Definition
Historical cost is a valuation method in accounting where assets are recorded at their original cost when purchased, regardless of changes in the market value over time. This cost includes the purchase price, transportation fees, installation costs, and other initial expenses necessary to get the asset ready for use. It’s a key principle of the Generally Accepted Accounting Principles (GAAP) and emphasizes reliability over relevance.
Key Takeaways
- Historical cost is a measurement in finance, referring to the original monetary value of an asset. This cost doesn’t change over time, in spite of market fluctuations or changes in value due to inflation.
- This accounting principle provides a clear, consistent value for assets and is less complicated to implement than other valuation methods. However, it doesn’t reflect the current market price or depreciation, which could lead to a significant difference between the asset’s recorded and actual value.
- The historical cost provides a baseline to calculate depreciation and amortization for long-term assets, which is significant for tax and financial reporting purposes. It’s a key component of the balance sheet, affecting the total value of an organization’s assets and their financial health.
Importance
Historical cost is a crucial concept in finance because it pertains to the original cost or purchase price of an asset, serving as a reliable and objective measure of value.
It’s important as it eliminates subjective pricing, ensures consistent reporting, and helps maintain accountability.
This term is heavily used in accounting for balance sheet calculations where assets are usually recorded at their initial purchase cost, acting as a basis for determining possible gains or losses upon the asset’s disposition.
It also aids in depreciation calculation for tangible assets.
Despite its limitations in failing to capture the current market value, it’s fundamental for decision-making, budgeting, and financial planning.
Explanation
Historical cost serves a significant role in finance and accounting as it is used for evaluating and recording business transactions. This concept is based on the value of assets and liabilities, which is recorded at their initial purchase prices.
By keeping track of the actual amount paid for an asset as opposed to its inflation-adjusted cost or potential selling price, businesses can maintain financial stability and transparency. By recording transactions at their historical cost, it also enables businesses to accurately track profits or losses when the asset is sold.
This method plays an important role in cost control and managerial decisions. Moreover, historical cost brings consistency and certainty into financial statements, making them easier to understand and compare over time.
This is crucial for investors and stakeholders as it contributes to a more precise evaluation of a company’s financial performance and economic reality. Although it may not necessarily reflect the current market value of an asset, it does provide a clear picture of what was paid for that asset, making historical cost a key measure of value in finance.
Examples of Historical Cost
Property Purchase: In 1990, a company purchased a piece of land that cost them $200,No matter what the current market price is, the company would still record the purchase at its historical cost of $200,000 in their financial statements. This land may now be worth $500,000, but the historical cost principle requires them to use the original purchase price.
Vehicle Depreciation: Suppose a business bought a truck for deliveries for $50,Even if the value of the truck decreases over time and it’s currently worth $25,000 in the market, the business continues to record the truck in its books at the original price of $50,
It will, of course, factor in the depreciation separately but the historical cost remains the same.Equipment: A restaurant purchases a commercial oven for $10,
Regardless of its current market price or value due to usage over time, the initial cost of $10,000 is maintained in the accounting books under the historical cost principle. Even if new models have come out and reduced the selling price of this model to $7,000, the historical cost for this oven in the books will still remain at $10,It will however record depreciation to demonstrate the oven’s decreasing economic value.
FAQs About Historical Cost
What is Historical Cost?
Historical cost refers to the original monetary value of an asset or liability. It represents the cost at the time of its acquisition or assumption and is generally recorded on the balance sheet at this value.
How is Historical Cost used in accounting?
Historical cost is used as the measurement base in traditional accounting. It involves recording assets and liabilities at the initial purchase price. The principle of keeping accounts at their purchase price is known as the Historical Cost Principle.
Does Historical Cost change over time?
Historical Cost does not usually change over time as it represents the original cost. Changes in market prices or inflation do not affect the Historical Cost of an asset. However, devaluation such as impairment or depreciation can reduce the carrying amount of the asset.
What is the significance of Historical Cost in financial statements?
Historical Cost provides a clear and objective measure of what a company has spent to acquire its assets. It allows a company to track its investments over time and provides valuable information to investors and creditors about management’s past investment decisions.
How does Historical Cost differ from Fair Market Value?
Historical Cost refers to the asset’s initial monetary value, while Fair market value represents the price that the asset could be sold for in the present day market. Thus, while the Historical cost remains constant, Fair market value of an asset changes with market conditions.
Related Entrepreneurship Terms
- Depreciation
- Asset Valuation
- Amortization
- Balance Sheet
- Accrual Accounting
Sources for More Information
- Investopedia: A comprehensive resource offering definitions, articles, and educational content on a wide range of topics including Historical Cost.
- AccountingCoach: A platform offering free accounts coaching and resources which cover finance terms like Historical Cost.
- Corporate Finance Institute (CFI): A certified provider of online financial modeling and valuation courses including topics such as Historical Cost.
- My Accounting Course: An online learning platform offering a range of accounting topics including definitions and explanations about Historical Cost.
