Historical cost

Historical cost is the original amount paid to acquire an asset. For example, if a company buys a building for $5 million, the historical cost is $5 million. This is the standard basis for recording most assets under GAAP and IFRS. Historical cost is adjusted for depreciation and amortization as the asset is used, and may be tested for impairment if its value declines unexpectedly. Historical cost contrasts with fair value, which is the current market price. Historical cost is less volatile but may be outdated; fair value is current but can be uncertain.

Historical cost principle

The historical cost principle is fundamental to accrual-accounting. Assets are recorded at what the company actually paid for them, adjusted for allocation (depreciation) and any indication of decline in value (impairment).

Example: A company buys land for $1 million. Under historical cost, the land remains on the balance sheet at $1 million forever (adjusted if impaired). Even if the land is worth $10 million five years later, the balance sheet shows $1 million.

This is conservative: it avoids inflating asset values based on speculation about future market prices.

Historical cost vs. current market value

The advantage of historical cost is objectivity. What was paid is a historical fact; current market value requires estimation. However, the disadvantage is that historical cost becomes less relevant over time.

Consider two companies with identical property:

• Company A bought in 1980 for $1 million. Historical cost: $1 million.
• Company B bought in 2020 for $10 million. Historical cost: $10 million.

If both properties are now worth $12 million, the balance sheet shows very different values, even though the economic reality is the same.

Depreciation and amortization under historical cost

Historical cost assets are reduced by depreciation or amortization:

• Building cost: $10,000,000
• Accumulated depreciation: ($4,000,000)
• Net book value: $6,000,000

The net book value is what appears on the balance sheet. The net book value is objective (based on original cost and mechanical depreciation schedules) but likely differs from fair value.

Impairment testing under historical cost

If the value of a historical cost asset declines below its net book value, the asset must be tested for impairment. If fair value falls substantially below book value (e.g., a building is damaged, or equipment becomes technologically obsolete), the asset must be written down.

This represents the main exception to the pure historical cost principle: assets are not written up for appreciation, but they are written down for decline.

When fair value is required instead

Some assets must be measured at fair value, not historical cost:

• Trading securities: fair value with changes in income statement.
• Derivatives: fair value.
• Certain debt: fair value option available.
• Investment property (under IFRS): fair value option.

The choice of measurement basis is specified in the relevant standard and disclosed in footnotes.

Historical cost and conservatism

Historical cost is viewed as a conservative measurement basis. It avoids overstating assets and profits. A balance sheet with assets at historical cost is more conservative than one with assets at fair value (assuming prices have risen).

Conversely, historical cost can understate assets if prices have risen significantly, which is why many companies voluntarily disclose fair values of major assets in footnotes.

International perspectives

IFRS permits revaluation of property, plant, and equipment to fair value on a class-by-class basis. Companies can choose to measure buildings at fair value and update them annually. GAAP does not permit this (with minor exceptions).

This means US companies’ balance sheets tend to be more conservative (assets at historical cost) than international companies’ (which may include fair value revaluations).

Historical cost as an assumption in valuation

When investors value a company, they often adjust for the gap between book value (based on historical cost) and fair value. A company with old, long-depreciated assets may have book values far below current market value. Adjustments for these hidden values are common in investment analysis.

See also