Historical cost concept

The historical cost concept (also known as the cost principle of accounting) states that the assets and liabilities of a business should be presented in accounting records at their historical cost.

Historical cost is the amount that is originally paid to acquire the asset and may be different from the current market value of the asset. Let us assume, for example, that a herbal medicine company purchases a piece of land for growing herbs on it, paying $25,000 in cash. The company will enter $25,000 as the cost of the land in its accounting records. In a booming real estate market, the fair market value of the land five years later might increase to $35,000. Although the market price of land has significantly increased, the amount entered in the balance sheet and other accounting records would remain unchanged at the original cost of $25,000.

A similar presentation is also required for liabilities. Companies issue various liabilities (such as accounts payable, bills payable, notes payable, bonds payable, etc.) in exchange for goods and services. These liabilities are normally reported at their cost. For example, a company acquires a tract of land at an agreed price of $12,000 and issues a note payable amounting to $12,000 for the full payment. The amount of the note payable to be entered in accounting records would be $12,000.

Importance of historical cost concept

An important advantage of the historical cost concept is that the records kept on its basis are considered consistent, comparable, verifiable, and therefore reliable.

Any valuation basis other than historical cost may create serious issues for companies. For example, if a company uses current market value or sales value rather than historical cost, each member of the accounting department is likely to suggest a different value for each asset of the company.

Further, current market or sales value is not appropriate for entities that prepare their financial statements more than once a year. For example, companies that compute net income or prepare their balance sheet on a monthly basis would have to establish a new sales value for inventory and other assets at the end of each month, which is usually inconvenient.

Exceptions to the cost principle

When a company prepares its balance sheet, most of the assets are listed at their historical cost. However, some highly liquid assets are subject to the exception of the historical cost concept. For example, investments in debt or equity instruments of other enterprises that are expected to be converted into cash in the near future are shown on the balance sheet at their current market value. Similarly, accounts receivable are presented on the balance sheet at their net realizable value. Net realizable value is the approximate amount of cash that a company expects to receive from receivables at the time of their collection.

The logic behind reporting some liquid assets at their fair market or net realizable value is to provide more reliable information to the users of financial statements and help them predict the company’s future cash inflows and make appropriate decisions.

Examples of historical cost concept or principle

Let’s take a few examples for a better understanding of the historical cost concept:

1. Washington Company constructed a building at a cost of $45,000 in 2011. On December 31, 2024, the fair market value of the building is $65,000, but it still stands on the company’s balance sheet at its original cost of $45,000.
2. New York Company purchased a tract of land for $50,000 on January 1, 2015. Today, the fair market value of the land is $65,000. Although the economic value or market price of the land has increased, the company would continue reporting it at its historical cost of $50,000.
3. Lasani Stone Crushing Company purchased a piece of equipment for $10,000 several years ago. Today, the value of equipment is only $2,500, but the company would still report it at its original cost less accumulated depreciation.
4. Mexico Trading Company purchased 1,000 units of an item last quarter for $1 per unit. The current price of inventory is $1.25 per unit. The company would report the inventory at its purchase price of $1,000 and not at $1,250.