Why Fixed Assets Are Recorded at Historical Cost Rather Than Fair Market Value
The choice between recording fixed assets at historical cost or fair market value is a nuanced subject in accounting, especially when it comes to compliance with Generally Accepted Accounting Principles (GAAP). This article explores the reasons behind the preference for using historical cost while highlighting the potential challenges and the underlying principles guiding this practice.
The Importance of Consistency in Financial Reporting
Consistency is Key: By adhering to historical cost, companies ensure a consistent methodology in their financial statements, making it easier to track and compare their financial performance over time. Fair market value, on the other hand, can vary widely due to fluctuations in market conditions, leading to inconsistencies in year-to-year comparisons.
In terms of objectivity: historical cost is determined by actual transactions and is therefore a more concrete and less subjective measure. This objective measurement is crucial for maintaining transparency and reliability in financial reporting.
GAAP Relevance and Practicality
The principle of recording fixed assets at historical cost is fundamentally rooted in GAAP: Generally Accepted Accounting Principles. GAAP mandates the use of historical cost as it ensures that financial statements reflect the true economic substance of transactions, reducing the element of opinion in financial reporting.
Recording assets at fair market value requires the identification of a transaction, which may not always be feasible or practical. For instance, a company would not want to sell its fixed assets annually to recalculate their value, as this would disrupt its operations and record-keeping. Without a transaction, there is no fair market value to be recorded.
The Historical Cost Principle and Its Challenges
Historical Cost vs. Fair Market Value: The Example of Land: The Historical Cost Principle, although beneficial for maintaining consistency, presents challenges, particularly with regard to assets like land. The value of land often increases over time, whereas the book value remains at the historical purchase price, leading to discrepancies in the asset's true market value. For example, buying a plot of land in Los Angeles or New York during the 1930s for $500 would result in a significant undervaluation using historical cost.
The Matching Principle and the Nature of Assets
The underlying matching principle of accounting emphasizes the need to match costs with the revenues they are expected to generate. The assets listed on a balance sheet, excluding cash and its equivalents and accounts receivable, are essentially cost residuals. The objective of financial accounting is to match costs and revenues over time, not to reflect fair market value at the point of the entry into the balance sheet.
Inventory, prepaid expenses, fixed assets, and intangibles are held with the expectation that they will generate future revenue or support ongoing operations. These assets are valued based on their anticipated benefit, not on their market value in an exchange context. For example, if a company purchases a piece of equipment, its value is recorded at the purchase price with the understanding that the equipment will generate revenue over its useful life.
Financial statements are designed to reflect the economic reality of a business’s operations, not its short-term market fluctuations. Historical cost provides a more stable and reliable basis for financial reporting, ensuring that the financial information presented is aligned with the actual transactions and commitments of the business.
In conclusion, the preference for Fixed Assets being recorded at historical cost rather than fair market value is driven by the need for consistency, objectivity, and adherence to GAAP. While the Historical Cost Principle does pose challenges, especially in the case of assets like land, it remains the most reliable and practical approach for maintaining the integrity and usefulness of financial statements.