Understanding Historical Costs

Understanding Historical Costs

In accounting, a historical cost refers to a measure of value, where a company will record the value of an asset at the price it acquired that asset on its balance sheet. Most companies would record most of their long-term assets at historical costs. The concept of historical costs follows the conservatism principle in accounting (Also see Financial Accounting – Basic Principles, Conventions and Assumptions) as it helps to avoid business owners from overstating the assets’ values. If you are not sure about how you should use the concept of historical costs, do not hesitate to contact an accounting firm in Johor Bahru.

According to the principle of historical cost, companies should record most of their assets at their respective historical costs, although there is a significant increase in their values as time passes. However, there are some exceptions to this. As an instance, business owners should record marketable securities at fair market values. Also, they need to write down the cost of impaired intangible assets (Also see Introduction to Tangible and Intangible Asset) from their historical costs to their fair market values.

Besides, based on the conservatism principle in accounting, companies should record asset depreciation to account for the wear and tear of the assets that can be used long-term. Business owners need to record depreciation for fixed assets like machines and buildings regularly over their useful life. Then, they should accumulate the annual depreciation of those assets and record the amount below their historical cost on the company’s balance sheet. After deducting the accumulated depreciation from the historical cost, the net asset value will be lower, and this ensures that the company will not overstate the value of assets that it owns.

Now, let us look at the relationship between the impairment of assets and the historical costs. Impairment is not relevant to the depreciation of assets due to physical wear and tear after the company uses them for a long time. It is something that may happen to certain assets, which causes the fair market value of an asset (Also see Are Market Value and Book Value the Same?) to fall under the original cost that the company has recorded on its balance sheet. The amount charged due to the impairment of an asset is a typical restructuring cost incurred when a company reanalyses the value of its assets and makes some alterations in its business.

When impairment happens, compared to maintaining the same historical cost in the balance sheet, a more conservative accounting practice would be devaluating the assets according to current market situations. When the company write off an asset as a result of asset impairment, the loss will reduce its profits directly.

The relationship between the historical costs of the assets and the mark-to-market is also something that business owners should understand. Sometimes, people would call the mark-to-market as fair value accounting. By using this accounting method, business owners should record some of the assets at their market values. This indicates that in the balance sheet, the values of those assets may fluctuate as the conditions of the market changes. The deviation of this mark-to-market accounting can help in reporting the assets held for sale.

Business owners can use the market value of an asset to forecast the company’s future cash flow generated from potential sales. There are various mark-to-market assets, and a common example would be the marketable securities that the companies hold for trading purposes. Business owners will mark the securities upwards or downwards as the market fluctuates. This is for the companies to show the actual values of the securities under specific condition. By doing so, the representation about what they would get if they sell those assets straight away will be more accurate. This is very useful when the companies are dealing with the assets with high liquidity.