Question

In accounting we record many assets at their historical cost. As an example, if a business purchased a building in 2005 for $100,000, the financial statements would continue to show that building at $100,000 on its books (less depreciation). However, everyone knows that real estate generally increases in value over time. So wouldn't it be better to reflect on the balance the current the market value of the building as opposed to its historical cost? Why does using historical cost make from an accounting perspective?

Answer 1

The financial statements are prepared based on each transactions which has an equal impact of Debit and Credit. For example, the business is purchased building for $100,000 then cash at a worth of $100,000 should be paid that means $100,000 cash will go out of the business so the assets side will have a decrease of $100,000 and building with a value of $100,000 will come into business so the assets will increase with $100,000 on the balance sheet as a result, assets will have an equal balance where buildings are shown at $100,000 and cash account will show less of $100,000 in balance then only the balance sheet tallies.

It means that for every dollar we spend, the corresponding account should have the same impact as a result, the financial statements like balance sheet will get tally. For the same example, if the fair market value of the building is increased to $150,000 so the increased amount of $50,000 ($150,000 - $100,000) is shown on the balance sheet then the assets side of the balance sheet will show $50,000 excess due to this increase.

To avoid such instances, U.S GAAP requires all the financial statements to be prepared based on the Historic cost basis.

The auditors are also look for financial statements to be prepared based on historic cost basis to help in audits.