Historical cost is an accounting principle that refers to the original nominal monetary value of an asset. It represents the amount paid to acquire the asset and includes any costs directly attributable to bringing the asset into working condition.
For example, if a company bought a piece of machinery for $50,000, that would be its historical cost. If an additional $5,000 was spent to install and get the machine working, then the total historical cost of the machine would be $55,000.
Historical cost is used in the calculation of depreciation for fixed assets (like equipment and buildings), and it’s the basis for inventory valuation in many accounting systems.
One important thing to note about the historical cost principle is that it doesn’t attempt to represent the current market value of an asset. An asset might be worth more or less than its historical cost due to factors like inflation, changes in market demand, or wear and tear. This is a limitation of the historical cost principle and is why some companies supplement it with other valuation methods, like fair value accounting, which aims to reflect the current market value of an asset.
Example of Historical Cost
Let’s consider an example of a business purchasing a delivery van for its operations.
Suppose that the company purchases the van for $30,000. This initial purchase price is the van’s historical cost. However, before the van can be used for business operations, it needs to have the company’s logo painted on it, which costs $2,000. It also needs $1,000 worth of internal modifications to carry the company’s specific type of goods.
The costs directly related to getting the van operational—the logo painting and internal modifications—are added to the initial purchase price. So, the total historical cost of the van would be $33,000 ($30,000 purchase price + $2,000 for painting + $1,000 for modifications).
This $33,000 would be the value at which the van is recorded on the company’s balance sheet as a fixed asset. It’s also the value that would be used to calculate depreciation expense over the van’s useful life.
It’s important to note that the historical cost of $33,000 doesn’t change on the company’s financial statements, even if the market value of the van decreases or increases over time due to factors like wear and tear or market demand changes. The only time the van’s recorded value would decrease under historical cost accounting is due to depreciation or if the van is identified as impaired, meaning its market value has decreased permanently below its book value.