What Is a Historical Cost?
A historical cost is a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. The historical-cost method is used for assets in the United States under generally accepted accounting principles (GAAP).
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.
Breaking Down Historical Cost
Based on the historical-cost principle, under GAAP, most assets held on the balance sheet are to be recorded at the historical cost even if they have significantly changed in value over time. Not all assets are held at historical cost. For example, marketable securities are held at market value on the balance sheet.
- Most assets are recorded at the historical cost.
- Historical cost is one of four basic accounting principles.
- Historical cost prevents overstating the value of an asset.
The historical-cost principle is one of the four basic accounting principles. Valuing assets at historical cost prevents overstating an asset's value when asset appreciation may be the result of volatile market conditions. Furthermore, observing the conservatism constraint in accounting, any asset depreciation must be noted and compared to the asset's historical cost. This is true for many long-lived fixed assets such as buildings and machinery. On the balance sheet, annual depreciation is accumulated over time and recorded below an asset's historical cost. The subtraction of the total depreciation from the historical cost results in a lower net asset value, ensuring no overstatement of an asset's true value.
Independent of asset depreciation from physical wear and tear over long periods of asset uses, asset impairment may occur to certain assets, including intangibles such as goodwill. With asset impairment, an asset's market value has become worth less than what is originally listed on the balance sheet.
Asset impairment charge is a typical restructuring cost as companies reevaluate the value of certain assets and make business changes. In this case, 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.
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 would be 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.