Historical cost is an accounting concept that values assets and liabilities at their original acquisition cost. This means that, for example, a company's buildings and equipment are recorded on the balance sheet at a price paid to purchase them. Historical cost is used in both financial accounting and managerial accounting.
The historical cost concept provides a consistent and objective basis for financial reporting. Assets and liabilities are recorded at their original cost, regardless of whether that cost is higher or lower than the current market value. This makes it easy for investors and other users of financial statements to compare companies' financial position and performance over time.
The historical cost concept is also important for managers because it provides a basis for deciding whether to replace or keep an existing asset. For example, suppose a company's equipment is aging and needs to be replaced. In that case, the decision to do so should be based on the cost of the new equipment minus the expected salvage value of the old equipment, not on the difference between the current market value of the old and new equipment.
Did you know? The cost incurred in the past or historical financial statements are classified as an actual cost in accounting. The actual cost of an asset includes the supplier-invoiced cost as well as delivery, installation, and testing costs.
How Does the Historical Concept Work?
The historical cost principle is the accounting rule that requires assets and liabilities to be recorded at their original cost. This cost is not updated for changes in market value or inflation. The historical cost principle is based on the idea that it is more objective and reliable to measure transactions using objective measures, such as money, than using subjective measures, such as opinion. This principle is also known as the cost principle of accounting.
Benefits of Historical Costs
The historical costs concept is an important accounting principle that requires businesses to record assets and liabilities at their original purchase price. This concept is important because it provides a consistent and objective way to value assets and liabilities, and this concept also ensures that financial statements are not misleading.
1. Historical costs are objective as they are based on facts, and this means that they are not influenced by personal opinion or bias. This is important as it provides users of financial statements with accurate and reliable information.
2. Historical costs are verifiable as they can be checked against records. This means that users of financial statements can be confident that the information contained therein is accurate.
3. Historical costs are reliable as they are not influenced by personal opinion. This means that users of financial statements can rely on the information contained therein.
4. Historical costs are consistent as they value assets and liabilities using the same method. This means that users of financial statements can compare information across businesses and over time.
5. Historical costs are relevant as they provide information that is useful to users of financial statements. This means that the information can be used to make decisions about investment, credit and other financial matters.
6. Historical costs are timely as they are based on information that is available when preparing financial statements. This means that users of financial statements can receive up-to-date information.
7. Historical costs are a true and fair representation of the financial position of a business. This means that they give a realistic view of a business’s assets, liabilities and financial performance.
8. Historical costs are understandable as they are based on simple and common accounting principles. This means that users of financial statements can easily understand the information contained therein.
9. Historical costs are flexible as they can be adapted to suit the needs of different users. This means that businesses can tailor their financial statements to meet the specific needs of their users.
10. Historical costs are economical as they are less expensive to prepare financial statements using the historical cost concept. This means that businesses can save money by using this accounting method.
Importance of Historical Cost to Businesses
The historical cost principle is important to businesses because it provides a consistent and objective basis for valuing assets and recording expenses. This principle is based on the idea that assets should be valued at their original purchase price and that expenses should be recorded when they are incurred.
This principle is important because it provides a consistent basis for financial reporting. For example, if a company purchases a piece of equipment for ₹7500,000, the company can depreciate the asset over its useful life. The historical cost principle would require the company to report the asset at its original cost, regardless of any changes in the asset's market value.
This principle is also important because it provides an objective basis for valuing assets. For example, if a company purchases a piece of equipment for ₹850,000, the company can depreciate the asset over its useful life and at the moment provides the true value of the asset also. The historical cost principle would require the company to report the asset at its original cost, regardless of any changes in the asset's market value.
The historical cost principle is a basic accounting principle that is important to businesses because it provides a consistent and objective basis for valuing assets and recording expenses.
Asset Impairment vs Historical Cost
Traditionally businesses have valued assets at the rate they were purchased. However, this had the disadvantage of the not reflecting its current value. This is where the asset impairment comes in. The concept of asset impairment is important in accounting because it allows businesses to account for the decrease in the value of an asset. This is important because it allows businesses to record the asset at its current market value rather than its historical cost. This can be important for tax purposes, as well as for financial reporting.
The main difference between asset impairment and historical cost is that asset impairment is based on the current market value of the asset, while historical cost is based on the original purchase price of the asset. This means that asset impairment can be a more accurate reflection of the true value of an asset.
Asset impairment is generally calculated using a fair value approach, and this means that the asset is valued at its current market value, less any costs to sell the asset. This approach is generally considered more accurate than the historical cost approach, as it considers changes in market conditions.
However, the asset impairment approach can be more complex and time-consuming than the historical cost approach. This is because businesses need to constantly monitor market conditions to determine the current market value of their assets.
For instance, ABC Ltd. is the owner of a car which was bought at ₹2,50,000 in 2018. After accounting for an accumulated depreciation of ₹50,000 over the past years, its book value is ₹2,00,000 in 2021. But the market value of the car is only ₹1,30,000. This difference of ₹70,000 is the asset impairment in this case .
Overall, the asset impairment approach is generally considered to be more accurate than the historical cost approach. However, the historical cost approach is simpler and less time-consuming.
Mark-to-Market vs Historical Cost.
The main difference between mark-to-market and historical cost accounting is that mark-to-market accounting values assets and liabilities at their current market prices, while historical cost accounting values them at their original prices.
Mark-to-market accounting is required by accounting standards for some financial instruments, such as derivatives. It is also used by some companies for other assets and liabilities, even though it is not required.
Historical cost accounting is the more traditional approach and is generally simpler. It is also less likely to result in large swings in the reported values of assets and liabilities.
Mark-to-market accounting can be more volatile as it is based on current market prices. This means that the reported values of assets and liabilities can fluctuate more depending on market conditions.
To understand the concept of MTM, we can use an example, ie. Suppose an investor purchases 100 shares of company A at ₹10 each. The total investment is going to be ₹1,000
At the end of the first day, the value of shares decreases to ₹9. Therefore the value for investment adjusts to MTM and turns ₹900, which is a loss of ₹100
Next, at the end of the second day, the value of shares rises to ₹12. Therefore, the value of the investment will be ₹1200 as there is a gain of ₹300 for the day but a net gain of ₹200 as an original investment.
On day 3, the share price goes up to ₹10. Now the investment value is ₹1,000 [loss of ₹200 but no net loss or gain for original investment]
Overall, mark-to-market accounting is generally considered to be more accurate than historical cost accounting. However, historical cost accounting is simpler and less volatile.
Also read: Cost Accounting vs Management Accounting
Historical costs can be adjusted to account for inflation, changes in the marketplace, or other factors. Additionally, companies may choose to depreciate assets over time to reflect their declining value. Adjusting historical costs is important to maintain accurate financial statements.
Some examples of historical cost include the original price of an asset, such as a piece of equipment, or the cost of a building. Other examples include the costs of labour and materials used to create a product or service. Historical cost can also refer to the value of an asset at the time it was acquired.
There are several exceptions to the cost principles, which include assets that are donated, leased, or purchased at a discount. Additionally, costs that are considered unallowable, such as those related to alcohol or politics, are not included in the calculation of historical cost.
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