is because the historical cost does not make any price adjustment for effects linked to inflation and depreciation. As such, one cannot get a fair market value for the company by calculating the historical cost of its assets and liabilities.

Difficulties with replacing fixed assets

Historical cost accounting is inadequate for calculating the cost of replacing depreciable fixed assets. This is because the original cost does not factor in inflation, which is essential in estimating the cost of replacing fixed assets.

Inaccurate profit determination

Inflation, essential in calculations for profit and loss, is not accounted for in historical cost accounting. As such, assets are often undervalued, leading to an inability to determine profit margins accurately. 

Conclusion

Indeed, the historical cost principle is inaccurate for deducing accounting estimates where inflation is a factor. Nevertheless, it remains valuable for businesses as it provides an objective and consistent basis for asset valuation.

Companies that want to maintain accurate financial statements must adjust historical costs to include depreciating expenses. Other accounting measures like fair market and mark-to-market costs should be considered for financial statements that reflect long-term asset values. 

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