What Is Historical Cost Principle?

When you buy assets for your small business, you need to account for them in your books. Recordkeeping for assets doesn’t need to be difficult. The cost principle is a simple method for managing the value of your long-term assets.

What is historical cost?

With the cost principle, you record a business asset at its purchase amount. Track assets on the balance sheet at their cash values during the time you acquired them. You do not adjust an asset’s cost for changes in the market. You can also use the historical cost concept to record liabilities.

For example, you buy a piece of equipment for $500. The cost you record in your books reflects the original price ($500). You do not change the amount recorded if the market causes the equipment’s value to change.

What is the cost principle going to do for your business?

Your assets are a big deal no matter how small your business is. You need to know how to manage and account for them properly. The cost principle is a simple and reliable way to track assets.

The historical cost principle shows the actual amount you paid for an asset, ensuring that an objective cost was recorded. The price principle is based on past transactions.

Issues with cost principle accounting

The cost principle might not always be the most useful way to value an asset. For some assets, the price principle doesn’t reflect what the asset is currently worth. If an asset belongs to a frequently fluctuating market, you might need to look at its fair market value.

Usually, historical cost accounting is more problematic with long-term assets. Long-term assets are items of value that you do not expect to convert into cash within one year. Examples of long-term assets include buildings, land, vehicles, and equipment.

Cost principle can be confusing when you’re selling long-term assets. The market value could have changed between the initial purchase and when you sell the item. The different values can make it harder to determine your company’s financial health. You must explain the different values in your financial statements.

The value of long-term assets tends to change over time. The cost principle might not reflect a current value of long-term property after so many years. For example, a building could be worth a different price now than it was 50 years ago.

On the other hand, short-term assets aren’t in your possession long enough to significantly change value. Market value should not dramatically affect the value of short-term assets, like inventory.

Cost principle and depreciation

You need to factor in depreciation when using the historical cost principle. Depreciation helps you offset the value of an asset over time on your tax return. You decrease the value of the asset in your books throughout the life of the asset.

Let’s say you buy equipment for $1,000, and it has a useful life of five years. With the cost principle, you record the initial purchase amount in your accounting books for small business.

Then, account for a depreciation expense each year of the equipment’s life. In this case, the depreciation expense would be $200 per year ($1,000 / 5 years). The balance sheet should reflect the historical cost minus accumulated depreciation each year.

Year 1$200
Year 2$200
Year 3$200
Year 4$200
Year 5$200

Cost principle vs. fair market value

There is more than one way to value an asset. Instead of using the cost principle, you can look at the market value. An asset’s market value is different than the amount recorded with the price principle.

Market value reflects the price of an item in the current marketplace. You report the value with estimated prices. The amounts show how much you could receive if you sold the assets.

Fair market pricing aims to make records more accurate and relevant. But, the method can be an issue if the market is constantly changing. Depending on the situation, you will want to use the cost principle or the fair market price to determine an asset’s value.

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This article has been updated from its original publication date of October 20, 2017.

This is not intended as legal advice; for more information, please click here.

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