What is the Historical Cost Principle?
Cost Principle states that an asset should always be recorded at original buying price or cost and not the perceived value and therefore, any changes in the market value of the asset should not affect how they are represented in the balance sheet.
This is also known as the “historical cost principle”. Historical Cost Principle is better suited for short term assets since their values don’t get changed much in a short time. For a fixed asset, to correctly record, asset value over the years, accountants use depreciation, amortization, and impairment, etc.
Historical Cost Principle Example
Let’s say your firm has bought a machine. At the time of acquiring, the original cost of the machine was $100,000. Based on your business experience, you know that this machine can work for the next 10 years only and then its value will be nil. So, initially, your fixed asset will get debited (increased by $100,000 and cash will get credited by $100,000.
Since you know the machine will work for only 10 years that means its fair value gets depreciated each year. So, next year, your accountant can use straight-line depreciation and divide asset value by 10 to get depreciation value as $10,000 for each year. In next year, accounting for the asset will be the following:
There are other ways such as impairment. Let’s say a company bought another company for $1 million. But after 5 years, the value of the acquired company suddenly drops by half due to an issue. Then based on accounting principles, this company value can be impaired based on the current value.
We will review 2 examples related to the cost principle.
Example #1 – Google acquisition of YouTube
The first cost principle accounting example is the Google acquisition of YouTube. In 2006, Google bought YouTube for $1.65 billion as one of the biggest tech acquisitions in history. As per Cost Principal in the books of Google, the value of YouTube will be shown as $1.65 billion.
However, years after the acquisition, YouTube value increases by many folds because of the increase in its popularity and base increase because of the increase in internet users and net speed. But in the books of Google, its value remains at $1.65 billion. Usually, if the fair value of the asset is higher, then companies won’t increase the value of the asset.
Example #2 – Infosys acquisition of Panaya and Skava
Now lets us take the example of Infosys acquisition of Panaya and Skava. In Feb 2015, Infosys bought 2 companies ‘Panaya’ and ‘Skava’ for USD 340 million. Since the closing of the acquisition, Infosys has struggled with this deal. There were many allegations thrown related to the deal which has hampered these companies’ profiles because of that fair value of these companies reduced significantly.
From 2018, Infosys has started reducing the value of these companies by means of additional amortization and depreciation. As of now the current value of Panaya and Skava is shown as $206 million in Infosys books. This shows us that companies need to do a fair assessment of their asset regularly and if asset market value is going down then in the books their value needs to be reduced by additional depreciation, amortization, or asset impairment.
- Since assets need to be recorded at cost price hence it is very easy to use. You just need to enter the cost of the asset in accounting books.
- Since asset value is recorded as per books that cost can be rallied back from the invoice or any other means. Hence it can be easily verifiable.
- Since this is very easy to use, so it is a much cheaper way to record the journal entries.
- Since asset price will be changed over the years, so this method is not the accurate one as it is not showing the fair value of the asset.
- This method also doesn’t show the value of intangible assets example goodwill, customer value, etc. which could be a very crucial aspect of the asset. These intangible assets add a lot of value of the asset over time.
- If a company wants to sell its asset at that time of selling, there can be some confusion arise, because the market value of that asset, at which company wants to sell will be quite different than the book value of the asset.
Historical Cost Principle Limitations
- This method is most suitable for short term assets.
- If an asset is highly liquid or has some market value, then this method is not applicable. That asset should be listed as a market value rather than historical cost.
- The company’s financial investment accounting should not be based on the cost principle. Rather its value should be changed each accounting period based on market value.
Important Points to Note
- Cost Principle in accounting is easy to implement and cheap, but it has few limitations in terms of the fair value of an asset.
- It ignores any kind of inflation in the value of the asset.
- As already mentioned, financial investment should not be booked as per Cost Principle rather its value should get changed in each accounting period as per market value.
- As per Cost Principle in accounting, asset value should not get changed but GAAP allows the asset value to change based on their fair value. This can be done using asset impairment also.
This has been a guide to what is Cost Principle and its definition. Here we discuss historical cost principles examples along with its advantages and disadvantages. You can learn more about accounting from the following articles –