What is Historical Cost?
Historical cost is a key accounting concept that applies to the balance sheet generally, one of the three key financial statements prepared by a business.
Financial statements aim to provide a historical record of the finances of a company for a particular period (typically 1 year). An understanding of past performance helps stakeholders, such as investors, analysts and management, in predicting the future performance of a business.
One of the key financial statements is the balance sheet, which shows the assets, liabilities, and equity at the end of the most recent reporting period. The historical cost concept implies that the balance sheet represents a historical record of past transactions and their impact on assets, liabilities, and equity. This means that the amounts shown are unlikely to approximate market values. If an asset was purchased on the balance sheet date 10 years ago, then it may well be market value, but it is the market value at that point in time.
Key Learning Points
- Historical cost is a key accounting concept, which requires recording assets in the balance sheet at their historical costs even if their value may have changed over time. It is in line with the conservatism principle of accounting
- The principle prevents overstating or exaggerating the value of an asset in the balance sheet. For example, inventory is recorded at cost initially and not its potential resale value
- There are exceptions where assets are reported at their fair values and not at their historical cost. These exceptions include marketable securities and impaired intangible assets
Historical Cost and the Conservatism Principle
The historical cost concept is in line with the conservatism principle of accounting. Conservatism implies prudence when preparing financial statements. Under this principle, it is acceptable to record expected losses, but gains should be recognized only when they are certain. The principle prevents overstating or exaggerating the value of an asset in the balance sheet.
For example, inventory is recorded at cost initially even though its resale value is expected to be higher than cost. However, if it is expected that the inventory will need to be sold at a loss, then the amount on the balance sheet will be written down to the expected recoverable amount, to reflect this fact. So generally, with assets, decreases in value are recorded, whereas increases are not.
Exceptions to the Historical Cost Principle
There are some exceptions where assets are revalued from their historical cost. These include:
- In a mergers and acquisition (M&A) transaction
- For some financial assets, such as marketable securities
- Under IFRS, if a policy of revaluation is followed, it must be done consistently, and the assets must be revalued regularly
Here are some examples of assets, which are not recorded at their historical cost.
Marketable securities are highly liquid assets meaning they can be easily converted to cash at no loss of value. Marketable securities are included in all liquidity ratios as they are seen as “spare cash”. They are recorded at their fair value in the balance sheet and not at their historical cost.
Impaired Intangible Assets
Intangibles can be classified into definite life (e.g., trademarks or non-compete agreements) and indefinite life (e.g., goodwill). Definite life intangibles have a finite useful life, which is the basis of amortization calculation. Definite life intangibles may be impaired if the business believes that their fair value is lower than their carrying value on the balance sheet
Example: Historical Cost
Here is an excerpt from the 2018 annual report of Nestle, Inc. The footnote includes detail on the breakdown of property, plant, and equipment in the company’s balance sheet.
Nestle, Inc. – Extract from 2018 financial statements
Their owned assets include land. Under the rules of conservatism, the asset is reported at its book value. While it is not depreciated, it is likely that its value may have appreciated over time. It is likely the asset’s reported value is very different from its market value.