The Historical Cost Principle and Business Accounting

Historical cost measures the value of an asset for accounting purposes but not all assets are held this way. Marketable securities and impaired intangible assets are recorded at their fair market value. An impairment may occur to certain assets, including intangibles such as goodwill, independent of asset depreciation from physical wear and tear over long periods of use. An asset’s fair market value has dropped below what’s originally listed on the balance sheet with asset impairment.

In other words, businesses have to record an asset on their balance sheet for the amount paid for the asset. The asset cost or price is then never adjusted for changes in the market or economy and changes due to inflation. The Historical Cost Convention is an accounting concept that states that assets and liabilities should be reported on a company’s balance sheet at their original cost, regardless of any changes in value. This method of valuation ensures consistency in financial reporting by allowing companies to compare current asset values with historical costs over time. In accounting, the historical cost of an asset refers to its purchase price or its original monetary value. Based on the historical cost principle, the transactions of a business tend to be recorded at their historical costs.

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Inventory is also usually recorded at historical cost although it may be recorded at the lower of cost or market. The exception to historical cost is used for financial instruments like stocks and bonds, which are usually recorded at their fair market value. It’s sometimes called mark to market accounting because it values an asset at current market value. The cost principle might not reflect a current value of long-term property after so many years. For example, a building could be worth a different price now than it was 50 years ago. Since fair market values and replacement costs are left up to estimates and opinions, the FASB has decided to stick with the historical cost principle because it is reliable and objective.

1. Company B purchased a similar plant for $200,000 on 31st December 2010.
2. In the U.S., the Financial Accounting Standards Board (FASB) has set standards, called Generally Accepted Accounting Procedures (GAAP), requiring the use of the historical cost principle.
3. The subtraction of accumulated depreciation from the historical cost results in a lower net asset value, ensuring that there’s no overstatement of an asset’s true value.
4. Historical cost has the disadvantage of not necessarily representing the actual fair value of an asset, which is likely to diverge from its purchase cost over time.

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Fixed assets such as buildings and machinery will have depreciation recorded regularly over the asset’s useful life. Annual depreciation is accumulated over time and recorded below an asset’s historical cost on the balance sheet. Marketable securities are recorded on the balance sheet at their fair market value and impaired intangible assets are written down from historical cost to their fair market value.

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This effect of the use of historical cost basis is best explained by way of an example. Market value accounting allows a business to make corrections to the value of certain types of assets by estimating the value of these assets based on what they think the price is at the current time. The cost you record in your books reflects the original price ($500).

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In the U.S., the Financial Accounting Standards Board (FASB) has set standards, called Generally Accepted Accounting Procedures (GAAP), requiring the use of the historical cost principle. The International Financial Reporting Standards Board (IFRS) sets similar standards for international service charge meaning companies. The historical cost principle (also called the cost principle) states that virtually all business assets must be recorded as the value on the date the asset was bought or assumed ownership. You need to factor in depreciation when using the historical cost principle. Depreciation helps you offset the value of an asset over time on your tax return.

Instead of using the cost principle, you can look at the market value. An asset’s market value is different than the best payroll software for accountants amount recorded with the price principle. Costs recorded in the Income Statement are based on the historical cost of items sold or used, rather than their replacement costs.