Historical value

What Is Historical Cost?

Historical cost is a fundamental principle in financial accounting that dictates how most assets and liabilities are recorded on a company's balance sheet. It states that these items should be recognized at their original purchase price or acquisition cost at the time of the transaction, rather than their current market value. This principle is a cornerstone of Generally Accepted Accounting Principles (GAAP) in the United States, providing a verifiable and objective basis for financial reporting. The concept is closely aligned with accrual accounting, emphasizing the recording of economic events as they occur, regardless of cash flow.

History and Origin

The concept of valuing assets at their original cost has deep roots in accounting practices, long predating formal accounting standards. Its widespread adoption and entrenchment within U.S. GAAP can be largely attributed to the influence of regulatory bodies like the Securities and Exchange Commission (SEC). From its founding in 1934 through the 1970s, the SEC played a powerful role in ensuring the predominance of historical cost accounting for inventories and fixed assets in the U.S. financial reporting system, often pushing back against attempts to introduce upward revaluations of non-financial assets⁹, ¹⁰. This regulatory stance solidified historical cost as a bedrock principle, valued for its objectivity and reliability in an era focused on preventing speculative asset valuations in financial statements.

Key Takeaways

• Historical cost records assets and liabilities at their original purchase price.
• It is a core principle under U.S. Generally Accepted Accounting Principles (GAAP).
• The principle prioritizes reliability and verifiability over current market relevance.
• Adjustments such as depreciation are applied to historical cost for certain assets over time.
• Historical cost offers a conservative approach to asset valuation on the balance sheet.

Formula and Calculation

The calculation of historical cost begins with the initial outlay for an asset. This includes the acquisition price itself, plus any additional costs necessary to get the asset ready for its intended use. For example, the historical cost of a piece of machinery would include its purchase price, shipping fees, installation costs, and any testing expenses.

For many long-term assets, the initial historical cost is then systematically reduced over its useful life through depreciation (for tangible assets) or amortization (for intangible assets). The recorded value on the balance sheet at any given time is often referred to as the asset's net book value or carrying value.

For example, if a company purchases equipment:

Original Purchase Price + Direct Costs (shipping, installation, testing) = Historical Cost

Then, over time:

Historical Cost - Accumulated Depreciation = Net Book Value

Where:

• Original Purchase Price = Price paid for the asset.
• Direct Costs = All necessary expenditures to make the asset operational, such as capital expenditures.
• Accumulated Depreciation = Total depreciation expense recognized to date.
• Net Book Value = The asset's carrying amount on the balance sheet.

Interpreting Historical Cost

Interpreting historical cost requires an understanding of its underlying philosophy: reliability and verifiability. Because assets are recorded at their original cost, which is supported by transaction documents, the figures presented on financial statements are objective and less subject to subjective estimation. This offers a stable and consistent basis for comparing financial performance over time and across different entities.

However, a key aspect of interpreting historical cost is recognizing its inherent limitation regarding current market values. The historical cost of an asset acquired many years ago may bear little resemblance to its current market value, especially in periods of inflation or rapid technological change. This means that while the historical cost provides a reliable record of the original transaction, it does not necessarily reflect the current economic value of an asset. The principle aligns with the conservatism principle in accounting, which encourages prudence and a bias towards understating assets and overstating liabilities when estimates are involved.

Hypothetical Example

Consider a logistics company, Speedy Delivery Co., that purchased a warehouse and land for its operations on January 1, 2020. The purchase price of the land was $1,000,000, and the warehouse building cost $2,000,000. Additionally, Speedy Delivery Co. incurred $100,000 in legal fees and other closing costs directly attributable to acquiring the property.

Under the historical cost principle, the Property, Plant, and Equipment (PP&E) on Speedy Delivery Co.'s balance sheet would initially be recorded as follows:

• Land: $1,000,000
• Warehouse Building: $2,000,000 (purchase price) + $100,000 (closing costs) = $2,100,000

Even if, by January 1, 2025, the market value of the land has appreciated to $1,500,000 and the warehouse to $2,500,000 due to local development, Speedy Delivery Co. will continue to report these assets at their historical cost (minus any accumulated depreciation for the building) on its balance sheet. The financial records will not reflect the current market appreciation until the assets are sold or revalued under specific accounting standards that permit fair value adjustments.

Practical Applications

Historical cost is extensively applied across various aspects of financial reporting and analysis, particularly in how companies account for their tangible and some intangible holdings. It is most commonly seen in the valuation of long-lived tangible assets such as Property, Plant, and Equipment (PP&E), which includes land, buildings, and machinery⁸. These assets are recorded at their initial purchase price, including all expenses required to get them ready for use.

Another significant application is in the accounting for inventory. Companies typically record inventory at the cost incurred to acquire or produce it. This cost remains on the balance sheet until the inventory is sold, at which point it is expensed as cost of goods sold. The principle also extends to many liabilities, which are often recorded at the cash or cash equivalent amount of the obligation when incurred⁷. This provides a consistent and objective record of past transactions that is vital for auditors, investors, and other stakeholders.

Limitations and Criticisms

Despite its widespread use and advantages in verifiability, historical cost accounting faces several limitations and criticisms, primarily concerning its relevance in a dynamic economic environment. A major drawback is its failure to reflect current market values or the impact of inflation⁵, ⁶. An asset purchased years ago may have a significantly different economic value today due to appreciation, depreciation beyond systematic allowances, or changes in purchasing power. Critics argue that this can lead to financial statements that do not accurately represent a company's true economic position or the current value of its resources⁴.

Furthermore, historical cost accounting struggles with the valuation of certain intangible assets, such as brand recognition, customer lists, or internally developed intellectual property. Unless these assets are acquired through a verifiable market transaction (like a business acquisition where goodwill might be recognized), their significant economic value often remains unrecorded on the balance sheet, as there is no historical cost basis³. This can make financial statements less comprehensive, especially for companies in the knowledge-based economy where intangible assets constitute a large portion of their true worth.

Historical Cost vs. Fair Value

Historical cost and fair value represent two distinct approaches to asset and liability valuation in financial reporting. The fundamental difference lies in their measurement basis and the information they aim to provide.

While historical cost emphasizes the reliability of verifiable past transactions, fair value accounting seeks to provide more current information about assets and liabilities by reflecting their market-based value¹. The accounting world often employs a "mixed-attribute model," where both historical cost and fair value are used depending on the nature of the asset or liability and its intended use.

FAQs

Why is historical cost important in accounting?

Historical cost is important because it provides a reliable, objective, and verifiable basis for recording financial transactions. It ensures that the values presented on the balance sheet are based on actual, auditable costs rather than subjective estimations, contributing to the consistency of financial statements.

Does historical cost reflect the current market value of an asset?

No, historical cost generally does not reflect the current market value of an asset. It records the asset at its original purchase price. Market values can fluctuate significantly due to inflation, economic conditions, or changes in demand, which are not typically captured by the historical cost principle.

What types of assets are typically recorded at historical cost?

Most long-lived tangible assets, such as land, buildings, machinery, and equipment (Property, Plant, and Equipment), are initially recorded at historical cost. Inventory is also typically accounted for using historical cost.

Are there exceptions to the historical cost principle?

Yes, there are exceptions. Certain assets, such as marketable securities or derivatives, are often recorded at fair value rather than historical cost, especially if they are actively traded. Additionally, if an asset's value permanently declines below its historical cost, an impairment charge may be recognized, writing down the asset's value.

How does historical cost relate to a company's equity?

Historical cost impacts a company's equity indirectly through the valuation of its assets and liabilities. The assets, valued at historical cost (and adjusted for depreciation or amortization), contribute to the overall book value of the company, which is a component of shareholders' equity.