Definition of Historical Cost
Historical cost accounting is accounting that involves reporting items at their historical cost (at the purchasing prices), not their market value. In other words, under this regime, the asset is recorded at the price that is paid at the time of the acquisition.
Under the historical cost accounting concept, accountants are supposed to record revenue, expenditure, and asset acquisitions at the historical cost – i.e. the actual amount of money received or paid to complete the transaction.
Explanation of Historical Cost Accounting
Under the principle of historical cost accounting, all assets in the company’s Balance Sheet are supposed to be paid when they are purchased.
Similarly, all liabilities are also supposed to be recorded based on the expected values paid when due. In other words, there is no adjustment for market value or inflation.
The historical cost principle is mostly applicable in order to record and measure the value of items, which have been disclosed in the Balance Sheet. Items mentioned on the Income Statement are not recorded in accordance with the historical cost concept.
In fact, all line items in the Income Statement are recorded at their fair value or market value. For example, revenue is recorded at the amount that is likely to be received, not the amount received.
Mostly, Fixed Assets like Property, Plant, and Equipment are recorded at historical cost. They are not recorded at the fair value or the market value of the particular item.
Example of Historical Cost Accounting
The concept of Historical Cost Accounting is illustrated in the following example:
Jerry Inc. purchased machinery worth $200,000 in 2019. However, due to the global shortage of steel, the prices of machinery increased to $300,000 in 2020.
In the same manner, Jerry had inventory worth $10,000 in their storage facility. However, due to floods, this inventory was damaged. It could no longer be sold for the price that would have been paid if the inventory was in proper condition. The accountants estimated the realizable value of the inventory to be $7,000.
In the scenario mentioned above, two types of assets are mentioned: Machinery, and Inventory.
As far as machinery is concerned, it is a Fixed Asset. Under the rules set by IFRS and GAAP, fixed assets are supposed to be recorded at their historical cost.
This implies that the machinery that was purchased in 2019 (equivalent to $200,000), would still be recorded at the same amount in the financial statements.
This would not be adjusted for the change in market value. However, the asset’s carrying value is supposed to reflect any depreciation that is charged on the asset. The base value will stay the same.
On the contrary, inventory is supposed to be recorded at a lower cost or net realizable value of the company.
Given the fact that the value of inventory had decreased as a result of the flood, the inventory needs to be adjusted to its fair value, i.e. the net realizable value. Since the net realizable value is lower than the cost of the inventory ($10,000), the inventory is going to be adjusted as such in the financial statements.
Advantages of Historical Cost
The historical Cost concept is widely used across business entities when preparing their financial statements. It has numerous advantages from the perspective of the company:
- The greatest advantage of the historical cost concept is that the users of the financial statements can know the exact and original value of the assets and liabilities. This means that assets in the financial statements are prepared with a proper idea regarding the assets, and how they are disclosed in the financial statements.
- Financial statements that are prepared using historical cost are relatively easier to prepare. This is predominantly because of the fact that estimating and constantly gauging the historical cost of different assets tend to be difficult from the perspective of the company. It saves the effort to carry out market research pertaining to the current price, or the market value of the financial items, as the historical cost is not subject to any future changes. It also enables quicker decision-making since generating financial reports tends to be easy and speedy compared to market values.
- From the stakeholder’s perspective, too, historical costs are termed to be more accurate because the shareholders know that there are fewer chances of error in finding out fair values of the given asset.
Therefore, it can be seen that verification of the value of assets, and liabilities on a cost basis is a much easier approach as compared to other market value approaches. It is easily comprehendible by the management, the accountant, as well as the auditors of the company.
Disadvantages of Historical Cost
Regardless of the convenience offered by the historical Cost concept, there are a couple of disadvantages associated with historical costs that need to be considered. These drawbacks are as follows:
- The cost of the asset recorded under the historical cost concept is fixed – the cost mentioned on the financial statements does not account for inflation or any changing prices. This might not present an actual value from the perspective of the company. Hence, financial statements that solely rely on historical cost accounting might not depict the company’s true and actual financial position.
- Historical Cost Accounting does not show the true value of the company. In fact, it only represents assets at the prices on the day when they are acquired. Since they deviate from their true value, that balance sheet prepared under historical cost concept might not be solely reliable from the perspective of the company.
- From an internal decision-making process, relying on historical cost might hamper the company from making better-informed decisions. For example, if the company has recorded fixed assets at a historical cost of $200,000, whereas the resale value of fixed asset is $500,000, the company would not know that the given asset can be sold for a price greater than $300,000 than what was mentioned in the Balance Sheet of the company.
Therefore, it can be seen that whilst historical cost does tend to be easy and convenient from the perspective of the company, these drawbacks raise a question mark pertaining to the efficacy of the historical cost concept, to say the least.
