Historical cost

What Is Historical Cost?

Historical cost is a fundamental principle in Financial Accounting that requires companies to record and report assets, liabilities, and equity at their original acquisition cost. This means that once an item is purchased, its value is typically maintained on the Balance Sheet at that initial cost, rather than being revalued to reflect current market fluctuations. The historical cost principle forms a cornerstone of traditional Financial Statements, aligning with the Conservatism Principle by preventing the overstatement of asset values.

History and Origin

The adherence to historical cost as a core accounting principle largely stems from its emphasis on objectivity and verifiability. In the early 20th century, particularly after periods of market instability, there was a strong push for financial reporting to be based on verifiable transaction data rather than subjective valuations. The Securities and Exchange Commission (SEC) in the United States, established in 1934, played a significant role in solidifying the prevalence of historical cost accounting. The SEC, through its policies, consistently favored historical cost due to its objective and verifiable nature, viewing it as a reliable basis for financial reporting.¹⁷,¹⁶,¹⁵ This preference helped entrench historical cost as the dominant method for recording many assets and liabilities in U.S. financial practice for decades.

Key Takeaways

• Historical cost records assets, liabilities, and equity at their original purchase price.
• It emphasizes objectivity and verifiability in financial reporting.
• The principle helps prevent the overstatement of asset values and provides a consistent baseline.
• While widely used, it may not reflect an asset's current market value or account for inflation.
• Adjustments such as depreciation and impairment are applied to historical cost over time for certain assets.

Interpreting the Historical Cost

Historical cost provides a verifiable and reliable basis for financial reporting. When interpreting financial statements prepared under the historical cost principle, it is important to understand that the reported values for many long-term assets do not necessarily reflect their current economic worth or replacement cost. For instance, a building purchased decades ago will still be recorded at its original cost, subject to adjustments for Depreciation. This approach aims for consistency and comparability across accounting periods, making it easier to track changes from the initial acquisition. However, if the value of an asset declines significantly below its historical cost, an Impairment charge may be recognized to reduce its carrying amount, adhering to the conservatism principle.

Hypothetical Example

Consider XYZ Corp., which purchased a piece of land for manufacturing expansion on January 1, 2020, for $500,000. Additionally, the company incurred $20,000 in legal fees and surveying costs directly related to the acquisition.

Under the historical cost principle, the land would be recorded on XYZ Corp.'s books at its initial total cost.
The calculation is straightforward:

In this case:

This $520,000 would be the value reported on XYZ Corp.'s balance sheet for the land, regardless of any subsequent appreciation in its market value. Even if by January 1, 2025, the market value of similar land had risen to $700,000, the company's financial statements would still show the land at its historical cost of $520,000. This stable reporting impacts how the company's Income Statement and Cash Flow are analyzed in relation to its asset base.

Practical Applications

Historical cost is a foundational concept widely applied across various aspects of financial management and reporting. It forms the basis for recording most assets, especially property, plant, and equipment, on a company's balance sheet. This principle is mandated by major accounting frameworks globally, including Generally Accepted Accounting Principles (GAAP) in the United States and, to a significant extent, International Financial Reporting Standards (IFRS).¹⁴,¹³

Its application ensures a high degree of verifiability in Financial Reporting because the original transaction cost is typically supported by objective documentation like invoices and receipts. This verifiability contributes to the reliability of financial statements, which is crucial for auditors, investors, and creditors. For example, the Financial Accounting Standards Board (FASB) defines historical cost and emphasizes its role in accounting for assets.¹²

Limitations and Criticisms

Despite its advantages in reliability and verifiability, the historical cost principle faces several limitations and criticisms. A primary concern is its inability to reflect current economic realities, particularly in periods of inflation or significant changes in Market Value. An asset recorded at its historical cost may be significantly undervalued on the balance sheet if its current market value has appreciated considerably, or overstated if its market value has declined but an Impairment has not been recognized. This can lead to financial statements that do not provide a complete picture of a company's true financial position.¹¹,¹⁰,⁹

Critics argue that historical cost accounting can lead to misleading information for decision-makers, as it may distort profitability and the true value of a company's equity and liabilities.⁸,⁷ For instance, depreciation expense based on historical cost might be understated during inflationary periods, leading to an overstatement of profits.⁶,⁵ While the historical cost principle emphasizes objectivity, it can sometimes prioritize reliability over relevance, especially in dynamic economic environments.⁴

Historical Cost vs. Fair Value Accounting

Historical cost and Fair Value Accounting represent two distinct approaches to asset valuation in financial reporting, often debated for their respective merits.

The core difference lies in their temporal focus: historical cost looks backward to the original transaction, while fair value looks forward to the current market.³,² The debate between these two valuation methods intensifies during financial crises, where their different impacts on reported financial results become highly visible.¹

FAQs

What is the primary purpose of the historical cost principle?

The primary purpose of the historical cost principle is to provide a reliable, objective, and verifiable basis for recording financial transactions. By using the original acquisition cost, it minimizes subjective valuations and enhances the consistency of Accrual Accounting over time.

Does historical cost apply to all assets?

While historical cost is widely applied to most long-term tangible assets like property, plant, and equipment, there are exceptions. Certain assets, particularly highly liquid ones such as marketable securities and some financial instruments, may be recorded at their Market Value or fair value.

How does inflation affect historical cost accounting?

Inflation can significantly distort financial statements prepared under the historical cost principle. When prices rise, assets recorded at older, lower historical costs may lead to an understatement of asset values and an overstatement of profits, as expenses (like depreciation) are based on outdated costs. This can misrepresent a company's true Financial Position.

Why is historical cost still used despite its limitations?

Historical cost remains prevalent due to its objectivity, ease of Valuation, and reduced susceptibility to manipulation compared to more subjective valuation methods. It also provides a clear audit trail and helps maintain comparability of financial data across different periods.