What Is Historical Cost Accounting?
Historical cost accounting is an accounting principle requiring that assets, liabilities, and equity investments be recorded at their original acquisition cost. This method falls under the broader umbrella of accounting principles and is a foundational concept in financial accounting. It dictates that the value initially paid for an item, including any expenses necessary to bring it into usable condition, remains its reported value on the balance sheet over time, regardless of subsequent changes in its market value. The core objective of historical cost accounting is to provide stable, objective, and verifiable financial information114, 115, 116.
History and Origin
The origins of accounting can be traced back to ancient Mesopotamia, with early records from around 7500 BC using clay objects to keep track of goods113. The double-entry bookkeeping system, a cornerstone of modern accounting, was formalized by Italian mathematician Luca Pacioli in 1494, laying the groundwork for many of today's practices, including the emphasis on verifiable transaction costs111, 112.
The widespread adoption of historical cost accounting became prominent as businesses grew larger and more complex during the Industrial Revolution, necessitating more sophisticated methods for tracking production costs and calculating profits109, 110. In the United States, the principle gained significant traction following the Stock Market Crash of 1929 and the Great Depression. These events highlighted the risks of manipulative financial reporting, leading to a push for standardized rules to ensure accuracy and transparency106, 107, 108. This led to the development of Generally Accepted Accounting Principles (GAAP), under which historical cost accounting became a fundamental guideline for financial reporting, enforced and updated by bodies like the Financial Accounting Standards Board (FASB)103, 104, 105.
Key Takeaways
- Historical cost accounting records assets and liabilities at their original purchase price.100, 101, 102
- It prioritizes objectivity, reliability, and verifiability in financial reporting.98, 99
- The principle is a core component of Generally Accepted Accounting Principles (GAAP) in the United States.96, 97
- While stable, it may not reflect current market values, especially for long-term assets.95
- Adjustments such as depreciation and impairment are made to historical cost over an asset's useful life.93, 94
Formula and Calculation
The historical cost of an asset is its original purchase price plus any additional costs incurred to acquire, install, and prepare the asset for its intended use91, 92. While there isn't a complex formula to calculate the initial historical cost itself (it's simply the verifiable acquisition cost), the value of an asset recorded under this principle often changes over time due to accounting adjustments.
The book value of a depreciable asset, which is its value on the company's books, is calculated by subtracting accumulated depreciation from its historical cost:
For instance, if a company purchases a piece of equipment for $100,000 and it has accumulated $30,000 in depreciation, its current book value based on historical cost accounting would be $70,00089, 90. Similarly, for intangible assets, amortization reduces their recorded value over time88.
Interpreting Historical Cost Accounting
Interpreting financial statements prepared using historical cost accounting requires an understanding that the reported values for many assets and liabilities may not reflect their current economic worth87. This method provides a clear, verifiable record of past transactions, making financial data reliable and consistent across reporting periods85, 86. For example, a piece of land purchased decades ago will still appear on the company's balance sheet at its original purchase price, even if its market value has appreciated significantly83, 84.
This consistency allows for easier comparative analysis over time and across different companies, as the underlying basis for valuation remains constant81, 82. However, users of financial statements, such as investors and analysts, must recognize that these reported figures might not provide a complete picture of an entity's current financial health or the true value of its holdings, especially for fixed assets like property, plant, and equipment79, 80. They may need to consider external information or supplemental disclosures to gauge current values.
Hypothetical Example
Imagine a small manufacturing business, "InnovateTech," purchases a new specialized machine for its production line on January 1, 2024. The machine's purchase price is $75,000. Additionally, InnovateTech incurs $2,000 for shipping and $3,000 for installation and testing to get the machine ready for use.
Under historical cost accounting, InnovateTech would record the machine on its books at its total acquisition cost.
- Purchase Price: $75,000
- Shipping Cost: $2,000
- Installation & Testing: $3,000
- Total Historical Cost: $80,00078
This $80,000 is the value that will be listed for the machine on InnovateTech's balance sheet. If, two years later, a similar used machine could only be sold for $60,000 in the market, or a new, more advanced model becomes available for $90,000, the historical cost of InnovateTech's machine on its financial statements would still remain $80,000, before considering any depreciation expense over its useful life77.
Practical Applications
Historical cost accounting is widely applied across various aspects of finance and business. Its primary application is in the preparation of core financial statements, particularly the balance sheet, where most long-term assets are recorded at their original cost73, 74, 75, 76. This includes tangible assets such as land, buildings, and machinery, as well as many types of liabilities and equity investments70, 71, 72.
In regulatory contexts, historical cost is a cornerstone of Generally Accepted Accounting Principles (GAAP) in the United States, providing a standardized framework for financial reporting for public companies69. The U.S. Securities and Exchange Commission (SEC) relies on GAAP to ensure that investors receive consistent and verifiable financial information. Investors can access detailed guidance on interpreting financial statements, often prepared using historical cost principles, through resources like Investor.gov.68
Furthermore, historical cost is crucial for calculating depreciation and amortization expenses, which systematically allocate the cost of an asset over its useful life66, 67. It also plays a significant role in tax accounting, where the original cost basis of an asset impacts tax calculations related to gains, losses, and depreciation deductions65.
Limitations and Criticisms
Despite its advantages in objectivity and verifiability, historical cost accounting faces several significant limitations and criticisms, particularly in dynamic economic environments. One of the primary drawbacks is its inability to reflect current market values or the economic reality of an asset's worth over time63, 64. For instance, a building or piece of land purchased decades ago may be recorded at a very low value on the balance sheet, while its actual market value could be many times higher due to inflation or market appreciation59, 60, 61, 62. This can lead to an understatement of a company's true net worth and potentially mislead stakeholders57, 58.
Another major criticism is that historical cost accounting does not inherently account for inflation55, 56. During periods of rising prices, the reported costs of assets may become increasingly irrelevant, failing to reflect the actual cost of replacing those assets52, 53, 54. This can result in understated expenses (such as depreciation based on old costs) and overstated profits, potentially distorting financial ratios and a company's reported financial performance50, 51. The Federal Reserve Bank of San Francisco has discussed the complexities of "Accounting for Inflation" and its impact on financial reporting.49
The principle also struggles with valuing certain types of assets, such as intangible assets like brand value or patents, which may have significant economic value but no discernible historical cost of acquisition, or whose value is highly subjective47, 48. While some adjustments, such as impairment charges, can reduce an asset's value if it falls below its historical cost, upward revaluations for appreciation are generally not permitted under GAAP45, 46. This conservatism can mean that balance sheets may not fully depict the economic value available to a company43, 44.
Historical Cost Accounting vs. Fair Value Accounting
Historical cost accounting and fair value accounting represent two distinct approaches to asset and liability valuation, each with its own merits and drawbacks. The fundamental difference lies in their basis of valuation:
| Feature | Historical Cost Accounting | Fair Value Accounting |
|---|---|---|
| Basis of Valuation | Original acquisition cost, plus direct expenses.41, 42 | Current market price or estimated exit price.39, 40 |
| Volatility | Tends to result in less volatility in financial statements.38 | Can lead to more volatility due to market fluctuations.37 |
| Objectivity | High objectivity, as it's based on verifiable transactions.35, 36 | Can involve more judgment and estimation, introducing subjectivity.33, 34 |
| Relevance | May become less relevant over time, especially for long-held assets.31, 32 | Aims to provide more timely and current valuations.29, 30 |
| Complexity/Cost | Generally simpler and less costly to implement.27, 28 | More complex calculations and assumptions; potentially costlier.25, 26 |
Historical cost accounting emphasizes reliability and consistency, making it easier to compare financial data across different periods23, 24. In contrast, fair value accounting aims to provide a more accurate representation of an asset's current worth, which can be particularly useful for assets with readily available market prices, such as certain current assets like marketable securities20, 21, 22. While historical cost aligns with the conservatism principle by preventing overstatements of value, fair value is often seen as more relevant in reflecting current economic conditions18, 19. The debate between these two methods has been ongoing, with proponents of fair value arguing for its relevance in capturing market trends17, and historical cost advocates stressing its reliability and verifiability16.
FAQs
What is the historical cost principle?
The historical cost principle is a fundamental accounting guideline stating that a company should record assets, liabilities, and equity at their original cash or cash equivalent cost at the time of acquisition14, 15. This initial recorded amount remains largely unchanged over time, except for specific adjustments like depreciation or impairment.
Why is historical cost accounting used?
Historical cost accounting is used primarily for its objectivity, reliability, and verifiability12, 13. The original purchase price is an actual, verifiable transaction, supported by documentation, which reduces the potential for subjective valuations that could mislead stakeholders10, 11. It also provides a consistent basis for financial reporting, aiding in period-over-period comparison8, 9.
Does historical cost accounting reflect an asset's current value?
Generally, historical cost accounting does not reflect an asset's current market value7. While it provides a stable record of the initial transaction, it does not account for subsequent changes in value due to market fluctuations, inflation, or appreciation5, 6. For a current valuation, fair value accounting or other appraisal methods would be needed4.
What are some examples of assets recorded at historical cost?
Common examples of assets recorded at historical cost include fixed assets such as land, buildings, machinery, vehicles, and furniture3. These are typically long-term assets that a company expects to use for more than one year2. Capital expenditures related to acquiring and preparing these assets are included in their historical cost1.