Definition
Historical Cost refers to the original monetary value of an asset incurred by an organization. This cost remains unchanged on the company’s balance sheet regardless of market changes or inflation. The historical cost principle is a fundamental accounting practice that involves recording the acquisition cost of assets on the balance sheet without adjusting for market value fluctuations. This technique invaluates not only the cost of assets but also charges against profits through inventory valuation methods like First-In-First-Out (FIFO) or Average Cost. Similarly, it involves the application of depreciation methods where the original cost of an asset is expensed over its useful life in the profit and loss account.
Examples
Example 1: Purchase of Equipment
A company purchases a piece of machinery for $100,000. Under the historical cost method, this machinery is recorded on the balance sheet at $100,000, even if its market value appreciates or depreciates over time.
Example 2: Inventory Valuation
An organization in the retail business uses the FIFO method for inventory costing. If the first unit of stock was purchased at $10 and the second at $12, the cost of goods sold (COGS) when the first unit is sold would be $10, in compliance with the historical cost principle.
Example 3: Depreciation
A company buys a building for $1,000,000. Using historical cost accounting, the building remains recorded at this purchase price, and depreciation is charged based on this original cost over the asset’s useful life.
Frequently Asked Questions (FAQs)
Q1: Why is the historical cost principle important?
- Answer: The historical cost principle provides consistency and reliability in financial reporting. It ensures that the values reported for assets are based on verifiable and objective transactions.
Q2: How does historical cost differ from fair value?
- Answer: Historical cost values assets based on their original purchase price, while fair value measures assets based on their current market value or the amount they could be sold for in an open market.
Q3: Can historical cost provide an accurate representation of an asset’s current value?
- Answer: No, historical cost reflects the original purchase price of an asset and does not account for market changes, hence it might not represent the current value of the asset.
Q4: How do historical cost accounting and inflation interact?
- Answer: Historical cost accounting does not adjust for inflation, which means assets’ book values remain at their acquisition cost, potentially understating the value in an inflationary environment.
Q5: What are the limitations of historical cost?
- Answer: The main limitations include its failure to reflect current market values and inflationary impacts, which can result in undervaluation or overvaluation of assets in financial statements.
Related Terms
- Original Cost: The purchase price or the amount incurred to bring an asset to its present state.
- First-In-First-Out (FIFO): An inventory valuation method where the cost of the oldest inventory is charged first.
- Average Cost: An inventory valuation method where the cost is determined by averaging the cost of similar items.
- Profit and Loss Account: A financial statement that summarizes revenues, costs, and expenses during a specific period.
- Depreciation: The systematic expensing of the cost of an asset over its useful life.
- Current Cost: The cost that would be incurred to replace an asset currently in a similar condition.
Online Resources
Suggested Books for Further Studies
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso.
- “Fundamentals of Financial Accounting” by Fred Phillips, Robert Libby, and Patricia Libby.
- “Financial Accounting” by Walter T. Harrison Jr. and Charles T. Horngren.
Accounting Basics: “Historical Cost” Fundamentals Quiz
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