What is Historical Cost Accounting?
Historical cost accounting is an accounting method that records assets and liabilities at their original acquisition or production cost, rather than their current market value or fair market value. It is based on the principle that financial transactions should be recorded at their original cost when they occurred, providing a reliable and verifiable basis for financial reporting.
Understanding Historical Cost Accounting
Historical cost accounting is a widely used method in accounting and finance, especially in traditional financial reporting frameworks. Here are some key points to understand about historical cost accounting:
- Original Acquisition or Production Cost: Historical cost accounting records assets at the price paid to acquire or produce them at the time of purchase or production. This original cost includes all expenses directly attributable to acquiring or producing the asset, such as purchase price, taxes, shipping costs, and installation fees.
- Stability and Reliability: Historical cost accounting emphasizes the stability and reliability of financial information by using objective and verifiable data. Since original acquisition or production costs are based on actual transactions and supported by documentation, they provide a credible basis for financial reporting.
- Conservatism Principle: Historical cost accounting aligns with the conservatism principle, which states that assets should not be overstated and liabilities should not be understated. By recording assets at their historical cost, this method ensures that financial statements reflect a conservative estimate of an entity’s financial position.
- Non-Market Valuation: Unlike other valuation methods such as fair value accounting, which adjusts asset and liability values to reflect current market prices, historical cost accounting does not consider changes in market value. Instead, it focuses on the original cost incurred at the time of acquisition or production.
Application of Historical Cost Accounting
Historical cost accounting is applied across various financial reporting areas, including:
- Asset Valuation: Under historical cost accounting, assets such as property, plant, equipment, inventory, and investments are recorded on the balance sheet at their original cost. This provides a reliable basis for measuring an entity’s investment in its resources.
- Depreciation and Amortization: Historical cost accounting requires the periodic allocation of the cost of assets with limited useful lives, such as property, plant, and equipment, through depreciation or amortization expenses. These expenses reflect the consumption or expiration of the asset’s economic benefits over time.
- Inventory Valuation: Inventory is typically valued at the lower of cost or market under historical cost accounting. This means that inventory is recorded at its historical cost or its current market value, whichever is lower, to prevent overstatement of asset values on the balance sheet.
Example of Historical Cost Accounting
Consider the following example to illustrate how historical cost accounting works:
ABC Company purchases a piece of machinery for $50,000 to be used in its manufacturing operations. The machinery has an estimated useful life of 10 years and no residual value. Under historical cost accounting:
- ABC Company records the machinery on its balance sheet at its original acquisition cost of $50,000.
- Each year, ABC Company records depreciation expense of $5,000 ($50,000 / 10 years) to allocate the cost of the machinery over its useful life.
- At the end of 10 years, the machinery’s carrying value on the balance sheet is $0, reflecting the full allocation of its cost through depreciation expense.
Conclusion
Historical cost accounting is an accounting method that records assets and liabilities at their original acquisition or production cost. It provides a stable and reliable basis for financial reporting by emphasizing objective and verifiable data. While historical cost accounting may not reflect current market values, it remains a widely used method in traditional financial reporting frameworks for its simplicity, objectivity, and conservatism.
Reference:
- Financial Accounting Standards Board (FASB). (2022). “Statement of Financial Accounting Concepts No. 5: Recognition and Measurement in Financial Statements of Business Enterprises.” FASB. Link