what is the meaning of Historical Cost in finance?

Last updated on January 27th, 2023 at 06:40 pm

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Author: Sarthak Bhalerao

Table of Contents

  1. What is Historical Cost?
  2. Historical Cost Principle
  3. 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.

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.