If you’re a small business owner, bookkeeper, or accountant, you need to be aware of the basic principles of bookkeeping, such as the historical cost principle, to increase precision and improve accuracy in accounting and business finance. The historical cost principle asserts that you can only record an asset at the cost of its purchase. This cost principle plays a crucial role in your financial statements, indicating how much it cost you to buy an asset and helping you to estimate the value of your company.
What Is Historical Cost?
Historical cost is the original, or nominal, acquisition cost of your company’s assets. In essence, it’s the actual amount at you spend when buying and recording an asset. If the original cost of your company’s equipment is $500, the equipment would have a historical cost of $500.
What if you trade in one of your assets when buying another asset? Historical costs may include trade-ins, so you should record the initial cost of an asset plus the value of the property you trade in. For example, if you purchase a company car at $10,000 and trade in an old company car worth $2,000, then, the historical cost would be $12,000.
How Changes in Value of Assets Affect Historical Costs
But what should you do if the cost changes? As a small business owner, some of your assets would most definitely lose value over time. The historical cost principle recognizes such changes — depreciation and amortization — in the value of your assets. Depreciation is when your physical assets decrease in value, whereas amortization is the decrease of value in your firm’s intangible assets.
If your company’s furniture cost $10,000 on the day of purchase and it depreciates by $1,000 after one year, you need to minus the accumulated depreciation from the original purchase amount. The new book value, which is the value of your asset on the balance sheet, for your furniture is $9,000.
What Are the Benefits of Historical Costs to Small Businesses?
If you’re a responsible accountant or small business owner, you need to manage and track your firm’s assets in a standard way that everyone knows. The historical costs principle allows you to record the actual amount you spend on an asset minus accumulated depreciation. This makes it easier to know the current value of your business.
When you’re buying or selling your business, it’s important to know that all assets and liabilities are recorded in basic and agreed-upon accounting standards. You can easily tell how much you should buy or sell your company if the original cost remains constant and methods of calculating depreciation are standard.
As a small business owner, you need to put all measures in place to ensure that you’re ready for taxation. Knowing the historical cost for items you plan on selling in the future lets you plan ahead for taxes. You most obviously want to keep a reliable record of all of the original prices of all the items your business owns and the taxable income you would pay to the CRA if you sell the items.
Differences Between Historical Cost Principles and Fair Market Value
There’s more to one way to value your company’s assets. And one other way to record your assets is the fair market value (FMV). FMV refers to an estimate of the price your business property would change hands. In its simplest sense, FMV is the estimate of the price you would sell or buy a property in the market to a willing buyer or from a willing seller, respectively. You may also refer to this accounting principle as mark-to-market accounting.
If you’re a small business owner, you’re likely to have assets that change in value frequently. Take for instance your company’s marketable securities, such as stocks and bonds, which change in value every other day. As such, you would sell and buy the securities frequently as per the market dictates to make profits.
In the preceding example, you would want to use fair market value, rather than the historical cost principle, to record your assets. But what’s the benefit of FMV in comparison to the historical cost method? Fair value accounting takes into consideration the current market price and allows you to make corrections to the value of the marketable securities and other assets that change value frequently. This accounting approach gives you a truer picture of the value of your company.
The historical cost principle asserts that you record the original cost of an asset in your books of accounts. You would have to ignore inflation and the current market value of an asset when using historic costs. In some cases, you would have to use other methods of accounting, such as the fair market value, to record your firm’s assets. Use QuickBooks Online to keep your books accurate and up to date automatically, and change the way you manage your finances now.