Historical cost

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In accounting, historical cost is the original monetary value of an economic item. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of acquisition. The balance sheet value of the item may therefore differ from the "true" value.

While historical cost is criticised for its inaccuracy (deviation from "true" value), it remains in use in most accounting systems due to its simplicity, ease of use and verifiability. Various corrections to historical cost are used, many of which require the use of management judgment and may be difficult to implement or verify. The trend in most accounting standards is a move to more accurate reflection of the fair or market value, although the historical cost principle remains in use, particularly for assets of little importance.

Depreciation affects the carrying value of an asset on the balance sheet. The historical cost will equal the carrying value if there has been no change recorded in the value of the asset since acquisition. Improvements may be added to the cost basis of an asset.

Historical cost does not generally reflect current market valuation. Alternatives to historical cost accounting, which may be applied for some types of assets for which market values are readily available, require that the carrying value of an asset (or liability) be updated to the market price (mark-to-market valuation) or some other estimate of value that better approximates the real value. Accounting standards may also have different methods required or allowed (even for different types of balance sheet assets or liabilities) as to how the resultant change in value of an asset or liability is recorded, as a part of income or as a direct change to shareholders' equity.

[edit] Historical cost calculation

Historical costs that are used as values for assets and liabilities are often just the actual purchase cost of a given item. But modifications to purchase cost are necessary for some types of assets and liabilities.

[edit] Fixed assets

Historical cost is the actual purchase price plus incidental costs incurred in getting the fixed asset in a condition and position ready for initial use / commercial production.

• Land: Purchase price + legal fees + costs on leveling, grading, draining, clearing + mortgages, liens, encumbrances + additional permanent improvements (e.g. pavements, sewers, landscaping) - any proceeds from getting the land ready for its intended use (e.g. sale of cleared timber or materials from demolished buildings).

• Building: Purchase price + legal fees + and costs incurred in respect of major improvements / alterations / betterments.

• Machinery: Purchase price (net) + freight + shipping + loading & unloading + installation charges + commissioning (expenses on trial run and experimental production).
• Furniture & Fixtures: Purchase price (net) + installation charges.
• Vehicles: Purchase price + registration charges + cost incurred on accessories.

[edit] Special cases

• Discounts should be considered a reduction in the purchase price.
• If an asset has been received in consideration of issuing shares / bonds or notes payable, historical cost is recorded at fair market value of shares / bonds or notes payable. For example: machinery is bought in return of 10,000 shares which have a market value of $12 each at that time, then the historical cost of the machinery is $120,000 (any subsequent change in the value of those shares is accounted for separately).
• If a group of assets are purchased for a single lump sum, the cost paid is allocated among various assets on the basis of their fair market value.
• If an asset has been received in exchange for another non-monetary asset, historical cost is recorded as the fair market value of the asset given up or the asset acquired whichever is more evident.

[edit] Costs after acquisition

In general, costs incurred to improve an asset should be capitalized (that is, added to the historical price), whereas expenditures that simply maintain a given level of services should be treated as ordinary expenses. In order for cost to be capitalized, one of these conditions must be met:

• the useful life of the asset must be increased
• the quality of units produced from the asset must be increased
• the quantity of units produced must be increased.

[edit] Depreciation

[edit] Historical cost principle

Under U.S. generally accepted accounting principles (US GAAP), the historical cost principle dictates that most assets and liabilities should be recorded at their historical cost. For example, a tract of land which was purchased 40 years ago for $10,000 may be worth $1 million today, but it will be recorded on the balance sheet at its historical cost of $10,000. The historical cost principle is used because of its reliability and freedom from bias when compared to the fair market value principle.

[edit] Adjustment for current valuation

In the US, the Financial Accounting Standards Board allows current valuation for certain assets such as marketable securities, impaired assets, and derivatives.^[1]

In contrast to US GAAP, under UK GAAP firms may revalue assets based on appraised market values. This can result in the recognition of unrealized gains as income.

[edit] Adjustment for inflation

As PwC described it in a paper on accounting in hyperinflationary environments:

Financial statements unadjusted for inflation in most countries are prepared on the basis of historical cost without regard to changes in the general level of prices. The individual assets, liabilities, shareholders’ equity, revenue, expenses and gains and losses are therefore stated at cost at the time at which these items were originated. The impact of inflation is ignored. This produces a meaningful result provided that there are no dramatic changes in the purchasing power of money. Significant changes in the purchasing power of money mean that financial statements unadjusted for inflation are likely to be misleading. Amounts are not comparable between periods, and the gain or loss in general purchasing power that arises in the reporting period is not recorded. Financial statements unadjusted for inflation do not properly reflect the company’s position at the balance sheet date, the results of its operations or cash flows.^[2]

During periods of severe monetary inflation, such as during the 1970s in the United States, accounting standard-setting bodies such as the Financial Accounting Standards Board have considered various new ways to present financial information. In the United States, as in all low inflationary economies, financial information regarding historical cost items are not adjusted for inflation.^[3]

It is accepted in low inflationary economies that the historical cost model will undermine the accuracy of financial statements whenever inflation is non-zero, which means always. When inflation is low or moderate however, the inaccuracy is considered insufficiently important to warrant applying other methods. The IASB requires that hyperinflation accounting methods be used whenever cumulative inflation over a three-year period is greater than 100%. This limit has been criticized as too high and arbitrary.^[4][5]

[edit] Notes and references