What Is a Historical Cost?
A historical cost is a measure of value used in accounting in which the value of an asset on the balance sheet is recorded at its original cost when acquired by the company. The historical cost method is used for fixed assets in the United States under generally accepted accounting principles (GAAP).
Key Takeaways
- Most long-term assets are recorded at their historical cost on a company's balance sheet.
- Historical cost is one of the basic accounting principles laid out under generally accepted accounting principles (GAAP).
- Historical cost is in line with conservative accounting, as it prevents overstating the value of an asset.
- Highly liquid assets may be recorded at fair market value, and impaired assets may be written down to fair market value.
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Understanding Historical Costs
The historical cost principle is a basic accounting principle under U.S. GAAP. Under the historical cost principle, most assets are to be recorded on the balance sheet at their historical cost even if they have significantly increased in value over time. Not all assets are held at historical cost. For example, marketable securities are recorded at their fair market value on the balance sheet, and impaired intangible assets are written down from historical cost to their fair market value.
Valuing assets at historical cost prevents overstating an asset's value when asset appreciation may be the result of volatile market conditions. For example, if a company's main headquarters, including the land and building, was purchased for $100,000 in 1925, and its expected market value today is $20 million, the asset is still recorded on the balance sheet at $100,000.
Asset Depreciation
Furthermore, in accordance with accounting conservatism, asset depreciation must be recorded to account for wear and tear on long-lived assets. Fixed assets, such as buildings and machinery, will have depreciation recorded on a regular basis over the asset's useful life. On the balance sheet, annual depreciation is accumulated over time and recorded below an asset's historical cost. The subtraction of accumulated depreciation from the historical cost results in a lower net asset value, ensuring no overstatement of an asset's true value.
Asset Impairment vs. Historical Cost
Independent of asset depreciation from physical wear and tear over long periods of use, an impairment may occur to certain assets, including intangibles such as goodwill. With asset impairment, an asset's fair market value has dropped below what is originally listed on the balance sheet. An asset impairment charge is a typical restructuring cost as companies reevaluate the value of certain assets and make business changes.
For example, goodwill must be tested and reviewed at least annually for any impairment. If it is worth less than carrying value on the books, the asset is considered impaired. If it has risen in value, no change is made to historical cost. In the case of impairment, the devaluation of an asset based on present market conditions would be a more conservative accounting practice than keeping the historical cost intact. When an asset is written off due to asset impairment, the loss directly reduces a company's profits.
Mark-to-Market vs. Historical Cost
The mark-to-market practice is known as fair value accounting, whereby certain assets are recorded at their market value. This means that when the market moves, the value of an asset as reported in the balance sheet may go up or down. The deviation of the mark-to-market accounting from the historical cost principle is actually helpful to report on held-for-sale assets.
An asset's market value can be used to predict future cash flow from potential sales. A common example of mark-to-market assets includes marketable securities held for trading purposes. As the market swings, securities are marked upward or downward to reflect their true value under a given market condition. This allows for a more accurate representation of what the company would receive if the assets were sold immediately, and it is useful for highly liquid assets.
What Is Historical Cost?
Historical cost is the price paid for an asset when it was purchased. Historical cost is a fundamental basis in accounting, as it is often used in the reporting for fixed assets. It is also used to determine the basis of potential gains and losses on the disposal of fixed assets.
What Is the Difference Between Historical Cost and Fair Market Value??
Historical cost is the cash or cash equivalent value of an asset at the time of acquisition. Fair market value is the current value of that asset. Imagine if someone were to have purchased an acre of land 10 years ago for $10,000 and that land is now worth $20,000. The historical cost is $10,000, and the fair market value is $20,000.
How Are Historical Costs Used in Accounting?
GAAP requires that certain assets be accounted for using the historical cost method. Fixed assets are recorded at their cost at the time of purchase. Inventory is also usually recorded at historical cost, though inventory may be recorded at the lower of cost or market.
How Do I Calculate Historical Cost?
Historical cost is often calculated as the cash or cash equivalent cost at the time of purchase. This includes the purchase price and any additional expenses incurred to get the asset in place and prepared for use.
What Is the Conservatism Principle?
The conservatism principle in accounting dictates that estimates, uncertainty, and financial record-keeping should be done in a manner that does not intentionally overstate the financial health of an organization. Historical cost is one way of adhering to the conservatism principle, as companies must report certain assets at cost and have a more difficult time exaggerating the value of the asset.
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Now, let's dissect the key concepts embedded in the article on historical cost:
1. Historical Cost:
- Definition: Historical cost is a fundamental accounting measure representing the original cost at which an asset is recorded on the balance sheet when acquired by a company.
- Application: Most long-term assets adhere to the historical cost method under U.S. GAAP, aligning with conservative accounting principles to prevent overstatement of asset values.
2. Historical Cost Principle:
- Significance: The historical cost principle, a cornerstone of U.S. GAAP, mandates recording assets on the balance sheet at their original cost, even if their market value has significantly increased.
- Exceptions: Marketable securities and impaired intangible assets may be recorded at fair market value to reflect their true worth.
3. Asset Depreciation:
- Purpose: Accounting conservatism necessitates recording asset depreciation to account for wear and tear on long-lived assets, like buildings and machinery.
- Recording: Annual depreciation accumulates over time and is subtracted from historical cost on the balance sheet, ensuring a realistic representation of net asset value.
4. Asset Impairment vs. Historical Cost:
- Definition: Asset impairment occurs when an asset's fair market value falls below its original historical cost on the balance sheet.
- Accounting Practice: Impairment charges are a form of restructuring cost, demonstrating a more conservative approach than maintaining historical cost when market conditions change.
5. Mark-to-Market vs. Historical Cost:
- Mark-to-Market: A fair value accounting practice, where certain assets are recorded at their current market value, deviating from the historical cost principle.
- Application: Useful for assets held for sale, such as marketable securities, providing an accurate representation of potential sales proceeds based on market conditions.
Additional Concepts:
- Difference Between Historical Cost and Fair Market Value:
- Historical cost: Original acquisition cost; Fair market value: Current value of the asset.
- How Historical Costs Are Used in Accounting:
- GAAP mandates historical cost for certain assets like fixed assets and inventory, ensuring consistency in reporting.
- Calculation of Historical Cost:
- Involves the cash or cash equivalent cost at the time of purchase, encompassing the purchase price and additional expenses to prepare the asset for use.
- Conservatism Principle:
- Dictates that financial reporting should avoid intentionally overstating an organization's financial health; historical cost aligns with this principle.
In conclusion, the article provides a comprehensive overview of historical cost, emphasizing its role in accounting, its principles, and its alignment with conservatism. The nuanced discussion on depreciation, impairment, and the interplay with fair market value enriches the understanding of these fundamental accounting concepts.
