What it means
The appeal of historic cost is that it is verifiable. There is an invoice, a bank payment and a contract behind every number, so two accountants looking at the same purchase will reach the same figure.
The weakness is that the balance sheet drifts away from economic reality over time. Property bought decades ago may sit at a small fraction of its current worth, making a business look far smaller and less asset-rich than it really is.
This matters commercially when a company borrows against its assets or is being valued for sale. Lenders and buyers usually commission separate valuations rather than relying on carrying values, precisely because the accounts are not trying to show market worth.
Accounting rules soften the pure historic cost model in several places. Inventory is written down to the lower of cost and net realisable value, impairment tests reduce assets that have lost value, and some standards permit revaluation of property or require fair value for financial instruments.
The result in practice is a mixed measurement model rather than pure historic cost. Reading a set of accounts well means knowing which lines are stated at old cost and which have been marked to a current value.
Inflation makes the problem worse the longer an asset is held, because depreciation is charged on money spent years ago while sales are earned in today's currency. That mismatch quietly overstates reported profit and understates the true cost of replacing the asset when it finally wears out.
In practice
Real-world examples.
Example
A family printing firm owns a workshop bought in 1998 for $250,000, now carried at $90,000 after depreciation. When the owners seek a $600,000 expansion loan, the bank ignores the carrying value entirely and commissions its own valuation, which comes in at $1,100,000.
Example
A software company capitalises development costs at the amount actually spent on staff time and licences. Even after the product becomes its main earner, the intangible asset stays at recorded cost less amortisation, so the balance sheet gives no clue to the product's commercial value.
Example
A retail group holds inventory at historic cost until a seasonal range stops selling. Because the rule is lower of cost and net realisable value, it writes the stock down from $480,000 to an expected $150,000 of clearance proceeds, showing that historic cost only ever moves downwards.
Think of it
“Historic cost records what you paid-the original price, not what something is worth now.
Formula
Calculation
Carrying value = original cost - accumulated depreciation - any impairment.
A manufacturer bought a site in 2005 for $1,200,000, split between land of $400,000 and buildings of $800,000. Land is not depreciated, and the buildings are depreciated on a straight-line basis over 40 years, giving annual depreciation of $800,000 / 40 = $20,000. After 20 years, accumulated depreciation is $20,000 x 20 = $400,000, so the buildings carry at $800,000 - $400,000 = $400,000. Total carrying value of the site is $400,000 of land plus $400,000 of buildings, which is $800,000. A surveyor values the same site today at $3,000,000, so the accounts understate its market worth by $3,000,000 - $800,000 = $2,200,000, and none of that difference appears anywhere in the profit and loss account.Case study
Seen in the real world.
Dunmoor Textiles is a fictional weaving business created here for illustration. Its balance sheet showed net assets of $1,900,000, most of it working capital, because a mill bought in 1987 was carried at just $140,000 after nearly four decades of depreciation.
When a competitor made an approach, the directors initially anchored on that book figure and considered an offer of $2,400,000 to be generous. An independent valuation then put the mill and its land at $4,600,000 on its own, largely because the surrounding area had been rezoned for housing.
The board rejected the offer and eventually agreed a sale at a far higher price. In this illustrative account nothing about the business had changed; the accounts had simply been doing the job they are designed to do, which is to record cost rather than estimate worth.
Watch out
Common mistakes.
- Reading net book value as an estimate of what an asset would sell for, when it is only unrecovered original cost.
- Assuming a fully depreciated asset is worthless, when many machines and buildings keep working and selling long after their carrying value reaches zero.
- Believing historic cost never changes, when impairment and inventory write-downs can reduce it at any reporting date.
Questions
People also ask.
Why do accounting rules still favour historic cost?
Because it is objective and easy to verify from source documents, which makes accounts harder to manipulate than estimates of current value.
Does historic cost accounting cope with inflation?
Poorly, since long-held assets and their depreciation charges are stated in old currency values while revenues are stated in today's, which tends to flatter reported profit.
When is fair value used instead?
Fair value is generally required for financial instruments and investment property, and it is permitted as a policy choice for property, plant and equipment under some frameworks.
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