Last updated on August 2nd, 2024 at 11:09 pm
Author: Sarthak Bhalerao
Table of Contents
- What is Historical Cost?
- Historical Cost Principle
- Illustrative Example
What is Historical Cost?
The historical cost of an asset, in accounting terms under the U.S GAAP, is the original price at which it was purchased. The cost of all assets is recorded on the balance sheet at their historical cost. The transaction of any business is recorded at its historical cost. It is fairly easy to retrieve the original cost of any asset as long as all the records are kept properly. Trades, sales, and /or purchase documentation are used to determine the historical cost of any asset. However, the historical cost of an asset does not necessarily be equal to the fair value of the asset. The value of any asset is likely to deviate from its historical cost. For e.g., A share purchased for $10 may be less than/ greater than $10 in the foreseeable future.
Historical Cost Principle
The Historical cost principle states that a company or business must account for and record all the assets at the original cost. Any kind of adjustments to reflect fluctuation in the market are not made. This reflects on the usefulness and reliability of the asset. The historical price is not entirely useful in the long term. Knowing that a company might have bought an office for $20,000,000 10 years ago, does not provide an overview of the current fair value of the asset. In this scenario, the fair market value of the asset proves to be more useful. Since fair market values are an assumption and are subjective, the Financial Accounting Standards Board (FASB) is adamant about using the historical cost principle. The historical cost principle is also applicable to liabilities. For e.g., debt instruments are recorded in the balance sheet at their original cost price.
Integrating Intangible and Fixed Assets
The historical cost concept is equally applicable to both tangible and intangible assets. Intangible assets, such as patents, trademarks, and goodwill, are recorded at their original purchase price. Similarly, fixed assets like machinery, buildings, and equipment are recorded at their cost at the time of acquisition. Over time, these assets may become impaired, meaning their carrying amount exceeds their recoverable amount due to changes in market conditions. Asset impairment vs. historical cost reflects the difference between the asset’s book value and its fair market value. It’s important to note that historical cost accounting does not account for market fluctuations, making it less reflective of an asset’s current value compared to mark to market accounting.
Market Conditions and Asset Valuation
Market conditions play a significant role in the valuation of assets. While the historical cost principle provides a consistent method for recording assets, it may not accurately reflect the current market value of highly liquid assets or long-term assets. For example, marketable securities are recorded at their historical cost, but their market value can vary significantly over time. Similarly, held for sale assets are recorded at their historical cost until they are sold, which may not represent their fair market value. The distinction between historical cost and fair market value is crucial for understanding how historical cost principle works in different economic environments.
Implications for Future Cash Flow and Financial Reporting
Understanding the historical cost principle is vital for accurate financial reporting and forecasting future cash flow. The principle ensures that assets are recorded at their original purchase price, providing a clear historical record. However, it also means that the financial statements may not reflect the current market value of impaired assets. For instance, an asset purchased at a high value may become impaired over time due to market conditions, affecting future cash flow. This distinction between asset impairment vs. historical cost is critical for investors and analysts when assessing a company’s financial health. Similarly, the debate between mark to market vs. historical cost highlights the challenges in valuing assets accurately in fluctuating markets.
Illustrative Example
Roger owns an investment firm that has acquired various properties across North America. Assuming that inflation levels across the region have doubled over the recent years, the property investments are not worth anything close to what Roger spent on acquisition. The historical cost principle does not account for adjustments due to currency fluctuations. As a result, the financial statements will still record the value of the asset at the cost of purchase.
In addition to properties, Roger’s firm also holds marketable securities, highly liquid assets, and long-term assets. These assets are recorded at their original purchase price, regardless of current market conditions. For example, if Roger purchased marketable securities worth $1,000,000, their value on the balance sheet remains $1,000,000, even if the market value changes. Held for sale assets are similarly recorded at their historical cost until they are sold. The historical cost principle ensures consistency in financial reporting but may not always provide the most accurate reflection of an asset’s current worth.
Conclusion
The historical cost principle is a cornerstone of historical cost accounting under GAAP, ensuring that all assets and liabilities are recorded at their original purchase price. While this provides reliability and consistency, it may not always reflect the current fair market value of assets, particularly in fluctuating market conditions. Understanding the implications of the historical cost principle, including its application to both tangible and intangible assets, and the distinction between asset impairment and historical cost, is essential for accurate financial analysis and reporting.
