Definition of Historical Cost AccountingThis principle ignores the amount the asset could be sold for in the open market, called the fair value, until the asset is actually sold. The company carries the asset on the balance sheet at the purchase cost less any depreciation taken. At the time of sale, the company records a gain or a loss against the purchase cost of the asset less any depreciation if applicable. Historical Cost vs. Fair Value
Historical Cost Accounting ExampleFor example, if Sunny purchased an asset for $5,000 and estimated depreciation expense of $500 per year for 10 years, the cost of the asset after the first year less depreciation is $4,500. If the market value of the asset were $4,800 after year one in the open market, Sunny would not write up the asset after the first year. Rather, the asset would remain at original cost less any depreciation until the asset is sold. If Sunny sold the asset for $4,800 after year one, Sunny recognizes a realized gain of $300. Sale of Equipment
Therefore, assets on the balance sheet are recorded at historical costs until sold. Since everyone in the U.S. is currently required to follow the historical cost principle, users of financial statements understand where the asset values are coming from: the price originally paid for the asset (less any depreciation where applicable). Relevance vs. Reliability RevisitedThe historical cost principle follows the accounting quality of reliability since everyone can agree on the original purchase price of an asset. However, the historical price is not necessarily relevant information. Land that was purchased 20 years ago could be worth much more than the balance sheet shows. Likewise a building purchased many years ago and recorded on the balance sheet at the original cost does not reflect the current market price. For this reason, many accountants and users of financial statements argue that the market price, or fair value should be used when reporting financial information. The fair value is more relevant, but is not necessarily reliable. Selling the same item at different auctions will lead to a wide range of winning bids for the same item, and even professional appraisers will value an asset at a range of prices instead of a set value. Differences can involve the future use of the asset, assumptions about its useful life and output, and opinions and professional judgments that result in a range of values for an asset. Like so many professions, professional appraisers balance opinions and judgments with verifiable data. So although the market price, or fair value of an asset may be more relevant, it is less reliable. The reliability vs. relevance debate centers on one of the key issues in financial reporting and one of the major transitions currently underway in GAAP: the transition from historical cost to fair value.
Other countries, however, commonly write up assets to the market value. In order to make financial statements more uniform internationally, FASB is currently working with The International Accounting Standards Board (IASB) to follow consistent standards worldwide. As part of this project, FASB is recommending a transition from historical cost to fair value for some assets, which would create sweeping and somewhat controversial changes to how some assets are reported on the balance sheet as the reliability vs. relevance debate continues. Which is the Best Method for Financial Reporting: Historical Cost or Fair Value?
FASB has started a gradual convergence of financial reporting standards with the International Accounting Standards Board (IASB) to transition from the longstanding historical cost basis to fair value. Read What Others Say is the Best
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