What is the Historical Cost Principle?
The Historical Cost Principle requires the carrying value of assets on the balance sheet to be equal to the value on the date of acquisition – i.e. the original price paid.
Historical Cost Principle
As one of the most fundamental elements of accrual accounting, the cost principle aligns with the conservatism principle by preventing companies from overstating the value of an asset.
U.S. GAAP requires companies to abide by the historical cost guideline for financial reporting to be consistent without the constant need for appraisals, which would lead to re-valuations and:
Historical Cost vs. Market Value (FMV)
The market value, in contrast to the historical cost, refers to how much an asset can be sold in the market as of the present date.
One of the prime objectives of accrual accounting is for the public markets to remain stable – but within reason, of course (i.e. reasonable volatility).
Contrary to that statement, if financials were reported on the basis of market values, the constant adjustments on the financial statements would cause increased market volatility as investors digest any newly reported information.
Historical Cost and Intangible Assets
Intangible assets are not permitted to be assigned a value until a price is readily observable in the market.
More specifically, the value of a company’s internal intangible assets – regardless of how valuable their intellectual property (IP), copyrights, etc. are – will remain off the balance sheet unless the company is acquired.
If a company undergoes a merger/acquisition, there is a verifiable purchase price and a portion of the excess amount paid over the identifiable assets is allocated towards the rights of ownership for the intangible assets – which is then recorded on the closing balance sheet (i.e. “goodwill”).
But note that even if the value of a company’s intangible assets are left out of a company’s balance sheet, the company’s share price (and market capitalization) does take them into account.
Historical Cost Example
For example, if a company spends $10 million in capital expenditures (CapEx) – i.e. the purchase of property, plant & equipment (PP&E) – the value of the PP&E will be unaffected by changes in the market value.
The carrying value of the PP&E can be impacted by the following factors:
- New Capital Expenditures (CapEx)
- PP&E Write-Up/Write-Down
From above, we can see that purchases (i.e. CapEx) and the allocation of the expenditure across its useful life (i.e. depreciation) impact the PP&E balance, as well as M&A-related adjustments (e.g. PP&E write-ups and write-downs).
Yet changes in market sentiment that bring a positive (or negative) impact on the market value of the PP&E are NOT among the factors that can impact the value shown on the balance sheet – unless the asset is deemed impaired by management.
Just as a side remark, an impaired asset is defined as an asset with a market value that is less than its book value (i..e the amount shown on its balance sheet).
Assets Exempt from Historical Cost
The majority of assets are reported based on their historical cost, but one exception is short-term investments in actively traded shares issued by public companies (i.e. held-for-sale assets like marketable securities).
The important distinction is the high liquidity of these short-term assets, as their market values reflect a more accurate representation of these assets’ values.
If the share price of an investment changes, then the value of the asset on the balance sheet changes, as well – however, these adjustments are beneficial in terms of providing full transparency to investors and other users of financial statements.