The historical cost principle is one of the basic concepts of accounting and bookkeeping. It states that businesses must record and account for assets and liabilities at their historical cost or original cost at the time of its purchase or acquisition by a company.
Put simply, once the asset is recorded at its original cost on the balance sheet, it cannot be adjusted for any changes in its market value.
Importance of Historical Cost Concept
Records that are kept based on the historical cost principle are usually considered to be more consistent, reliable, verifiable, and comparable.
- Reliable: The process of recording the assets or liabilities on the balance sheet will always remain the same. It will not change, and users of the financial statements will get an accurate picture of the business every time.
- Comparable: It will be easier to compare the value of the assets when doing a comparative analysis of the various assets.
- Verifiable: All the cost figures will be a hundred per cent verifiable as there will be records available for the transactions of the purchase or acquisition of various assets.
If the records are kept on a fair value basis, this would create serious concerns for the company as each member of the accounting department will value the assets differently. This will increase subjectivity and reduce the consistency and reliability of the financial statements. It will also be highly inconvenient for those companies that prepare their financial statements more frequently such as monthly.
Exceptions to Historical Cost Principle
There are some exceptions to the historical cost principle which need to be mentioned. When a company prepares its balance sheet, most of its assets will be recorded at historical cost. However, some highly liquid assets need to be recorded at fair market value. The logic behind this is that these assets are more short term in nature and valuing them on a fair value basis or current value will give an accurate prediction of future cash flows of the company and will facilitate the users of financial statements in making operational level decisions.
For instance, investments in debt or equity securities are recorded on a current market value basis as they are expected to be converted to cash in the near future. Accounts receivables have to be shown on a net realizable value on the balance sheet. Net realizable value is the amount of cash that the company expects to receive when these receivable accounts are paid.
How the Historical Cost Principle Works
A business asset is something of value that a company purchases or acquires. It will have two kinds of value – cost and fair market value. The cost is the amount the company originally paid out to purchase the asset, whereas, the fair market value is the expected amount that the asset will sell for.
Market value is prone to change. A business asset will be worth more in good economic conditions and thus would be able to fetch a higher price as compared to selling the asset during a recession. Therefore, the market value will always be highly subjective. Historical cost, on the other hand, is fixed and is not based on perception or expectation of the value of an asset. Therefore, it is unarguably the better way to show assets or liabilities on a company’s balance sheet.
The original cost will include every expense that goes into the cost of acquiring an asset and setting it up for use. These include shipping and delivery, set-up cost, training cost, renovation/restoration cost, etc. The historical cost will appear on the balance sheet and would not change based on market expectations of its value.
The cost of intangible assets like copyrights, trademarks and patents will be recorded as the cost required to produce the asset. For instance, the cost of a trademark would include the cost of creating it, the added cost of an attorney registering it, etc.
Book Value of an Asset
The historical cost concept will recognize that there will be a change in the value of an asset due to obsolescence and deterioration amongst other reasons. These are recorded on the company books either by depreciation (for physical assets) or amortization (intangible assets). The book value of an asset can be calculated by subtracting the depreciation of amortization amount from the original cost of the asset.
Book value should not be confused with fair value. The fair value or market value of an asset is the value that the company is expected to receive for selling an asset. This will depend on various factors. For example, a company vehicle might have been in an accident and completely totaled. The book value or current value would still be showing the vehicle is worth something on the books. The market value would obviously be way lower since the vehicle is now out of order and would require significant repair work.
Examples of Historical Cost Concept
- Trump Inc. constructs a building for $5 million in 2005. It is still worth that on his books in 2020 and has not changed. The fair market value of that property is easily above $300 million in 2020.
- Levis Strauss purchases a piece of equipment worth $50,000 for one of its factories in 2015. Its fair market value in 2020 is around $15,000. However, the current value of the equipment on its books is $25,000 ($50,000 cost of equipment minus accumulated depreciation of $25,000 for 5 years).
- Kraft Foods buy a packaging machine for $60,000 and records it in the books in 2018. In 2020, the market value of that machine is $55,000. However, the company books show the current value of the machine for $50,000 ($60,000 cost of machine minus the accumulated depreciation over 2 years of $10,000).
- The Lakeland Bank purchases a piece of land for $500,000 on January 1, 2013. Today the fair market value of the land is roughly worth $6.5 million. The company will continue reporting the land at its historical cost of $500,000, despite the current market value of it increasing more than ten-fold.