To describe the historical cost principle one would say that when valuing an asset, the original cost of the asset is used. The historical cost, or price paid, less any depreciation on the asset, is recorded when the asset is sold or disposed.
Generally Accepted Accounting Principle and the Historical Cost Principle
The concept of historical cost concerns itself only with the original purchase price of an asset. It ignores other cost considerations such as fair value, replacement cost, or current market value. Only the original price paid is considered.
The Generally Accepted Accounting Principle (GAAP) requires reporting of most assets on the balance sheet at historical cost. GAAP focuses heavily on reliability in the data reported on the balance sheet. Because historical cost is based on a reliable transaction that occurred, rather than speculated market value, the cost is considered very reliable. This level of reliability is the reason GAAP favors the historical cost principle for reporting assets.
Historical cost works well for long-term assets that are not expected to be sold immediately, but rather used throughout the assets life in the operation of the business. Such assets include property plant and equipment. Historical cost is not typically used for recording the value of stocks. This is because the value of stock is expected to change. Stocks may also be expected to be purchased and sold rather quickly. Stock is typically reported at it's market value or fair market value.
Using Historical Cost in Sale or Disposal of an Asset
When the historical cost principle is used, assets will remain at their historical value on the balance sheet until the time of their sale or disposal. For example, land purchased by company XYZ at a cost of twenty thousand dollars may increase in value and be worth forty thousand dollars, but it would remain on the books at the amount of twenty thousand dollars until it was sold. At the time of the sale, the increase in value is recorded as a gain on the asset.
Equipment purchased by company XYZ would remain on the balance sheet at historical cost. If at any time the equipment is sold, or disposed of, the transaction is recorded using the historical cost, less depreciation, and if there is a gain, or loss, on the disposal that would be recorded as well.
Disadvantages of the Historical Cost Principle
In order to describe the historical cost principle, keep in mind it is preferred by GAAP for recording of most assets on the balance sheet, the word reliability is often used. Because it is considered more reliable than fair, or market value. However, if there is a significant change in the value of an asset, it may be ignored and remain on the books at the historical value until its sale, or disposal. Substantial changes in the value of assets, whether these changes are gains, or losses, can remain unrecognized in the accounting records for significant lengths of time using the historical cost method. These unrecognized gains and losses can skew the value of business assets if they are substantial.
The concept used to describe the historical cost principle is that it concerns itself only with the original purchase price of an asset. It ignores other cost considerations such as fair value, replacement cost, or current market value. Only the price paid is considered in accounting transactions.
Rennett Stowe. flickr.com/photos/tomsaint/2987926396