What Is Historical Cost?
Historical cost is a fundamental accounting principle that dictates that assets, liabilities, and equity investments be recorded on the balance sheet at their original cost when acquired, rather than at their current market value. This method falls under the broader umbrella of Accounting Principles, which provide a standardized framework for financial reporting. The historical cost principle emphasizes objectivity and verifiability, as the original transaction price is typically supported by clear documentation. Once recorded, the value of an asset under historical cost remains constant, except for adjustments like depreciation or amortization for long-term assets, or impairment charges if its value permanently declines. The Financial Accounting Standards Board (FASB) defines historical cost as the cost incurred to acquire or create an asset, including the consideration paid and transaction costs.9
History and Origin
The adherence to the historical cost principle in accounting, particularly in the United States, gained significant traction following pivotal economic events. The widespread financial reporting irregularities that contributed to the stock market crash of 1929 and the ensuing Great Depression underscored the urgent need for more transparent and consistent financial reporting standards.8 In response, legislation such as the Securities Act of 1933 and the Securities Exchange Act of 1934 was enacted, leading to the gradual establishment of Generally Accepted Accounting Principles (GAAP).7 The U.S. Securities and Exchange Commission (SEC), established in 1934, played a crucial role in promoting and solidifying the use of historical cost accounting. From its inception until the early 1970s, the SEC generally opposed revaluations of fixed assets upward, thereby cementing historical cost as the predominant valuation method for many assets.6 This historical context highlights the principle's role in ensuring reliability and preventing manipulative reporting practices during a crucial period of financial market development.
Key Takeaways
- Historical cost records assets, liabilities, and equity at their original purchase or acquisition price.
- The principle prioritizes objectivity and verifiability, as original transaction costs are typically well-documented.
- Once an asset is recorded at historical cost, its value generally remains unchanged on the balance sheet unless adjusted for depreciation, amortization, or impairment.
- Historical cost is a cornerstone of GAAP, promoting consistency and comparability in financial statements.
- It serves as the foundation for calculating cost basis for tax purposes on investments and other property.
Interpreting the Historical Cost
Interpreting historical cost primarily involves understanding that it represents the objective, verifiable transaction price at the time of an asset's acquisition, not its current economic worth. For instance, a piece of land purchased decades ago for a low price will still appear on a company's balance sheet at that original, historical cost, despite significant appreciation in its market value. This can mean that the recorded value of assets on financial statements may not reflect their current economic reality. However, this adherence to initial cost provides a reliable and consistent benchmark that avoids subjective valuations. It allows users to trace the original investment in an asset and understand how it has been accounted for over time, including any accumulated depreciation that reduces its book value. This method also simplifies comparison across reporting periods, as the basis of valuation remains constant.
Hypothetical Example
Consider "Tech Innovations Inc." which, on January 1, 2020, purchases new manufacturing equipment for its production line. The invoice for the equipment is $500,000. Additionally, the company incurs $10,000 for shipping and handling, $5,000 for installation, and $2,000 for initial testing to ensure it's ready for use.
Under the historical cost principle, Tech Innovations Inc. would record this equipment as an asset on its balance sheet at its total cost incurred to acquire and prepare it for its intended use.
Calculation:
- Purchase Price: $500,000
- Shipping and Handling: $10,000
- Installation: $5,000
- Initial Testing: $2,000
Total Historical Cost = $500,000 + $10,000 + $5,000 + $2,000 = $517,000
This $517,000 will be the initial value recorded for the equipment under fixed assets. Over its useful life, this equipment will be subject to depreciation expenses, which systematically reduce its book value on the balance sheet and are recorded on the income statement. Even if the market value of similar equipment increases or decreases significantly in subsequent years, the recorded historical cost (adjusted for depreciation) will remain the basis for its valuation on the company's financial statements.
Practical Applications
The historical cost principle is widely applied across various areas of finance and accounting, forming the backbone of traditional financial reporting. In corporate accounting, companies use historical cost to record the acquisition of physical assets such as property, plant, and equipment, as well as intangible assets like patents and trademarks. It is also fundamental in determining the cost basis of investments for tax purposes, where capital gains or losses are calculated based on the difference between the sale price and the adjusted historical cost of an asset. The Internal Revenue Service (IRS) provides detailed guidance on how to determine the basis of property for tax calculations, which is intrinsically linked to its historical cost. This principle further extends to the valuation of inventory, where the cost of goods sold is derived from the historical cost of inventory items. For liabilities, historical cost means recording obligations at the amount of cash or its equivalent exchanged when the liability was incurred.
Limitations and Criticisms
While historical cost offers objectivity and verifiability, it faces several criticisms, primarily regarding its relevance in dynamic economic environments. One major limitation is its inability to reflect current market values.5 Assets held for long periods, such as real estate, may have a historical cost far removed from their present economic value, leading to financial statements that do not accurately portray a company's true worth or a realistic measure of its equity. This can mislead investors and other stakeholders who rely on financial reports for informed decision-making.4
Furthermore, historical cost accounting does not inherently account for inflation. In periods of rising prices, the purchasing power of money diminishes, yet assets are still recorded at their original, nominal cost. This can result in understated expenses (e.g., depreciation based on lower historical costs) and overstated profits, providing a distorted view of a company's financial performance.3 Critics also argue that historical cost can hinder the comparability of financial statements, particularly between companies that acquired similar assets at different times or those operating in different economic conditions. The debate between historical cost and alternative valuation methods, such as fair value accounting, highlights these concerns, with arguments often centering on a trade-off between the reliability of historical cost and the relevance of current values.2 A speech by an SEC Commissioner, for example, explores this balance, noting how fair value accounting emphasizes the balance sheet while historical cost accounting emphasizes the income statement.1
Historical Cost vs. Fair Value
The distinction between historical cost and fair value is a central debate in modern accounting. Historical cost records assets and liabilities at their original transaction price, prioritizing objectivity and verifiability. This means the value on the balance sheet reflects what was paid, supported by transaction records. For example, if a building was bought for $1 million, it would be recorded at $1 million, adjusted for depreciation, regardless of its current market worth.
In contrast, fair value represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This approach aims to provide a more current and relevant valuation of a company's financial position, particularly for items like marketable securities or derivatives that have readily observable market prices. While fair value offers greater relevance by reflecting current economic conditions, it can introduce more subjectivity, especially when active markets do not exist for certain assets or liabilities, requiring estimates and assumptions. Historical cost provides a stable, verifiable record, whereas fair value seeks to capture dynamic market realities, reflecting differing objectives in financial reporting.
FAQs
What types of assets are typically recorded using historical cost?
Most long-lived assets such as property, plant, and equipment, as well as intangible assets, are recorded at their historical cost. This also applies to inventory and certain investments that are not actively traded.
Does historical cost accounting reflect the current value of a company?
No, historical cost accounting does not directly reflect the current market value or true economic worth of a company's assets. It focuses on the original transaction price, which may differ significantly from current values due to market fluctuations, inflation, or technological advancements. Financial statements prepared solely on a historical cost basis may not fully represent a company's present financial health.
Why is historical cost still used despite its limitations?
Historical cost remains widely used because it provides a highly reliable, objective, and verifiable measure of assets and liabilities. The original transaction price is typically supported by clear documentation, making it less susceptible to manipulation or subjective estimates than other valuation methods. It also promotes consistency and comparability in financial reporting over time.
Can historical cost be adjusted?
Yes, the historical cost of an asset can be adjusted over time. For fixed assets, it is systematically reduced by depreciation (or amortization for intangibles) over its useful life to reflect wear and tear or obsolescence. Additionally, if an asset's value permanently declines below its carrying amount, an impairment charge may be recognized to reduce its book value.