Historical Cost

Historical cost is the amount of cash, or the fair value of other consideration, paid to acquire an asset at the time it was bought, including all costs needed to bring it to the condition and location for its intended use. Under the historical cost basis of accounting, many assets continue to be reported at that original amount, reduced over time by depreciation, amortization or impairment, rather than being revalued to current market prices. Liabilities are similarly recorded at the amount received in exchange for the obligation.

Historical cost is the measurement basis behind the cost principle, one of the long-standing conventions of US GAAP. Its main strength is reliability: the amount is based on an actual transaction and can be checked against invoices, contracts and bank records. Its main weakness is that it can become out of date, especially for long-lived assets such as land and buildings.

The cost of an asset includes more than its purchase price. For property, plant and equipment, it usually includes:

• The purchase price, after deducting trade discounts and rebates.
• Import duties and non-refundable purchase taxes.
• Delivery, handling and installation costs.
• Professional fees such as legal costs for a property purchase or engineering fees for setting up a machine.
• Testing costs needed to make sure the asset works properly, and, for assets built over time, certain interest costs during construction.

Costs of training staff, general overheads and losses from operating an asset below capacity are not included. Once an asset is in use, later spending is capitalized only if it improves the asset or extends its life; routine repairs are expensed.

In 2010, a company bought a warehouse for $1,800,000, paid $40,000 in legal fees and transfer taxes, and spent $160,000 on renovations before moving in. Its historical cost is $2,000,000, of which the company assigns $500,000 to land and $1,500,000 to the building. The building is depreciated over 30 years with no salvage value, at $50,000 a year. By 2026, after 16 years, accumulated depreciation is $800,000, so the building's carrying amount is $700,000 and the total property is carried at $1,200,000. An appraiser estimates the market value of the property at $3,400,000. Under the historical cost model, the balance sheet still shows $1,200,000, and the $2,200,000 difference is not recognized until the property is sold.

Modern accounting uses a mix of measurement bases. Historical cost dominates for inventory (subject to lower of cost and net realizable value), property, plant and equipment, and most intangible assets under US GAAP. Fair value, which reflects current market prices, is required for many financial instruments, such as trading securities and derivatives, and is explained through the fair value hierarchy. Some items are adjusted to market each period, a practice described in the entry on mark-to-market.

IFRS gives companies more choice than US GAAP. Under IAS 16, a company may adopt a revaluation model for a whole class of property, plant and equipment, carrying it at fair value less subsequent depreciation, with gains generally going to equity. Under IAS 40, investment property may be measured at fair value with changes in profit or loss. US GAAP does not permit upward revaluation of these assets.

Supporters of historical cost argue that it is objective, verifiable and less open to manipulation, since it does not depend on management's estimates of market prices. It also fits well with the idea of matching the cost of an asset against the revenue it helps earn over its life.

Critics argue that, in periods of inflation, historical cost understates the value of older assets, understates depreciation compared with what it would cost to replace them and therefore overstates real profits. It also makes companies that bought assets at different times hard to compare. In cases of hyperinflation, IFRS (IAS 29) requires amounts to be restated in current purchasing power because historical figures become almost meaningless. Analysts therefore treat historical cost figures as a starting point and consider market values, replacement costs and disclosures in the notes when judging what a company's assets are really worth on its balance sheet.