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 ten years only, and then its value will be nil. So, initially, your fixed assetFixed AssetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. will get debited (increased by $100,000, and cash will get credited by $100,000.
Since you know, the machine will work for only ten years, which means its fair value gets depreciated each year. So, next year, your accountant can use straight-line depreciationUse Straight-line DepreciationStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. 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 five years, the value of the acquired company suddenly drops by half due to an issue. Then based on accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts., this company value can be impaired based on the current value.
We will review two 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 most significant 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 rise 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 two 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 using additional amortization and depreciation. As of now, the current value of Panaya and Skava is shown as $206 million in Infosys books. This case shows us that companies need to do a fair assessment of their asset regularly. 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 accountingAsset In AccountingAssets in accounting refer to the organization's resources that hold specific economic value and facilitate business operations, meet expenses, and generate cash flow. They create the company's worth and are recorded in the balance sheet. 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 exampleIntangible Assets ExampleSome of the most common intangible assets are logos, self-developed software, customer data, franchise agreements, Newspaper Mastheads, license, royalty, Marketing Rights, Import Quotas, Servicing Rights etc., goodwill, customer value, etc. which could be a very crucial aspect of the asset. These intangible assetsThese Intangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. 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 assetsShort Term AssetsShort term assets (also known as current assets) are the assets that are highly liquid in nature and can be easily sold to realize money from the market. They have a maturity of fewer than 12 months and are highly tradable and marketable in nature..
- 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. Instead, its value should be changed each accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. 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; instead, its value should get changed in each accounting period as per market value.
- As per the 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 –