Principle 1: Historical Cost
Financial statements report companies’ resources at an initial historical or acquisition cost. Let’s assume a company purchased a piece of land for $1 million 10 years ago. Under GAAP, it will continue to record this original purchase price (typically called book value) even though the market value (referred to as fair value) of this land has risen to $10 million.
Why is such undervaluation of a company’s resources required?
It represents the easiest measurement method without the need for constant appraisal and revaluation. Just imagine the considerable amount of effort and subjectivity required to determine the fair value of all of General Electric’s resources (plants, facilities, land) every year.
Additionally, marking resources up to fair value allows for management discretion and subjectivity, which GAAP attempts to minimize by using historical cost.