How the Historical Cost Principle Affects Business Accounting
Historical Cost vs. Market Value of Business Assets
The historical cost principle is one of the basic principles of business bookkeeping. Essentially, the historical cost principle says that you record an asset at its historical cost when it was purchased.
How the Historical Cost Principle Works
A business asset is something of value that you buy for your business, like a computer or desk, and has two values: the cost (what you paid for it when you bought it) and its value or fair market value (what you could get for it if you sold it).
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.
The original cost can include everything that goes into the cost, including shipping and delivery fees, setup, and training. With a few exceptions (stocks and bonds, for example), all other business assets are recorded using the historical cost principle. These assets can be anything from equipment and computers to vehicles, land, and buildings.
The cost of intangible assets, like copyrights, patents, and trademarks, is recorded as the cost of producing the asset. For example, the cost you paid for someone to create a trademark for your business, added to the cost of having an attorney register the trademark, would be major parts of the cost of that trademark.
Using the historical cost principle is not only good accounting, but is a standard for public companies (those selling their stock on public stock exchanges). 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 companies.
Historical Cost vs. Market Value
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.
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. This estimation changes the value of assets.
While mark to market asset valuation can help businesses get a more current value for assets, it may be dangerous in an economic downturn, lessening asset values.
Historical Cost vs. Asset Basis
For tax purposes, the IRS uses a term called "basis" for business assets as the actual cost of property. The cost includes expenses connected with the purchase, like sales tax, setup, delivery, installation, and testing.
Asset basis is used to calculate changes in the value of the asset for tax purposes from the following:
- Depreciation for physical assets.
- Amortization for intangible assets (like copyrights or patents).
- Casualty losses.
- Gains or loss on the sale or exchange of property.
Land doesn't depreciate and it (usually) can't be destroyed, so its value stays the same.
How Are Changes in Cost and Value Recorded?
For accounting purposes, assets change in cost through depreciation or amortization. The rate of change is set by accounting standards and is recorded in the business's balance sheet. To record a change, the historical cost is stated first, then the accumulated amount of depreciation/amortization for the period is shown, with book value at the end of the accounting period shown.
The amount of depreciation or amortization is shown on the business income statement as an expense.
The book value of an asset is its current value on the balance sheet. Book value is calculated by subtracting depreciation or amortization from the original cost of that asset.
|How an Asset is Recorded on a Business Balance Sheet|
|Furniture and Fixtures||$10,000|
|Less Accumulated Depreciation||$1,400|
|Book Value: Furniture and Fixtures||$8,600|
Don't confuse book value with an amount that you can sell an asset for. The selling price of an asset depends on many factors that aren't related to the book value. For example, if your business vehicle has been in an accident and you want to sell it, its condition would almost certainly not match the book value.
Why Is the Historical Cost Principle Important?
This cost principle is one of the four basic financial reporting principles used by all accounting professionals and businesses. It states that all goods and services purchased by a business must be recorded at historical cost, not fair market value.
Historical cost is important to people reading a balance sheet or analyzing the books (records) of a company. Historical cost is:
- Reliable:The process of showing historical cost on a business balance sheet is always the same. It doesn't change; it's reliable. This is important because anyone looking at a balance sheet can get a reliable picture of the assets of the business.
- Comparable: It's easy to compare the cost of one asset with another using the historical cost principle. This is important when making decisions about assets.
- Verifiable: It's also easy to verify historical cost because there are records underlying what's showing on the balance sheet.
The fact that everyone is using the same system makes it easier for everyone to know the exact value of business assets.