What is a historical cost?
Historical cost is a measure of value used in accounting in which the value of an asset on the balance sheet is recognized at its original cost when it is acquired by the company. The historical cost method is used for capital assets in the United States according to generally accepted accounting principles (GAAP).
Key points to remember
- Most long-lived assets are recorded at their historical cost in a company’s balance sheet.
- Historical cost is one of the basic accounting principles set out in generally accepted accounting principles (GAAP).
- The historical cost is consistent with prudent accounting, because it avoids overestimating the value of an asset.
- Highly liquid assets can be recorded at their fair market value and impaired assets can be reduced to their fair market value.
Understanding the historical cost
The historical cost principle is a basic accounting principle under US GAAP. Under the historical cost principle, most assets should be recorded on the balance sheet at their historical cost even if they have increased significantly over time. Not all assets are held at historical cost. For example, marketable securities are recorded at fair market value on the balance sheet and impaired intangible assets are reduced from historical cost to their fair market value.
The valuation of assets at historic cost avoids overestimating the value of an asset when the appreciation of the asset can be the result of volatile market conditions. For example, if the head office of a business, including land and building, was purchased for $ 100,000 in 1925 and its expected market value today is $ 20 million, the assets are still listed on the balance sheet at $ 100,000.
Depreciation of assets
In addition, in accordance with accounting conservatism, the impairment of assets must be recorded to account for long-term wear and tear. Fixed assets, such as buildings and machinery, will have their depreciation recorded regularly over the useful life of the asset. On the balance sheet, annual depreciation is accumulated over time and recorded below the historic cost of an asset. Subtracting the accumulated amortization from the historical cost results in a lower net asset value, which does not guarantee any overestimation of the real value of an asset.
Impairment of assets compared to historical cost
Regardless of the impairment of assets due to physical wear and tear over an extended period, impairment may occur for certain assets, including intangible assets such as goodwill. With the impairment of assets, the fair market value of an asset has fallen below what was initially recorded on the balance sheet. An asset impairment charge is a typical restructuring cost when companies reassess the value of certain assets and modify their activities.
For example, goodwill must be tested and reviewed at least once a year for any impairment. If it is worth less than the book value on the books, the asset is considered to be impaired. If it has increased in value, no change is made to the historical cost. In the event of impairment, devaluing an asset on the basis of current market conditions would be a more conservative accounting practice than keeping the historic cost intact. When an asset is written off due to an asset impairment, the loss directly reduces the profits of a business.
Mark-to-Market vs historical cost
The practice of measuring at market value is known as fair value accounting, whereby certain assets are recorded at market value. This means that when the market changes, the value of an asset as declared in the balance sheet can increase or decrease. The difference between market value accounting and the historical cost principle is actually useful for accounting for assets held for sale.
The market value of an asset can be used to predict future cash flows from potential sales. A common example of mark-to-market assets includes marketable securities held for trading. As the market moves, stocks are marked up or down to reflect their true value under a given market condition. This allows for a more accurate representation of what the business would receive if the assets were sold immediately, and is useful for very liquid assets.