Historical Cost: Definition, Principle, and How It Works

What Is a Historical Cost?

A historical cost is a measure of value that's used in accounting. The value of an asset on the balance sheet is recorded at its original cost when it's acquired by the company. The historical cost method is used for fixed assets in the United States under generally accepted accounting principles (GAAP).

Understanding Historical Costs

The historical cost principle is a basic accounting principle under U.S. GAAP. Most assets are to be recorded on the balance sheet at their historical cost under the historical cost principle even if they've significantly increased in value over time.

Not all assets are held at historical cost. 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.

Valuing assets at historical cost prevents overstating an asset's value when asset appreciation may be the result of volatile market conditions. The asset would still be recorded on the balance sheet at $100,000 if a company's main headquarters, including the land and building, was purchased for $100,000 in 1925 and its current expected market value is $20 million.

Asset Depreciation

Asset depreciation must be recorded to account for wear and tear on long-lived assets in accordance with accounting conservatism. 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.

Asset Impairment vs. Historical Cost

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. An asset impairment charge is a typical restructuring cost as companies reevaluate the value of certain assets and make business changes.

Goodwill must be tested and reviewed at least annually for any impairment. The asset is considered impaired if it's worth less than carrying value on the books. No change is made to historical cost if it's risen in value. The devaluation of an asset based on present market conditions would be a more conservative accounting practice than keeping the historical cost intact.

Mark-to-Market vs. Historical Cost

The mark-to-market practice is known as fair value accounting. Certain assets are recorded at their market value. The value of an asset as reported in the balance sheet may go up or down when the market moves. The deviation of the mark-to-market accounting from the historical cost principle is 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 includes marketable securities held for trading purposes. Securities are marked upward or downward to reflect their true value under a given market condition as the market swings. This allows for a more accurate representation of what the company would receive if the assets were sold immediately and it's useful for highly liquid assets.

The Bottom Line

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.

Historical cost prevents the overstating of an asset’s value in cases where appreciation is the result of market volatility. It’s one of the basic accounting principles used in the U.S. under generally accepted accounting principles (GAAP).