The practice of accounting records assets to the balance sheet initially at their cost of acquisition. This means that assets are initially booked at fair value. That is, they are recorded at their cash value in an otherwise arms-length transaction.

Assets may be acquired by companies with cash, on credit, via stock issuance or in a non-cash asset exchange (for example, a warehouse for another warehouse). Of course, the cost of an asset is easily determined when it is acquired with cash. When it’s not directly purchased with cash, generally accepted accounting principles (GAAP — note that the word “principle” in GAAP references a standard accounting method or rule of practice while the term “principle” in cost principle refers to a broad concept that underlies GAAP rules) provide for how a cash value is determined for the acquisition.

Further, the cost principle is sometimes referred to as the “historical cost” principle. That may sound a bit confusing. The meaning of “historical” is intended to communicate that once an asset has been recorded at its cost, that original cost is maintained on the balance sheet as the asset’s book value. When depreciation is taken over future years after the acquisition of a long-term fixed asset, it is an amount written off accounting period by accounting period that continues to be calculated as a portion of the original cost.

Thus, assets are recognized at their cost (or fair value) at acquisition. Thereafter, they continue to be valued based on their initial cost. So, while the cost was a current one at acquisition, it is carried into the future, making it a historical cost. Their are exceptions to the continuance of assets held by a company at valuations based on the original costs. For example, companies that invest company cash into securities like stocks or bonds are often required to adjust the investments to their current values at each subsequent balance sheet date.

Since asset valuations on corporate balance sheets are generally based on costs that occurred in the past, often well in the past, numbers used for assessment purposes toward investing in common stocks today clearly are unlikely to mimic a true picture of the current worth of the balance sheet. This does not mean the numbers are useless. Every investor is working with the same strengths and weaknesses inherent in accounting practices when evaluating risk and return. That is, it’s basically a level playing field when it comes to analysis of accounting numbers. Yet, a realization of broad assumptions and principles behind the numbers can make us better at using the numbers.